Understanding a Business
...for Years to Come
by Alex Schay (TMF Nexus6)
ALEXANDRIA, VA (Oct. 26, 1998) -- Reality Bites, Love Hurts... oh, and add to that, Turnover Kills. Hang on, Dilution Kills, Too. After I "Bored" everyone on Monday of last week with more philosophy about capital allocation, Dale took over and began to wax poetic on the virtues of glacial-like turnover, as well as the folly of diversification. On Friday, Dale promised that Monday's piece would entail some look at mutual fund investing. Sorry, it just ain't true. That content will come later in the week as we wind down the discussion on how we want to run the portfolio -- which will simultaneously get us geared up for the company analysis phase of the program. Today though, we're going to kick off the Boring festivities with a look at "understanding a business" and how it relates to portfolio diversification.
"If a business is complex or subject to constant change, we're not smart enough to predict future cash flows. Incidentally, that shortcoming doesn't bother us. What counts for most people in investing is not how much they know, but rather how realistically they define what they don't know. An investor needs to do very few things right as long as he or she avoids big mistakes."Berkshire Hathaway 1987 Annual Report,
Letter to Shareholders
As previously mentioned, Warren Buffett has set quite a high hurdle with regard to the ability of the investor to state with confidence, "I understand" a business." The ability to accurately predict cash flows ten years out, is a feat that precious few investors have been able to accomplish with any success. Here's what Buffett said at Berkshire Hathaway's 1997 meeting with shareholders, "When I say 'understand,' what I mean is, that you have a pretty good idea where it's going to be 10 years from now. And I just can't get that conviction with a lot of businesses, whereas I can get it with a relative few. Fortunately... I only need a few -- maybe six or eight or something like that." Actually eight was about right Mr. Buffett, as Dale took note of on Friday:
At the end of fiscal 1997, 65% of $56.11 billion in total assets and 79% of $45.8 billion of invested capital for Berkshire Hathaway was represented by this small group of investments:
Company Market Value American Express Company $ 4,414.0 The Coca-Cola Company 13,337.5 The Walt Disney Company 2,134.8 Freddie Mac 2,683.1 The Gillette Company 4,821.0 Travelers Group Inc 1,278.6 The Washington Post Company 840.6 Wells Fargo & Company 2,270.9
The risk that is taken when making liberal use of quotations from the Oracle of Omaha, is the fundamentalist debate that invariably ensues. These investment-specific arguments, where the crux of the disagreement turns on whether or not Buffett would buy "that kind" of business, amount to the criticism that one talks the Buffett talk but doesn't walk the Buffett walk (or perhaps the investor is accused of practicing some form of a la carte investing, that is, picking and choosing only what suits the practitioner). I hope the parallels with the interpretation of religious scripture are not lost on readers here.
The heretical point being, you don't have to always invest in what Buffett would consider in order to still put his fundamental investment tenets to good use -- as long as you buy a business that you understand (adding value to the analysis) and purchase it with a sufficient margin of safety. The thing is, Buffett's investment universe is small, by design. Again, Buffett at the 1997 shareholders' meeting: "...there's a whole group of companies -- in fact, a very large group of companies -- that Charlie and I just don't know how to value. And that doesn't bother us." So, you invested in Intel and think you need to join the local chapter of Buffett Adherents Gone Astray (BAGA)? Here's what Buffet would have to say about that (OID):
"IBM also owned a big piece of Intel and sold it in the mid-'80s. So here are a bunch of people who should know a lot about that business. Yet, they couldn't see the future either. I think it's very tough to make money that way. I think some people can make a lot of money understanding those kinds of businesses. There are people with the insights..."
Now, is the time that we begin to flirt with hubris. It seems colossally arrogant to invest in businesses that (arguably) the greatest businessman of the twentieth century wouldn't touch with a ten foot pole. However, the simple fact is, there aren't that many truly "great" businesses out there -- and an even smaller fraction of those trade at sufficiently attractive prices to warrant purchase. So, as ambulatory Fools treading on ground that Angels fear to tread, we are "merely" hoping to buy some "good" businesses at "cheap" prices, taking big positions and holding on for years to come.
Stock Change Bid ANDW +1 1/16 15.81 CGO -1 33.50 BGP - 1/2 23.63 CSL -1 37.13 CSCO +2 11/16 61.38 FCH + 5/8 23.38 PNR + 3/8 38.00 TBY + 1/8 7.00
Day Month Year History BORING +0.87% 3.83% -11.15% 11.79% S&P: +0.16% 5.44% 10.50% 72.51% NASDAQ: +1.84% 1.84% 9.85% 65.71% Rec'd # Security In At Now Change 6/26/96 225 Cisco Syst 23.96 61.38 156.20% 2/28/96 400 Borders Gr 11.26 23.63 109.88% 3/5/97 150 Atlas Air 23.06 33.50 45.28% 8/13/96 200 Carlisle C 26.32 37.13 41.03% 4/14/98 100 Pentair 43.74 38.00 -13.13% 5/20/98 400 TCBY Enter 10.05 7.00 -30.31% 11/6/97 200 FelCor Sui 37.59 23.38 -37.82% 1/21/98 200 Andrew Cor 26.09 15.81 -39.39% Rec'd # Security In At Value Change 6/26/96 225 Cisco Syst 5389.99 13809.38 $8419.39 2/28/96 400 Borders Gr 4502.49 9450.00 $4947.51 8/13/96 200 Carlisle C 5264.99 7425.00 $2160.01 3/5/97 150 Atlas Air 3458.74 5025.00 $1566.26 4/14/98 100 Pentair 4374.25 3800.00 -$574.25 5/20/98 400 TCBY Enter 4018.00 2800.00 -$1218.00 1/21/98 200 Andrew Cor 5218.00 3162.50 -$2055.50 11/6/97 200 FelCor Sui 7518.00 4675.00 -$2843.00 CASH $5750.59 TOTAL $55897.47