Warren Buffett (Trades, Portfolio) is a man known for his dry wit and keen insights on value investing. One of the reasons why Berkshire Hathaway (BRK.A, Financial)(BRK.B, Financial) annual shareholder letters are such interesting reading is that Buffett and Charlie Munger (Trades, Portfolio) go out of their way to communicate not only the raw numbers of the past year’s financial performance, but also to enrich their shareholders’ understanding of how Berkshire’s management comes to the investment decisions that it does. This is an excerpt from Buffett’s annual letter from the year 2000, in which he invokes the wisdom of the ancient Greek storyteller Aesop.
Three important questions
“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.”
In other words: Are you sure this asset is undervalued? How undervalued is it? What is the discount factor of this investment? It is remarkable how the widely applicable this precept is. By answering these three questions, an investor can determine the relative value of any asset imaginable. In Buffett’s words: “Just insert the correct numbers, and you can rank the attractiveness of all possible uses of capital throughout the universe.”
Beware of exact numbers
However, answering some of these questions is sometimes easier said than done:
“Alas, though Aesop’s proposition and the third variable - that is, interest rates - are simple, plugging in numbers for the other two variables is a difficult task. Using precise numbers is, in fact, foolish; working with a range of possibilities is the better approach.
Usually, the range must be so wide that no useful conclusion can be reached. Occasionally, though, even very conservative estimates about the future emergence of birds reveal that the price quoted is startlingly low in relation to value. (Let’s call this phenomenon the IBT - Inefficient Bush Theory.) To be sure, an investor needs some general understanding of business economics as well as the ability to think independently to reach a well-founded positive conclusion. But the investor does not need brilliance nor blinding insights.
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.”
This is a famous Buffettism: Do not attempt to put an exact number on what you think the intrinsic value of an asset should be -- use a range of possibilities instead. By doing so you are giving yourself a lot of leeway when it comes to establishing your margin of safety. If you can think of all the problems that a stock may face (and then some), and still come up with an estimate of its value, which is in excess of its market price, then you may have a winner on your hands. Crucially, one does not have to be a genius to achieve this -- just have a modicum of common business sense.
The second point illustrates why Buffett and Munger have historically stayed away from fast-moving sectors. When the number of unknowns increases such that Aesop’s three questions cannot be answered even with a realistic range of values, then it becomes impossible to make an honest assessment of an asset. Investment in such cases is not actually investment -- it is speculation, and therefore falls outside of our margin of safety.
Disclosure: The author owns no stocks mentioned.
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Joel Greenblatt: Value Investing for the Small InvestorÂ
