One of the most important things in investing is to protect one's downside - the reason is that a single bad year can ruin compounding prospects.
1. If the market values a company at USD 100 Mn and your analysis pegs the value north of USD 150 Mn... is it a good buy?
2. If the market values a company at USD 100 Mn and your analysis pegs the value at USD ~80 Mn... is it a good buy?
Question 1:
What if the company is Kodak in 2003?
What if the company is Apple in 2002?
Question 2:
What if the company is Archer Daniels Midland in 2007?
What if the company is IBM in 2011?
My point here is that there is no absolute rule just based on valuations. It's hard enough coming to a range of values for a company. It's rather difficult peering into the future. Oddly, investing is primarily about the future because that is when your potential value will be realised.
The philosophy used by WB towards the beginning of his career was the classic Graham and Dodd Cigar Butt investing with an both eyes on Margin of Safety. He would invest in a company like Kodak and wait for the market to come up to his confident valuation numbers. Luckily, he was rather smart and therefore hit quite a few homeruns - somewhere along the way he bought into disasters such as Berkshire Hathaway, Dexter Shoes, US Air and of course, Solomon Brothers.
A few key things make investments disasters even though one may have entered with a margin of safety:
1. Management
2. Industry dynamics
3. Business Environment
4. Currency
5. Corporate Governance
By far, the most important are management and corporate governance, and more important that this is corporate governance. One should see what went wrong with BRK's Solomon investment - it is plausible that BRK may never again enter that sector unless if in the form of a superior security, e.g. preferreds in Goldman Sachs.
Once, a margin of safety has been established, it is essential to understand how the company is going to realise its full potential. What if it is as culturally and managerially broken as Kodak or Yahoo! ? Odds are that the company's management will indulge in thumb-sucking while money is being burned away in sustaining an unsustainable business operation.
The problem with the cigar butt investing approach is that the one last puff may take a long time to be realised unless one can influence the board or the management.
How did WB manage to invest in IBM at a supposed 3x book value? It is quite contrary to the margin of safety approach... or is it? WB bought into Coca Cola when it was near its then all time high (in 1988-89) - what led him to do this?
Sustainable competitive advantage or Moat.
How difficult is it for another company(ies) to enter my investee company's business domain?
How easy is it for my investee company to build on its business and pricing power?
Can IBM be seriously challenged in its domain expertise and reliability? Is its consumer loyalty questionable?
Can Parle increase prices of its Bisleri bottled water without driving consumers away? Does it have a brand that is blindly relied on?
The question for smaller companies is: Is the management sincere about keeping progress and innovation uninterrupted? Is the management careful and caring with respect to its investors and employees? Is it in a sector where it really knows what it's doing? How good is the competition that surrounds it?
As an investor, the difficulty with these questions (or may be the ease!) is that answers can be substantiated only over a period of time; often, gut instinct needs to be strong and no numbers can support you in answering these questions.
Going back to Margin of Safety. It is essential because a good company at a bad price is worse than a good company at an OK price. May be it is better to buy into IBM at a 20% overvaluation than it is to buy into Netflix at a 60% overvaluation. The trouble is that there are many non-quantifiable attributes to a company which cannot be incorporated into a numerical value.
Lethargy bordering on sloth is more important than people think it is.
1. If the market values a company at USD 100 Mn and your analysis pegs the value north of USD 150 Mn... is it a good buy?
2. If the market values a company at USD 100 Mn and your analysis pegs the value at USD ~80 Mn... is it a good buy?
Question 1:
What if the company is Kodak in 2003?
What if the company is Apple in 2002?
Question 2:
What if the company is Archer Daniels Midland in 2007?
What if the company is IBM in 2011?
My point here is that there is no absolute rule just based on valuations. It's hard enough coming to a range of values for a company. It's rather difficult peering into the future. Oddly, investing is primarily about the future because that is when your potential value will be realised.
The philosophy used by WB towards the beginning of his career was the classic Graham and Dodd Cigar Butt investing with an both eyes on Margin of Safety. He would invest in a company like Kodak and wait for the market to come up to his confident valuation numbers. Luckily, he was rather smart and therefore hit quite a few homeruns - somewhere along the way he bought into disasters such as Berkshire Hathaway, Dexter Shoes, US Air and of course, Solomon Brothers.
A few key things make investments disasters even though one may have entered with a margin of safety:
1. Management
2. Industry dynamics
3. Business Environment
4. Currency
5. Corporate Governance
By far, the most important are management and corporate governance, and more important that this is corporate governance. One should see what went wrong with BRK's Solomon investment - it is plausible that BRK may never again enter that sector unless if in the form of a superior security, e.g. preferreds in Goldman Sachs.
Once, a margin of safety has been established, it is essential to understand how the company is going to realise its full potential. What if it is as culturally and managerially broken as Kodak or Yahoo! ? Odds are that the company's management will indulge in thumb-sucking while money is being burned away in sustaining an unsustainable business operation.
The problem with the cigar butt investing approach is that the one last puff may take a long time to be realised unless one can influence the board or the management.
How did WB manage to invest in IBM at a supposed 3x book value? It is quite contrary to the margin of safety approach... or is it? WB bought into Coca Cola when it was near its then all time high (in 1988-89) - what led him to do this?
Sustainable competitive advantage or Moat.
How difficult is it for another company(ies) to enter my investee company's business domain?
How easy is it for my investee company to build on its business and pricing power?
Can IBM be seriously challenged in its domain expertise and reliability? Is its consumer loyalty questionable?
Can Parle increase prices of its Bisleri bottled water without driving consumers away? Does it have a brand that is blindly relied on?
The question for smaller companies is: Is the management sincere about keeping progress and innovation uninterrupted? Is the management careful and caring with respect to its investors and employees? Is it in a sector where it really knows what it's doing? How good is the competition that surrounds it?
As an investor, the difficulty with these questions (or may be the ease!) is that answers can be substantiated only over a period of time; often, gut instinct needs to be strong and no numbers can support you in answering these questions.
Going back to Margin of Safety. It is essential because a good company at a bad price is worse than a good company at an OK price. May be it is better to buy into IBM at a 20% overvaluation than it is to buy into Netflix at a 60% overvaluation. The trouble is that there are many non-quantifiable attributes to a company which cannot be incorporated into a numerical value.
Lethargy bordering on sloth is more important than people think it is.
