Benjamin Graham bought everything and anything as long as it was selling at a deep discount to intrinsic value providing him a margin of safety. This is analogous to walking into a Dollar Store to see what is on sale. Warren Buffett on the other hand decides what he wants to buy first – a consumer monopoly company with a durable competitive advantage with quality, rationale management – before walking into the store to see if it is on sale.
Mr. Market and the Neighborhood Farm
Benjamin Graham conceptualized the stock market as an individual, a business partner named Mr. Market who approaches the investor on a daily basis with a quote at which he can buy or sell a security. Mr. Market is a very moody individual. On some days he is very euphoric and offers a very high price. On other days he is quite depressed and quotes very low. He can be ignored routinely and without fail, he always returns. It is imperative to never heed nor fall under the spell of Mr. Market, to instead make rationale business decisions based on a company’s economic fundamentals and intrinsic value.
Be Fearful When Others are Greedy and Greedy When Others are Fearful
Warren Buffett recently analogized Mr. Market in the 2013 Berkshire Hathaway Annual Report describing a piece of farm land as the asset and the neighbor down the road as Mr. Market. The farm land in question is a great asset: it has produced a substantial yield of corn year after year despite the short-term gyrations of locusts, a drought and an early freeze and it is projected to do so well into the future. A daily quote is not needed in order to understand that the farm is an economically sound, productive asset.
On a daily basis the farmer from down the road approaches and offers to buy the farm or sell his at a quoted price. Some days he is euphoric and quotes high prices and some days he is depressed and quotes low. We can ignore him as much as we want, he always comes back.
Given that the fundamentals of our farm are economically sound – increasing revenues, a strong track record of earnings, high rates of return - and with some certainty we can predict that the farm will continue to perform well into the future, then perhaps the time to sell is never. If on the other hand we look down and determine that our farm is indeed a lemon, perhaps it is time to sell on a day of euphoria in lieu of purchasing a great farm at a good price.
On down days when the neighbor offers up his farm at a low price, a determination can be made – is his farm economically sound, will it present a substantial rate of return over time based on its intrinsic value and price offered - and perhaps a purchase is made. The depressed lows of our neighbor merely serve up the opportunity to effectuate high rates of return through the purchase of a great asset.
At no time did we come under the spell of our neighbor farmer from down the road, neither his exuberant highs nor his depressed lows. We merely rationally analyzed, from a business perspective, the assets at hand.
Do we buy great farms on days of the high bid? Perhaps, since it is better to buy a wonderful business at a good price than a good business at a wonderful price. Case in point: if you had bought Coca-Cola in 1919 at a price of $40 per share the next year would have cut you in half to $19 due to issues with bottlers and a spike in sugar prices. Even so, if you had held the asset until 2010, with reinvested dividends, the stock would be worth over $2.5 million. Time is the enemy of the mediocre business and the friend of the great business. The price paid also determines the rate of return though so it is prudent to buy wonderful businesses at good to great prices and not so much outlandishly high prices.
Do we sell a great asset at high prices in order to hold cash, wait for an anomaly and buy more of the great asset at a low price? This may appear rational at first but it opens up the psychological mine field of market timing and invites the tax man to the party.
The Economic Moat
Charlie Munger’s comments on Coca-Cola in his 1996 talk, Practical Thought on Practical Thought, illustrate the concept of a company with a durable competitive advantage or, a very strong business moat. In this talk he posits the thought process that must be undertaken in 1884 in order to start a globally successful carbonated beverage company:
“We can guess reasonably that by 2034 there will be about eight billion beverage consumers in the world. … Each consumer is composed mostly of water and must ingest about sixty-four ounces of water per day. This is eight, eight-ounce servings. Thus, if our new beverage and other imitative beverages in our market, can flavor and otherwise improve only twenty-five percent of ingested water worldwide, and we can occupy half of the new world market, we can sell 2.92 trillion eight ounce servings in 2034. And if we can then net four cents per serving, we will earn $117 billion. This will be enough, if our business is still growing at a good rate, to make it easily worth $2 trillion.”[i]
Think about it. In addition to its red trade dress and over 120 years of brand-building, Coca-Cola’s “moat” fundamentally rests on the fact that the human race is composed mostly of water and must ingest about sixty-four ounces of water per day. What better way to enhance the water-drinking experience than with a Coca-Cola. Underwear, hamburgers and razor blades tend to exhibit the same characteristics.
Investing is Most Intelligent When it is Most Business-Like
Over time, the market will weigh out the retained earnings of a business that, if reinvested successfully at high rates of return within the business, will lead to greater intrinsic value. Despite short-term gyrations, the market will recognize the weight of intrinsic value.
The key to the long-term aspect of the market as a weighing machine is predictability: it is imperative to have some degree of certainty as to what the economic characteristics of a business will look like in 10 to 20 years. Within this context, from time-to-time the market will present short-term anomalies whether it be in the form of flash crashes, Black Tuesdays, salad-oil scandals, the housing crisis or dot-com bubbles. This is the market as a voting machine and these are buying opportunities.
Why Productive Assets Matter
Businesses, Farm Land and Real Estate Versus an Infield of Gold – From the 2011 Berkshire Hathaway Annual Report
In relation to productive assets, you could take all of the world’s gold resources and fit them neatly in a cube in the infield of a minor league ball park.
Today the world’s gold stock is about 170,000 metric tons. If all of this gold were melded together, it would form a cube of about 68 feet per side. (Picture it fitting comfortably within a baseball infield.) At $1,750 per ounce – gold’s price as I write this – its value would be $9.6 trillion. Call this cube pile A.
Let’s now create a pile B costing an equal amount. For that, we could buy all U.S. cropland (400 million acres with output of about $200 billion annually), plus 16 Exxon Mobils (the world’s most profitable company, one earning more than $40 billion annually). After these purchases, we would have about $1 trillion left over for walking-around money (no sense feeling strapped after this buying binge). Can you imagine an investor with $9.6 trillion selecting pile A over pile B?
Beyond the staggering valuation given the existing stock of gold, current prices make today’s annual production of gold command about $160 billion. Buyers – whether jewelry and industrial users, frightened individuals, or speculators – must continually absorb this additional supply to merely maintain an equilibrium at present prices.
A century from now the 400 million acres of farmland will have produced staggering amounts of corn, wheat, cotton, and other crops – and will continue to produce that valuable bounty, whatever the currency may be. Exxon Mobil will probably have delivered trillions of dollars in dividends to its owners and will also hold assets worth many more trillions (and, remember, you get 16 Exxons).
The 170,000 tons of gold will be unchanged in size and still incapable of producing anything. You can fondle the cube, but it will not respond.
Admittedly, when people a century from now are fearful, it’s likely many will still rush to gold. I’m confident, however, that the $9.6 trillion current valuation of pile A will compound over the century at a rate far inferior to that achieved by pile B.
Our first two categories enjoy maximum popularity at peaks of fear: Terror over economic collapse drives individuals to currency-based assets, most particularly U.S. obligations, and fear of currency collapse fosters movement to sterile assets such as gold. We heard “cash is king” in late 2008, just when cash should have been deployed rather than held. Similarly, we heard “cash is trash” in the early 1980s just when fixed-dollar investments were at their most attractive level in memory. On those occasions, investors who required a supportive crowd paid dearly for that comfort.
My own preference – and you knew this was coming – is our third category: investment in productive assets, whether businesses, farms, or real estate. Ideally, these assets should have the ability in inflationary times to deliver output that will retain its purchasing-power value while requiring a minimum of new capital investment. Farms, real estate, and many businesses such as Coca-Cola, IBM and our own See’s Candy meet that double-barreled test. Certain other companies – think of our regulated utilities, for example – fail it because inflation places heavy capital requirements on them. To earn more, their owners must invest more. Even so, these investments will remain superior to nonproductive or currency-based assets.
Whether the currency a century from now is based on gold, seashells, shark teeth, or a piece of paper (as today), people will be willing to exchange a couple of minutes of their daily labor for a Coca-Cola or some See’s peanut brittle. In the future the U.S. population will move more goods, consume more food, and require more living space than it does now. People will forever exchange what they produce for what others produce.
Our country’s businesses will continue to efficiently deliver goods and services wanted by our citizens. Metaphorically, these commercial “cows” will live for centuries and give ever greater quantities of “milk” to boot. Their value will be determined not by the medium of exchange but rather by their capacity to deliver milk. Proceeds from the sale of the milk will compound for the owners of the cows, just as they did during the 20th century when the Dow increased from 66 to 11,497 (and paid loads of dividends as well). Berkshire’s goal will be to increase its ownership of first-class businesses. Our first choice will be to own them in their entirety – but we will also be owners by way of holding sizable amounts of marketable stocks. I believe that over any extended period of time this category of investing will prove to be the runaway winner among the three we’ve examined. More important, it will be by far the safest. – Warren Buffett, 2011 Berkshire Hathaway Annual Report
The Lemonade Stand
Conceptually, buying a stock is no different than buying the lemonade stand down the road. In buying the lemonade stand, you look at the books, determine the earnings, return on equity, debt levels, the competitive advantages of the business, the product, the customer base, compute an intrinsic value and determine if the price paid will deliver a sufficient rate of return. The stock is partial ownership in a business whereas the lemonade stand is wholly owned.
A better example is perhaps the bowling alley down the road. If you were offered the bowling alley down the road for purchase you would spend some time reviewing the books, making a thorough analysis, talking to the customers, determining if revenues and earnings will continue, etcetera, before plopping down a lifetime’s worth of savings or taking out a huge loan. This would not be a one weekend research experience. The same mindset should be applied to the purchase of a stock.
The problem is that stocks are so liquid an investor can be part-owner of Disney at 9 am and be out by 9:15. Instead, in approaching a stock as a business investment, imagine that you have a punch card with only 10 lifetime punches to be made. Each time you make a purchase, the card gets punched. So, with each investment the question is asked, is this worthy of one of the punches?
Rooting for Lower Prices and Margin of Safety
In many ways the investor should root for lower stock market prices. As Buffett has analogized in the past, think of it this way: if you are a net consumer of $1 hamburgers - you love them, you eat them every day, you spend $100 a month eating hamburgers – and then one day, all of a sudden, you find out that hamburgers are going to be on sale at $.75 for the next few months or so, are you happy or sad? I would guess happy as you can now buy more hamburgers and most likely are devising ways to freeze a large cache of them.
The same framework applies to buying great businesses through the stock market: if you are a net consumer of great businesses that ultimately will continue to generate earnings and increase in intrinsic value year-after-year, are you happy or sad when that business goes on sale at $.75 cents on the dollar? Market lows present opportunities to buy as many of those hamburger-businesses as you can get your hands on. The trick is to be prepared for those hamburgers to go on sale and right now, according to the market cap to GDP ratio, hamburger prices are approaching a 60 year high.
The good news is that through the stock market you have access to some of the best lemonade stands in the world. A stock purchase makes you a business owner. Additionally, I think the individual investor can do better than Berkshire given its current size. It takes much to move the needle at Berkshire whereas the individual investor has "nimbleness" on their side. The individual investor has size on their side.
Just because you imitate Tiger Woods' swing doesn't mean that you will play golf like him, but it can't hurt. Also, investors don't have to depend on physical physique to make great, rationale investments. Certainly, you need smarts but you don't have to be a genius. Buffett himself has said that if you have a 160 IQ that you can give 30 pts away and still be a great investor. Temperament is just as important as IQ in the world of investing.
An important metric that Buffett uses to gauge value in the overall market is a market cap to GDP ratio. Included below is the Market Cap to GDP chart for the past 60 years. Currently, it sits at 127%. It has surpassed the housing bubble levels of 110% and is heading towards dot com bubble levels of 150%. This is a 60 year chart and this metric is at a second all-time high.
On a 50,000 foot level, using market cap to GDP, the market appears to be significantly overvalued. This is not to say that it will crash in the next few days, weeks, months or years. It could certainly trot along at an even pace for the next 2 to 3 years perhaps producing returns of 2 to 3%. What I believe it says is that there is not much value in the overall market right now and albeit an anomaly, perhaps it is best to wait for an opportunity to buy at a lower price - a Black Tuesday, Flash Crash, salad-oil scandal, etc. Of course, value can potentially be found at a singular issue level.
Mr. Market and Underlying Intrinsic Value
Truly the market offers up two potential opportunities:
1. The opportunity to sell a lemon at a high price.
2. The opportunity to buy a great business at a good to great price.
Two key dynamics are going on here in relation to the stock market and a publicly traded business:
1. The market quote or Mr. Market
2. The underlying intrinsic value of the business.
Regardless of what the market is doing, the underlying value of the business will continue on, for our interests specifically, the underlying value of the business with great economics will continue to increase. Some days the market may price fairly, some days it may price lower, much lower and on other days much higher.
The Market – Mr. Market – is erratic, moody and a separate tract. Eventually he will realize the intrinsic value of the business but on days that he does not – so what? The intrinsic value of the business will always be based on a fact – the discounted present value of future cash flows and the intrinsic value of a business with sound economic fundamentals should continue to increase in value unless its economic fundamentals change.
The market exists as an opportunity to buy great businesses at great prices on days that it is erratically low and as the fact of a businesses’’ intrinsic value begin its intrinsic value reveals itself, returns will be heightened.
Select a business that you can hold forever. Select a business that you can purchase as a stock investment, go away for five or 10 years knowing with some degree of certainty that the intrinsic value of the business will be greater. In other words, the market could shut down for five years and it wouldn’t matter. You would not need a daily quote to know that the business is doing well.
According to Warren Buffett in his 2000 annual letter to shareholders, the formula for valuing all assets was correctly identified, with some needed modifications by Aesop in 600 B.C – “a bird in the hand is worth two in the bush.” The axiom needs to be modified with four questions: how certain are you that the birds are in the bush, when will they emerge, how many will there be and what is the risk-free interest rate? (The yield on long-term U.S. bonds.) “If you can answer these three questions, you will know the maximum value of the bush ¾ 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.”[ii]
This law according to Buffett is immutable. It applies to the “outlays for farms, oil royalties, bonds, stocks, lottery tickets, and manufacturing plants. … Just insert the correct numbers, and you can rank the attractiveness of all possible uses of capital throughout the universe.”[iii]
In The Theory of Investment Value, written over 50 years ago, John Burr Williams set forth the equation for value, which we condense here: The value of any stock, bond or business today is determined by the cash inflows and outflows - discounted at an appropriate interest rate - that can be expected to occur during the remaining life of the asset. Note that the formula is the same for stocks as for bonds. Even so, there is an important, and difficult to deal with, difference between the two: A bond has a coupon and maturity date that define future cash flows; but in the case of equities, the investment analyst must himself estimate the future "coupons." Furthermore, the quality of management affects the bond coupon only rarely - chiefly when management is so inept or dishonest that payment of interest is suspended. In contrast, the ability of management can dramatically affect the equity "coupons." – 1992 Berkshire Hathaway Letter to Shareholders
Buy a simple business that is easy to understand with great, enduring underlying economics working in its favor, with rational management and buy it at a reasonable price with a margin of safety.
1. Strong EPS track record
2. High, consistent ROE
3. Low LTD
4. The ability to adjust prices with inflation
5. Share buyback
[ii] Buffett, Warren. Annual Letter to Shareholders, 2000.
[iii] Buffett, Warren. Annual Letter to Shareholders, 2000.