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March 21, 2000
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The Changing Nature of Impermanence
At times, the apparent conflict between technology stocks and everything else seems to take on the attributes of a battle of cosmic proportions, a holy war of dogma. It is as if "good" and "evil" are fighting for investors' souls. Depending on your viewpoint, everything that is new and different is good or bad, and everything that is old and familiar is desirable or undesirable. In many investors, such dualistic thinking appears to have become the norm. However, I believe that to think in the popular terms of old economy and new economy is a mistake. Such an attitude clouds the mind, confuses the focus, and limits the options of the investor. These concepts of new economy and old economy are more the invention of media writers, desperate to finish their copy before print deadlines, than anything solidly based in reality. Instead, for me, the attention of the investor needs to be on the effects of change. And change is not what it used to be.
For change is occurring at an increasingly rapid rate. And such rate of change will only accelerate. So is change the friend or the enemy? Popular opinion holds that Warren Buffett believes that change is a bad thing. He wants to buy the securities of companies in which change is slow to nonexistent, and then to hold them forever. To him, change is the enemy; or so it seems anyway. I don't want to put words in the mouths of other investors, but many seem to believe that change, any change, will make them golden. To them, change is the friend; or at least they appear to act that way. But these perceptions are also born of dualistic thinking, and such claims dissolve under critical analysis.
Change is not friend or foe, but reality, and just one more component in the process of determining value. The prayer of the value investor goes something like this: God, give me the serenity to accept the change that I cannot understand, the courage to act on the change that I can understand, and the wisdom to know the difference. When the investor sets aside the tired argument that only certain types of stocks are worth considering, he can see that the securities of almost any honestly managed company can be good value; or bad value. A technology stock on the bleeding edge can be a value stock to the right investor at the right price, while the most understandable and lowest price security of all can be bad value when its operations are so fixed that they run counter to impermanence. Pray not for tech or non-tech, but for the wisdom to see the difference.
So what is the value investor to do? All I can discuss is what I try to do. To clear the thinking, the value investor needs to maintain his focus on what works for him. In its simplest form, value investing dictates buying securities at less than their determined worth. To take it one Benjamin Graham step further, the security should only be bought when there is a margin of safety in its purchase price. I believe that to much old and new economy thinking confuses the issue, especially since the role of change is a pivotal ingredient in the valuation of companies regardless of which economy label the media places on it.
Remember, a security is worth the present value of its future free cash flows. For me, there are four ingredients in this determination of worth: current earnings - or free cash flow if you prefer, the appropriate discount rate, the sustainability of earnings, and the predictability of earnings.
Take the last item, the predictability of earnings, first. This is where the idea of a circle of competence comes into play. A certain level of understanding of a company is required to predict its future economic results. What good is it to attempt to prepare a discounted cash flow if the future cash flow is not knowable with some degree of accuracy? Warren Buffet will just pass in such a situation. He will not require a larger margin of safety, he will not use a larger discount rate, he will just chose to not participate. He refers to this idea as a "go/no-go" switch. For the value investor in the Warren Buffett mold, when it is determined that the future of the company is sufficiently unknowable, it is recommended to just flip the toggle switch to "no-go" and move on to the next company. Again, this is not a tech/non-tech issue, but goes back to the prayer of the value investor and his search for the wisdom to know the difference.
Assuming the "go" switch is on, the value investor must first determine current free cash flows. In some instances this may be sufficiently identical to earnings. As an example, in the case of the non-insurance subsidiaries of Berkshire Hathaway, it appears to me that earnings can be safely substituted for free cash flow. Warren Buffet tends to buy companies that are lousy with free cash flow. This may not always be true even for Berkshire Hathaway; it is yet to be seen how some of the more recent, capital intensive acquisitions will play out with cash flow. But some kind of normalized cash flow must be determined. When companies are in the middle of significant earnings fluctuations, the role of change must be considered in determining what this normalized number should be. Again, the concept of a circle of competency of the investor comes into play.
Next, an appropriate discount rate is needed. For me, this is the easiest. I look for a 15% return on equity investments, so this is number I use. However, since Warren Buffet uses the long term federal rate in computing intrinsic value, this computation does not result in a Buffettesque Intrinsic Value amount. When the investor is trying to compare the value of an equity security of a specific company to another, non-equity type alternative, the long term federal rate is appropriate. But if the investor is looking for an appropriate purchase price, Warren Buffet warns "and that discount rate doesn't pay you as high a rate as it needs to." So a higher rate is needed.
This brings us to the sustainability of earnings. This is also all about change; or more specifically how change will effect the sustainability of a company's current, competitive advantages. To select the growth rate to use in the discounted cash flow computation, the investor must determine how well the company's current economic results will survive the inexorable forces of impermanence. I know I am repeating myself, but this too is not a tech/non-tech issue, but a consideration that applies to all companies, regardless of their industry or nature. Coke faces change. Cisco faces change. A passbook savings account faces change. If a value investor gets to this point and feels uncomfortable with selecting a rate of growth to place in the discounted cash flow model, the "no-go" switch is still available. Such indecision has probably identified a circle of competency issue. He can simply chose to not swing, there will be other pitches.
There is one more requirement for the value investor: he must be an independent thinker. At one time there was a term for certain types of investors: Contrarians. A Contrarian tended to go against the crowd. However, to habitually go against the crowd shows neither a commitment to value or independent thinking, just contrariness. But there is a shared characteristic between Contrarians and value investors, the willingness to be hold ideas that are out of favor. The requirement for value investors to hold unfavorable ideas has been amply demonstrated recently with the attitude expressed by many towards Warren Buffett. Although he has a long term investment record that would be almost universally envied, his current thinking and discipline is routinely derided. From hero to goat in eighteen short months. For the value investor to enjoy the full success that his methods allow, he must have the courage of his convictions. He will not always be provided the intellectual cover of one of the world's most successful investors ringing a "buy now bell" on the company he manages.
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