Of Investing & Investments

Let’s start by defining investing. The definition is simple but often forgotten.
Investing is laying out money now to get more money back in the future–more money in real terms, after taking inflation into account. – Warren Buffett

Let us use a simple illustration. It’s a man called “Capital” who is trying to ascend a descending escalator. He exerts all his efforts to exceed the speed at which the escalator descends (and be careful not to trip!). The escalator has a magical property. If Capital succeeds in ascending it, he would grow in size. But if despite his efforts he ends up descending, he will shrink. Shown below is Capital and the escalator along with the forces in either direction.

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Note: another magical property of the escalator is that as capital ascends higher over time, the rate at which he grows in size increases exponentially (not linearly). This is the compounding effect.

Capital’s singular goal in life is to grow in size in real terms.

Warren Buffet further takes a more demanding definition of investing: “Investing is defined as the transfer to others of purchasing power now with the reasoned expectation of receiving more purchasing power in the future. More succinctly, investing is forgoing consumption now in order to have the ability to consume more at a later date.”


Categories of Investing

All Investing falls in one of three categories :

1. Currency-Based
The first category is investments denominated in a given currency. Money-market funds, bonds, mortgages, bank deposits, and other similar instruments fall here. Most currency-based investments are thought of as “safe.” In truth they are among the most dangerous. Their volatility (or beta) may be zero, but their risk is huge.

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Governments produce inflation and from time to time their policies spin out of control. The US dollar has fallen a staggering 86% in value since 1965. It takes no less than $7 today to buy what $1 did at that time. Consequently, a tax-free institution would have needed 4.3% interest annually from bond investments over that period to simply maintain its purchasing power. Any manager would have been kidding himself if he thought of any portion of that interest as “income.” For taxpaying investors the picture turns far worse. During the same 47-year period, continuous rolling of U.S. Treasury bills produced 5.7% annually. That sounds satisfactory. But if an individual investor paid personal income taxes at a rate averaging 25%, this 5.7% return would have yielded nothing in the way of real income. This investor’s visible income tax would have stripped him of 1.4 points of the stated yield, and the invisible inflation tax would have devoured the remaining 4.3 points. The implicit inflation “tax” was more than triple the explicit income tax that our investor probably thought of as his main burden. “In God We Trust” may be imprinted on our currency, but the hand that activates our government’s printing press has been all too human. High interest rates, of course, can compensate purchasers for the inflation risk they face with currency-based investments – as they did nicely in the early 1980s.

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2. Speculations
The second major category involves assets that will never produce anything, but that are purchased in the buyer’s hope that someone else — who also knows that the assets will be forever unproductive — will pay more for them in the future. Tulips, of all things, briefly became a favourite of such buyers in the 17th century. This type of investment requires an expanding pool of buyers, who, in turn, are enticed because they believe the buying pool will expand still further. Owners are not inspired by what the asset itself can produce — it will remain lifeless forever — but rather by the belief that others will desire it even more avidly in the future.
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The major asset in this category is gold, a huge favorite of investors who fear almost all other assets, especially paper money (of whose value, as noted, they are right to be fearful). Gold, however, has two significant shortcomings, being neither of much use nor procreative. True, gold has some industrial and decorative utility, but the demand for these purposes is both limited and incapable of soaking up new production. Meanwhile, if you own one ounce of gold for an eternity, you will still own one ounce at its end. What motivates most gold purchasers is their belief that the ranks of the fearful will grow. During the past decade that belief has proved correct. Beyond that, the rising price has on its own generated additional buying enthusiasm, attracting purchasers who see the rise as validating an investment thesis. As “bandwagon” investors join any party, they create their own truth and a bubble– for a while.

In these bubbles, an army of originally skeptical investors succumbed to the “proof ” delivered by the market, and the pool of buyers — for a time — expanded sufficiently to keep the bandwagon rolling. But bubbles blown large enough inevitably pop. And then the old proverb is confirmed once again: “What the wise man does in the beginning, the fool does in the end.”

Today the world’s gold stock is about 170,000 metric tons. If all of this gold were melded together, it would form a cube of about 68 feet per side. (Picture it fitting comfortably within a baseball infield.) At $1,650 per ounce today its value would be about $9 trillion. Call this cube pile A.
Let’s now create a pile B costing an equal amount. For that, we could buy all U.S. cropland (400 million acres with output of about $200 billion annually), plus 16 Exxon Mobils (the world’s most profitable company, one earning more than $40 billion annually). After these purchases, we would have about $0.5 trillion left over for walking-around money (no sense feeling strapped after this buying binge). Can you imagine an investor with $9 trillion selecting pile A over pile B?
Beyond the staggering valuation given the existing stock of gold, current prices make today’s annual production of gold command about $160 billion !! Buyers — whether jewellery and industrial users, frightened individuals, or speculators — must continually absorb this additional supply to merely maintain an equilibrium at present prices. A century from now the 400 million acres of farmland will have produced staggering amounts of corn, wheat, cotton, and other crops — and will continue to produce that valuable bounty, whatever the currency may be. Exxon Mobil will probably have delivered trillions of dollars in dividends to its owners and will also hold assets worth many more trillions (and, remember, you get 16 Exxons). The 170,000 tons of gold will be unchanged in size and still incapable of producing anything. You can fondle the cube, but it will not respond. Admittedly, when people a century from now are fearful, it’s likely many will still rush to gold. You can be confident however, that the $9 trillion current valuation of pile A will compound over the century at a rate far inferior to that achieved by pile B.
Our first two categories enjoy maximum popularity at peaks of fear.
3. Investments
Our third category is Investments. These are productive assets, whether businesses, farms or real estate. Ideally, these assets should have the ability in inflationary times to deliver output that will retain its purchasing-power value while requiring a minimum of new capital investment. Farms, real estate, and many businesses meet that double-barreled test. Certain other companies — think of our regulated utilities, for example — fail it because inflation places heavy capital requirements on them. To earn more, their owners must invest more. Even so, these investments will remain superior to nonproductive or currency-based assets.
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A cow for her milk
A hen for her eggs
And a business, by heck, for its owner’s earnings.
An orchard for fruit,
Bees for their honey,
And a stock, besides, for its free cash flows

A 100 years from now, people, anywhere on earth, regardless of any currency they follow, will be willing to exchange a couple of minutes of their daily labor for a Coca-Cola. World population will move more goods, consume more food, and require more living space than it does now. People will forever exchange what they produce for what others produce. And businesses will continue to efficiently deliver goods and services desired by the world’s citizens.

“Metaphorically, these commercial cowswill live for centuries and give ever greater quantities of ‘milk’ to boot. Their value will be determined not by the medium of exchange but rather by their capacity to deliver milk. Proceeds from the sale of the milk will compound for the owners of the cows, just as they did during the 20th century when the Dow increased from 66 to 11,497 (and paid loads of dividends as well).” – Warren Buffett

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Screen Shot 2017-12-26 at 12.51.03 PM.jpg Dow Jones industrial average 2002-2012

Investments vs Speculations: a contrast

The two terms are widely and erroneously used and considered as equivalent. They couldn’t be more different.

Here is Warren Buffett on this important subject:

So there two types of assets to buy. One is where the asset itself delivers a return to you, such as, you know, rental properties, stocks, a farm… And then there’s assets that you buy where you hope somebody else pays you more later on, but the asset itself doesn’t produce anything. And those are two different games. I regard the second game as speculation. Now there’s nothing immoral or illegal or fattening about speculation, but it is an entirely different game to buy a lump of something and hope that somebody else pays you more for that lump two years from now than it is to buy something you expect to produce income for you over time. I bought a farm 30 years ago, not far from here. I’ve never had a quote on it since. What I do is I look at what it produces every year, and it produces a very satisfactory amount relative to what I paid for it.

If they closed the stock market for 10 years and we owned Coca-Cola and Wells Fargo and some other businesses, it wouldn’t bother me because I’m looking at what the business produces. If I buy a McDonald’s stand, I don’t get a quote on it every day. I look at how my business is every day. So those are the kind of assets I like to own, something that actually is going to deliver, and hopefully deliver to meet my expectations over time. A piece of art, you know, may go from $1,000 to $50 million, but it’s dependent on what the next guy wants to pay me. The art itself— the painting itself is not going to dispense cash. So I have to find somebody that’s going to like it more. And with most— with an asset like gold, for example, you know, basically gold is a way of going along on fear, and it’s been a pretty good way of going along on fear from time to time. But you really have to hope people become more afraid in the year or two years than they are now. And if they become more afraid you make money, if they become less afraid you lose money. But the gold itself doesn’t produce anything.

Further:

“Investing is an activity of forecasting the yield on the assets over its life; Speculation is the activity of forecasting the psychology of the market.” – Warren Buffett

“Investing is determining what the asset will do, Speculation is about guessing what the price will do” – Warren Buffett

Of Intrinsic Value

What is intrinsic value? Does every asset have an intrinsic value?

Short answers:

  • There are two kinds of values. Intrinsic Value(IV) and Relative Value.
  • An asset’s IV is that which is derived from its cash flows and their expected growth.
  • Only assets with cash flows can have an IV.
  • Currency-based and Investments have an IV. Speculations do not.

On the first question, here is a definition. Intrinsic value is “the value that you would attach to an asset, based upon its fundamentals: cash flows, expected growth of earnings and risk”. The essence of intrinsic value is that you can estimate it in a vacuum without any information on how the market is pricing it or similar assets (though it does certainly help to have that information). A discounted cash flow model is an intrinsic valuation model, because you are valuing an asset based upon its expected cash flows, adjusted for risk. Even a book value approach is an intrinsic valuation approach, where you are assuming that the accountant’s estimate of what fixed and current assets are worth is the true value of a business.

This definition answers the second question. Only assets that are expected to generate cash flows can have intrinsic values. Thus, a bond (coupons), a stock (dividends), a business (operating cash flows) or commercial real estate (net rental income) all have intrinsic values, though computing those values can be easier for some assets than others. At the other extreme, fine art and baseball cards do not have intrinsic value, since they generate no cash flows (though they may generate a more amorphous utility for their owners) and value, in a sense, is entirely in the eye of the beholder. Residential real estate is closer to the latter than the former and estimating the intrinsic value of your house is an exercise in futility.

So, how does the market value assets where intrinsic value cannot be estimated? They look at what other people are paying for similar or comparable assets: i.e., they use relative valuation. Thus, an auction house sets a value for your Picasso, based on what other Picasso’s have sold for in the recent past, adjusted for differences (which is where the experts come in). The realtor sets the price for residential real estate, based on what other residences in the neighborhood have sold for, adjusted for differences again. In fact, let’s face it: this is the way even assets that have intrinsic value are evaluated for the most part. Thus, the investment banker who takes Groupon public may go through the process of providing a discounted cash flow model to back up the valuation, but the pricing of the IPO will be determined largely by the euphoric reception that Linkedin got a few weeks ago.

This calls for clarification of terms. Most people who claim to be valuation specialists, experts or appraisers are really pricing specialists, experts and appraisers. In other words, what separates them in terms of skills is in how good they are in finding comparable assets and adjusting for differences across assets. In fact, when asked the question, “ of what the value of a business or stock is”, one should counter with: “Do you want a value for your business or a price for your business?”. The answers can be very different.

Note: this article has extracted text in several places from an article by Warren Buffet titled “Of Stocks, Bonds and Gold”.

Husain Kothari
March 17th, 2013

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