Berkshire Letter by Warren Buffett – 1992 (Part 5)
Jan 23rd, 2007 by Martin Lee
Value Investing
Compared to that stated 15 years ago, the only change in the equity-investing strategy of Warren Buffett is the addition of the word “very”:
“We select our marketable equity securities in much the way we would evaluate a business for acquisition in its entirety. We want the business to be one (a) that we can understand; (b) with favorable long-term prospects; (c) operated by honest and competent people; and (d) available at a very attractive price.”
The question one now needs to ask is how to decide what is attractive. Unlike most analysts who choose between either a growth or value approach, Buffett feels that growth is always a component of value. The important of which can vary from negligible to large, and the effects can be from negative to positive.
The term “value investing” is also redundant as all investing seeks to buy something of value that justifies the price paid. Overpaying for something in the hope of selling it at an even higher price is not investing, but speculation.
A “value investment” is not determined in any way by its price-earnings ratio, price to book ratio or even a high dividend yield.
Neither is it determined by the growth. While most growth often has a positive impact on value, it only benefits investors when each additional dollar used to finance the growth creates more than a dollar of long-term market value.
If business returns are low, growth actually hurts the investor.
Taken from The Theory of Investment Value written in 1937 by John Burr Williams, value can be defined as:
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.
You will notice that the same formula is used for stocks as well as bonds. An important difference to take note is that for bonds, the future cash flows can be accurately determined from the coupon rate and maturity dates. While for stocks, the future cash flows has to be estimated.
This is the part where most people can go wrong.
Berkshire overcomes this problem by:
1) Dealing only with businesses that they understand, are simple and stable in nature. The best businesses to own are those that can employ large amounts of incremental capital at very high rates of return over an extended period of time. The worst businesses to own are those that does the opposite – that is, consistently employ ever-increasing amounts of capital at very low rates of return.
2) Having a margin of safety (as strongly emphasized by Ben Graham) in the purchase price.
Using the discounted-flows-of-cash calculation, the investment that is shown to be cheapest should be brought. Other factors like growth, earnings volatility, book value wouldn’t matter at all as these would all have been factored in.
And if the calculations show that bonds are cheaper, then they should be bought instead.
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