Berkshire Annual Letter 2000 (Part 2)
Warren Buffett prefers to buy entire businesses rather than just a portion of a listed stock.
One reason is that their managers tend to be more rational and owner-oriented than at many public companies.
The main reason, however, is because of the tax benefits. Without going into details, owning 100% of a company ensures that Berkshire will only be taxed once and not twice on the holding.
All assets can be valued using an investment philosophy laid out in 600 B.C.
Aesop had this insight, “A bird in hand is worth two in the bush”. To apply this to your investment, you need to answer three questions (replace birds with dollars).
- 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 (long term US bond rate)?
Aesop’s investment axiom can be applied to anything from stocks, bonds, to even things like lottery tickets.
However, it is difficult to obtain absolute values for the first two questions. Thus, a range of values might be better.
Sometimes, the value you estimate might be very low compared to the quoted price. Warren Buffett jokingly calls this the inefficient bush theory. :)
To provide further validation of your estimate, an independent thinking with general understanding of business economics needs to be there aswell.
Common valuation terms like PE ratio, dividend yield, etc have nothing to do with your estimated valuation except they provide clues to the amount and timing of money flowing into (and from) the business.
Growth investment and value investing are not contrasting styles of approaching. Growth is just a component of the value equation.
Growth can destroy value if the cash inputs exceed the discounted value of the cash that can be generated as a result of the cash inputs.
At other times, you can’t decide how many birds will emerge from the bush. In such a scenario, any form of investment is a speculative one.
Focusing not on the asset, but on what the next person will pay for it, is not something that Warren Buffett or Charlie Munger will ever do.
The line between investing and speculation becomes blurred in a major bull market. When everyone seems to be making money effortlessly, normally sensible people will be sucked into the party as well.
It’s like Cinderella at the ball with all participants planning to leave just seconds before midnight.
In times of such exuberance, there’s often many IPOs of companies that do not create value. The net effect is to transfer wealth from the masses to a select few. Ultimately, every bubble ends in a burst and a new group of investors learn the lesson.
Speculation is most dangerous when it looks easiest.