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One of the biggest arguments we have here in I3 usually relates to “Business Sense”.
Koon Yew Yin and Stockmanmy etc usually take the side of “Business Sense”, while Kcchongnz usually takes the other, which I quantitative valuations (P/E, P/B, ROIC, ROE etc)
Having met Kcchongnz a month or 2 back, I realized that both Kcchongnz and Koon Yew Yin is actually quite similar to an extent.
Kcchongnz purchased one of my recommendations which was definitely not cheap by any quantitative metric, but had a fantastic business moat behind it. And his many picks were not fantastic quantitatively, but had pretty decent business.
While Koon Yew Yin talks about business sense a lot, but his golden rules say that the company should be below 10 P/E. So clearly, quantitative valuation still play a part. Having said that, I do wonder why he uses P/E instead of EV/E.
The difference between them, is that they both emphasize the other factor too hard.
Having said that, I would rather put my money with Kcchongnz, errors of omission is far better than errors of commission.
In investing, it’s better to be too conservative than too arrogant and aggressive. Which is definitely the defining trait for Koon yew Yin.
Valuation and intrinsic value.
There are 2 aspects to investing.
- Quantitative
- Qualitative
Quantitative
The first is fairly straightforward. Look at the EV/EBIT, P/E, ROIC, ROE, P/B ratios, and based on that, if it’s cheap enough, with a large margin of safety, purchase the company. Also remember to diversify.
This was practiced by Benjamin Graham and Walter Schloss, and they obtained pretty decent returns. This was when the US markets were still quite inefficient, and just came off a depression, bargains were everywhere.
And to an extent, can still be practiced relatively widely by retailers in the KLSE, given the inefficient nature of our markets.
Having said that, you should note that the incredibly out-sized returns are usually not found here. As you should be paying for earnings, not assets.
As Warren Buffet says, he is not a liquidator. Having said that, one of the reasons he moved away from this was because his capital got too big, and he preferred the process of buying fantastic companies at fair prices.
Qualitative.
This is what people like stockmanmy (now known as qqq3) or koon yew yin, call “Business Sense”.
This is most interesting aspect of investing, and the most profitable if done well.
What is the Intrinsic Value of any investment?
According to Warren Buffet, the intrinsic cash flow generated by the investment from now till infinity discounted at an appropriate rate back to the present.
Notice how he does not say P/E needs to less than 10, or that P/B needs to be 0.5 times. In fact, in his 2013 annual meeting, he said that he does not consider those instrumental to his decision to purchase.
And if you look at his best investments. Like Coca-cola, GEICO, General RE or American Express, he definitely paid what his teacher Benjamin Graham would not consider to be cheap.
And when you throw in NetJets, which lost USD677mil over the next 10 years after he bought it, before the company dominated the fractional jet space worldwide and started making outsized profits from 2013.
And looking at his most recent admitted mistakes. He confessed that he made an error in not buying Google, Microsoft and Amazon.
These purchases when purchased, were not cheap by any quantitative metric.
But, according to Buffet, as he bought them, or considered it his mistake not to buy them, he clearly considered that at the prices he paid (or would have paid), would be much lower than the amount of money that can be generated by these companies over its lifetime, even when discounted by the risk free rate of return.
So, the million dollar question.
How do you calculate the discounted cash flow of a business over its lifetime?
To do this, you need to know a few things.
- The resilience of the earnings.
- The growth rate and the resilience of the growth rate.
- The ability of the company to maintain pricing power in times of inflation.
Short questions, with simple but hard answers.
According to Buffet, he needs to understand the business so well, that he can see the next 5, 10, 20 and 30 years with a high level of certainty.
Most people do not know this. But he was one of the first investors in Intel (he was friends with Andy Grove), but he sold out early.
And many people are likely to also know that he is very close friends with Bill Gates, how could you not buy Microsoft? What question could you possibly have that Bill Gates cannot answer.
Interestingly, back in the year 2000, Bill Gates did admit that, if he had to go away for 20 years completely to an abandoned island, he would be more confident in his capital being secure in Coca Cola versus Microsoft.
Well, according to Warren Buffet, he understood the products, he used them and he could see their moat. However, he wasn’t able to understand the business so well, that he can guarantee that these companies will still be around.
Remember, this was 2000 or so. Google just overtook Altavista in the search engine space. And Microsoft was still very dominant, even in search. Google becoming as big as it was today, is not guaranteed.
Microsoft just over took Apple for a few years, and there wasn’t a guarantee that they won’t lose in the future.
And for Amazon, he always admired Jeff Bezos. Jeff was the first CEO to properly expense options. He admired him for that so much, he quoted him in the annual report, and bought Amazon bonds. But he just couldn’t buy the stock, as he thought it would be a close miracle for Amazon to make it, considering how many internet companies in the same field that died.
During those years, it was also so common for great companies to lose their moat so quickly, Kodak for example.
And amazingly, despite missing out those companies, he still obtained such amazing returns for the last 18 years.
It’s one thing to know roughly how a company will perform for the next 3 months, but it’s completely different to understand a company so well, that you can say with a high probability how it will be 10 to 20 years from today.
Using normal quantitative measurements only, it would be very very hard to buy Berkshire Hathaway whether at USD19 per share, or USD300,000 per share today. It was close to fair value at every level, it’s just the difference in size.
The only way you will be able to see the hidden qualitative of this business where, you can identify (accurately) intrinsic value that others wont be able to see, you need to know the management, the business, the competitors, the suppliers, the customers, the economic characteristics.
All of which takes a lot of time and thinking, Warren Buffet when he bought Coca Cola, read every single copy of the annual report from 1886. And very old news articles from more than 100 years ago.
Interesting bit of knowledge, in 1930, there was an article saying how most investors looked at Coca Cola, and felt bad that they missed it out in 1910 etc. And how it wasnt cheap then having gone up more than 20 times.
Well, i you bought one share at 1930 for 17 dollars, and held it to the day Warren Buffet bought in 1988, you would have roughly USD2.1 million.
And if you bought Coca Cola when Buffet bought it, you would be up about 22 times by today.
That is business sense for you.
Interestingly, even Benjamin Graham admitted that if you removed GEICO from his portfolio, his returns will go from more than 20% per annum for 30 years, to the low teens.
He bought it because it was cheap enough, but it was such a fantastic business, it could grow to where it is today.
Graham also said that he could see how the qualitative aspects are very important. But he felt it was much more difficult to teach how to value the qualitative aspects, and the buying quantitatively cheap companies were a much safer and secure way for the average person. Which is true.
But the second is also much more fun!
Conclusion
Having said it, most people will now say finding these amazing businesses at fair values is a very hard thing. You can maybe find 2 or 3 max. And less than 10 in your entire life.
However, do note this. You only need to put significant amounts of money into these companies once or twice, and as long as your hold long enough, your life and finances is guaranteed.
Why should something so financially rewarding be so easy?
Personally, I can see maybe 5-6 companies in Bursa that is fantastic, and only 2 or 3 that is at a fair value and not overvalued.
Here’s to finding more.
Choivo Capital 