Over the past few years, I've written a great deal about the process Warren Buffett (Trades, Portfolio) uses to find potential investments. One of the things I have learned writing about Buffett is that the Oracle of Omaha likes to keep things as simple as possible. This is the principle that sits at the core of his investment process. He is looking for investment ideas that are so obvious, they jump off the page.
As such, there's no need for detailed spreadsheets or discounted cash flow analysis. Such methods of valuation have their place on Wall Street, but they are highly subjective. They also rely on hundreds of different inputs, which can be adjusted or manipulated to provide a certain outcome. The more assumptions one plugs into an investment analysis, the higher the likelihood that one of the assumptions will be incorrect. This can have a knock-on effect on the rest of the calculation.
Keeping the process simple
Buffett has always strived to reduce the risk of this happening by keeping his process as simple as possible. One of the ideas that underpins Buffett's mentality on investing is Aesop's birds in the bush theory. Here's how Buffett described the theory in Berkshire Hathaway's (BRK.A, Financial) (BRK.B, Financial) 2000 letter to investors:
"Leaving aside tax factors, the formula we use for evaluating stocks and businesses is identical. Indeed, the formula for valuing all assets that are purchased for financial gain has been unchanged since it was first laid out by a very smart man in about 600 B.C. (though he wasn't smart enough to know it was 600 B.C.).
The oracle was Aesop and his enduring, though somewhat incomplete, investment insight was "a bird in the hand is worth two in the bush." To flesh out this principle, you must answer only three questions. How certain are you that there are indeed birds in the bush? When will they emerge and how many will there be? What is the risk-free interest rate (which we consider to be the yield on long-term U.S. bonds)? If you can answer these three questions, you will know the maximum value of the bush and the maximum number of the birds you now possess that should be offered for it. And, of course, don't literally think birds. Think dollars."
Birds in the bush
Trying to answer the question of how many birds are in the bush is the hardest of all. There are four ways investors can deal with this conundrum:
1. Ignore the challenge entirely and move on to a different investment
2. Use industry experience to try and guess using all available information
3. Guess without industry experience or available information
4. Use industry and management experience and detailed analysis of industry fundamentals and information gained from industry insiders.
The fourth solution is always going to be the best, but will be unrealistic for most investors. The third solution is equivalent to gambling or speculation, as this is placing a trade based on nothing but the hope that the stock might go up. The first solution is what Buffett would call putting the stock in his 'too hard pile.' This is probably the best solution for any investors who do not have the relevant industry or sector experience.
The second solution is probably the most straightforward for the vast majority of the investing community. It involves sticking with companies or sectors that one knows well and building a rough framework of these industries. Investors can use this framework to construct a general idea of how a company's growth could develop in the future. It's not a perfect solution, but it bridges the gap between knowing everything and knowing nothing.
However, when using this approach, it is also essential to buy the stock when it is trading as a deep discount to the estimate of entry to creditor account for the level of guesswork and uncertainty involved.
In conclusion, Buffett's example from 2000 can teach us that we shouldn't try if an opportunity is too hard to understand. Instead, we should only take an investment opportunity where the odds are in our favor and there's a reasonably high chance of being able to predict how many birds will emerge from the bush accurately.
