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Rupert Hargreaves
Rupert Hargreaves
Articles (687)  | Author's Website |

Buffett, Birds, Bushes and Tech Stocks

Some legacy advice from the Oracle of Omaha

December 18, 2018 | About:

Over the past few months, volatility has returned to the market. In just a few weeks, all of the market's gains, accrued in the months after the Trump administration passed its landmark tax reforms at the end of last year, have been wiped out. There is now a very strong chance that the sell-off could continue and lead to a bear market of epic proportions.

I'm not in the business of trying to forecast bull/bear markets. Indeed, I've been around long enough to know that 90% of these forecasts are irrelevant anyway. No one can predict what the market will be doing a week, month or year from now.

However, what I do know is that it is important to keep a cool head when Mr. Market starts acting irrationally.

Buffett's birds

I think the closest example in history to what we have today is the dot-com bubble. Investors rushed to buy tech stocks at any price in the years before 2000, dumping all other assets and buying indiscriminately, paying excessive multiples for companies that had no chance of generating a profit for years. The environment in the past few years has been fairly similar, although I should say that it is not the same; there are some key differences.

With this being the case, I thought it might be interesting to go back and have a look at the advice Warren Buffett (Trades, Portfolio) gave his investors after the dot-com bubble popped in the year 2000. In his year-end letter to shareholders of Berkshire Hathaway (NYSE:BRK.A)(NYSE:BRK.B), the Oracle of Omaha gave his readers a lesson on how to value businesses, which has now become legendary advice in the world of value investing:

"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."

This statement is beautifully simple. The critical takeaway is that if you cannot estimate a company's future cash flows, you should not be investing.

That being said, it is the job of growth investors to estimate a company's future potential, and then invest accordingly. This type of investing is entirely legitimate, but must be labeled as speculative, as Buffett went on to say:

"At the other extreme, there are many times when the most brilliant of investors can’t muster a conviction about the birds to emerge, not even when a very broad range of estimates is employed. This kind of uncertainty frequently occurs when new businesses and rapidly changing industries are under examination. In cases of this sort, any capital commitment must be labeled speculative."

The problem is, Buffett explained, that the line between investment and speculation, which is always blurred "becomes blurred still further when most market participants have a recently enjoyed triumphs." Investors, "mesmerized by soaring stock prices and ignoring all else," piled into these enterprises.

Many investors, both experienced and inexperienced, were drawn in by "much loose talk about 'value creation.'" But there was no value being created:

"We readily acknowledge that there has been a huge amount of true value created in the past decade by new or young businesses, and that there is much more to come. But value is destroyed, not created, by any business that loses money over its lifetime, no matter how high its interim valuation may get."

Instead, what was taking place is what Buffett described as a "wealth transfer often on a massive scale:"

"What actually occurs in these cases is wealth transfer, often on a massive scale. By shamelessly merchandising birdless bushes, promoters have in recent years moved billions of dollars from the pockets of the public to their own purses (and to those of their friends and associates). The fact is that a bubble market has allowed the creation of bubble companies, entities designed more with an eye to making money off investors rather than for them. Too often, an IPO, not profits, was the primary goal of a company’s promoters. At bottom, the "business model" for these companies has been the old-fashioned chain letter, for which many fee-hungry investment bankers acted as eager postmen."

The parallels between this investing environment and that of today are uncanny.

Disclosure: The author owns shares in Berkshire Hathaway.

Read more here: 

Hedge Funds Set for Big Payoff With Microsoft 

The Permanent Portfolio and Permanent Returns 

Some Thoughts on the Art of Waiting 

About the author:

Rupert Hargreaves
Rupert is a committed value investor and regularly writes and invests following the principles set out by Benjamin Graham. He is the editor and co-owner of Hidden Value Stocks, a quarterly investment newsletter aimed at institutional investors.

Rupert holds qualifications from the Chartered Institute for Securities & Investment and the CFA Society of the UK. He covers everything value investing for ValueWalk and other sites on a freelance basis.

Visit Rupert Hargreaves's Website

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