Tom Russo (Trades, Portfolio) is a Managing Member of Gardner Russo & Gardner and a General Partner of Sempre Vic Partners. As an investor, he looks for long-term value businesses, particularly family-owned businesses. All today, he manages over $12 billion in assets. He recently gave an interview in which he talked about two key investing lessons that he learned from Warren Buffett (Trades, Portfolio).
Two ways of looking at the margin of safety
Russo explains the difference between Buffetts early-life strategy of buying cigar butt companies, and his later approach of buying great businesses at fair prices:
Warren at our class [at Stanford Business School] said that the only break the government gives is the non-taxation of unrealised gains. So invest accordingly. Thats different than the 50 cent dollar bill approach that he had used as a starting investor when he bought liquidating trusts and other instruments.
The discounted price was the margin of safety [for 50 cent dollars]. The trouble is, to get a return from that - the asset is not growing in value - you have to close the discount. Take the cash, pay taxes, move on, try to find another one. But the fact is, another way to look at a margin of safety is as a businesss capacity to reinvest, and the strength of its competitive advantage. Then you dont have to sell.
In the cigar butt approach, the margin of safety is the price you pay - even if your valuation is off by some amount, you know that you are approximately right. In the great businesses approach, the margin of safety is the quality of the company - even if you overpay, you know that the difference will eventually be made up. Both are a form of insurance against mispricing and fundamentally represent the same thing.
The second lesson was that you cant make a good deal with a bad person. Thats [the concept of] agency cost. Thats when you give your money to a third party to invest on your behalf and they want to make it on their behalf. And that is something that is rife in the investment world and you have to guard against that.
The idea is that if youre holding a company for a long time, you are trusting management to reinvest capital in that business. As an investor you have to be sure that the executive and board is deploying that money in your interest, rather than their own. You would want them to pursue a course of action that ensured long-term stability, rather than a short-term increase in the stock price, so, for instance, choosing to devote more money to capex than share repurchases.
The problem is that management can often opt for the short-term gain, particularly if their incentives are distorted by free stock options. For this reason, successful long-term investing must necessarily involve a judgement of character, as well as a good assessment of financial strength.
Disclosure: The author owns no stocks mentioned.