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Adventures in Valuation #4

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By TMFCheeze
December 22, 2000

Posts selected for this feature rarely stand alone. They are usually a part of an ongoing thread, and are out of context when presented here. The material should be read in that light. How are these posts selected? Click here to find out and nominate a post yourself!

What follows will be familiar ground for those who are well-versed in the foundations of Value Investing. I don't pretend to have any special insight into these issues -- in fact, please consider the AIV series an invitation to study Value Investing's primary sources. A good place to start is with The Essays of Warren Buffett.

The essays in this book are excerpted from Buffett's Letters to his shareholders, which are available for free online.

In fact, stop reading this post and go read the letters first.

I especially welcome comments from those who can, when I'm wrong, correct me, and when I'm right, elaborate on my thoughts in ways that make these concepts more apparent to everyone.

***

If there is a difference between value investing and investing in general, it is that, while most investors are seeking simply to maximize the number of dollars they own, value investors are seeking to maximize their ownership of value. This is a subtle point, because while we often treat the two concepts -- value and money -- as interchangeable, they are not at all the same thing.

Money is not value. Money is a proxy for value. Yes, as a medium of exchange, money is sure a whole lot more convenient than beaver pelts or live chickens, but green pictures of dead presidents only have value by convention. Money can only be understood properly as an abstraction. After all, trying to figure out how many beaver pelts equals one live chicken is confusing enough, but at least with a chicken I know I have something tangible. Money, on the other hand -- now you're talking about some extremely dicey stuff, phenomenologically speaking.

To people living in pre-monetary societies, the use of money appears absolutely psychotic. Indians on the Great Plains in the 19th Century used to tell jokes about dumb white people and the stupid yellow rocks that made them go crazy. I mean, think about it: you walk into a car dealership, and the guys there are willing to let you drive off in a Volvo just because you promise that your bank's computer will transfer a few ones and zeroes to their bank's computer over the next sixty months. What kind of bizarro planet are we living on, anyway?

The concept of price -- the amount of money you are willing to give someone in exchange for something else -- has been a matter of confusion and dispute since money was invented. (And ten minutes after money was invented, they invented welching.) Ultimately, the only value money has is there because we can reliably depend on the respect other people have for this convention. And unless you have some reliable discipline for understanding what is a reasonable price you should pay for something, you're going to end up having problems not only in the everyday world of buying and selling, but also in your investments. And if the action in the stock market over the past year has any lessons for us, one surely is that people will behave very oddly when money is involved.

The thing to remember is that what we really want in life is not money, but value. As much as you love having that wad of simoleons in your pocket, you can't eat them. You can't live in them. And they can't love you back. And that has been the message of each of these Adventures in Valuation (AIV) screeds since I began writing them. Remember, it doesn't matter the slightest whether you paid fifty cents or a hundred dollars for the Snickers bar in your hand -- it's going to taste exactly the same as any other Snickers bar no matter how much cash you gave in exchange for it. Whatever value there exists is contained within the candy bar; the price you pay is irrelevant to it.

Most investors, I'm convinced, are failing to draw this distinction. Or, if they are drawing the distinction, they are not considering the greater implications of it. They are looking at the price tag rather than the object they are buying that is attached to it. And that can lead to all sorts of bad investment decisions.

Weird things happen in the gap between price and value. Obviously, nobody is going to pay $100 for a Snickers bar. But they will pay several times that amount for a Pokemon card. Or, twelve months ago, $150 for a share of CMGI. Or $45 for a share of ATHM, or $120 for MSFT. The problem, I suppose, is that while value is value regardless of our ability to recognize it, price requires that we make a judgment. And whenever we are forced to rely on fallible human judgment, we are likely to see some anomalies.

A value investor will very happily surrender large amounts of money if he perceives there to be a great deal of value to be had in exchange for it. Meanwhile, investors in general often find themselves surrendering large amounts of money for shares in companies which do not exhibit many reliable signs of value at all, because they are expecting (or, perhaps, hoping) to be able to sell those shares for an even higher price at some future date. In other words, investors in general manage their investments with most of their attention on price. The dictum they follow is the familiar "Buy Low/Sell High" mantra that is taken as the axiomatic formula for success in investing.

Now, let's be frank -- there isn't an investor alive who would not, all things considered, prefer that his stocks would fetch a higher price than he paid for them. But a preoccupation with price at the expense of value can lead to that cycle of delusion that leads to some very unpleasant surprises on those occasions when the market comes to insist on a more severely determined price for the asset you hold.

The Value Investor enters the world of investing with a different mindset from the common Buy Low/Sell High formulation, which seems to be Square One for most investors. His approach is more like: Buy Low/Sell� well, maybe you don't sell. From a value investor's point of view, if one places one's assets in an enterprise that generates a sufficient or superior and reliable return, there is no particular reason to sell it. And by  "return", I do not mean "growth in the stock price." Instead, I am speaking of the funds generated in profit by the economic efforts of the enterprise to which one has committed one's capital. Remember, it is not price which is the essential factor to the value investor. The essential issue is how well the businesses he owns are performing, not as stocks, but as businesses.

In short, the prospect of selling, to a value investor, while always an option, is not necessarily near the top of his mind. A value investor doesn't buy stock like the owner of a retail store buys merchandise, with the intent of selling it for a higher price than was paid for it. As a value investor buys because owning the business will generate a respectable return on his investment.

Think of the yummy chocolaty goodness of that candy bar. That's where life is. That's where value is. You don't want to give it up unless the price you get for it is a really good one.

Your aim in investing is to collect assets that perform well for you. The fact that there is a stock market out there where you can sell out your interest in the business on any five days out of seven is simply a matter of convenience to you. If you happen to notice one day that the market is offering you a price that is completely out of line with the actual income you expect the business to provide for you, and by your calculation the discrepancy is widely in your favor, then it is your happy opportunity to sell out your interest in that enterprise, and then deploy your serendipitously acquired greater capital elsewhere.

This is one aspect of what Warren Buffett calls "behaving like an owner." Buffett spends his days happily accumulating assets that have value. The market might price those assets in a wildly irrational manner from day to day -- but price is for people who are focusing only on money. And money, after all, is only a proxy for the things of real value in life, the things which we all are seeking -- or, at least, what we would be seeking if only we could see past the obscuring delusions we create for ourselves.

***

Speaking of serendipity, here's a post by DeliLama (#39612), made just the other night on the Berkshire Hathaway board, that explains these concepts probably better than I have. Deli speaks of two worlds in investing, each running parallel to each other in time:

The first is the world of stock price where the agreed-upon price to sell a particular stock changes over time due to any number of factors. The second is the world of actual business performance where goods and services are sold and profits are (hopefully) made.

You will find that investors will tend to focus mostly on one of these worlds, while keeping an eye on the other. Most of the people on this
[Berkshire] message board are focused on the business performance with an eye on the stock price to buy if it drops very low or sell if it gets very high relative to the actual business outlook.

The
real question to be asking is what's the difference between a target price and an intrinsic value. From a distance, they may seem like the same thing, but they are from each of the different worlds and represent very different frames of reference. A price target is what someone thinks people will be willing to buy/sell the stock for at some (usually unspecified) time in the future. An intrinsic value is what someone thinks the stock is worth based on the performance of the business.

Both of these are based on assumptions that must be made about people's behavior. In one case, the assumptions are about their willingness to buy/sell the stock in the future. The other is about people's ability to run the company and generate profits and handle those profits appropriately.



***

In AIV#3 I promised a discussion of the several approaches to investing which I see prevailing on these boards. I've decided to push that off to AIV#5, mainly because I felt I needed to lay this preliminary work before getting to it, and because 3,000-word posts are too long even by my standards.

Happy investing, Fools. I'm looking forward to your comments and criticism.

Cheeze

P.S. If you're really interested in this Value Investing stuff, add the Berkshire Hathaway board to your favorites. People are talking about these issues there 24/7, and the people who hang out there every day are far more knowledgeable about it than I am.

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