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Value Investing
Five core ideas of value investing, drawn from Warren Buffett's letters to Berkshire Hathaway shareholders and Michael Mauboussin's work on competitive advantage.
Intrinsic Value
Intrinsic value is what a business is actually worth, as distinct from the price the market happens to quote for it. Buffett defines it as "the discounted value of the cash that can be taken out of a business" over its remaining life.[1] The same logic, which Buffett credits to John Burr Williams, applies to stocks, bonds and whole businesses alike.[2]
Because it rests on forecasts of future cash and on interest rates, intrinsic value is an estimate rather than a precise number, and it must be revised when either changes.[1] Two careful people looking at the same facts will almost always arrive at somewhat different figures.[1] Book value, the accounting record of what has been put into a business, says little about what it is worth.[1]
Buffett argues that growth is not a separate investing style from value but one input into calculating it.[2] The cash that matters is owner earnings rather than reported accounting profit, which he treats as the relevant figure for valuation.[3] Since any estimate can be wrong, he insists on buying well below it, the idea known as margin of safety.[2]
Read next: Owner Earnings.
Moats
In investing, a moat is a durable competitive advantage that lets a business keep earning high returns on the capital it employs.[1] Buffett writes that a great business needs "an enduring 'moat' that protects excellent returns on invested capital."[1] Mauboussin and Callahan describe sustainable competitive advantage as a company earning a return on invested capital above its cost of capital.[3]
High returns attract rivals, and competition tends to pull returns back toward the cost of capital.[3] Common sources of advantage include cost advantages from scale, network effects, customer switching costs, and government licenses or patents.[3] Buffett adds that an advantage which must be continually rebuilt will eventually stop being an advantage at all.[1]
Buffett also observes that exceptional returns rarely survive severe change, so durable franchises tend to belong to companies doing much the same thing they did years before.[2] A moat raises intrinsic value only if the cash it protects is put to good use, which makes capital allocation its natural companion question.
Read next: Capital Allocation, Intrinsic Value.
Mr. Market
Mr. Market is Benjamin Graham's allegory for the stock market, retold by Buffett in his 1987 letter.[1] Imagine a business partner who appears every day and names a price at which he will buy your share or sell you his.[1] His prices swing with his mood, euphoric at some times and depressed at others.[1]
You are never obliged to trade with him, since he does not mind being ignored, and his foolish prices are opportunities rather than instructions.[1] As Buffett puts it, "Mr. Market is there to serve you, not to guide you."[1] The real danger is falling under his influence.[1]
Buffett later made the same point with a farm and a New York property he owns, which never receive price quotes and are judged by what they produce.[2] Stock owners, he wrote, too often let the irrational behavior of other owners make them behave irrationally too.[2] The discipline Mr. Market calls for is to compare his price with intrinsic value and to buy only with a margin of safety.[3]
Read next: Intrinsic Value.
Capital Allocation
Capital allocation is the set of decisions about where a company's cash goes: back into the business, into other businesses, or back to its owners. Buffett argued that many chief executives are not skilled at it, because most reached the top by excelling at something else, such as marketing, production or engineering.[1] The stakes are large: a CEO whose company retains earnings equal to 10% of net worth each year will, after ten years, have deployed more than 60% of all the capital in the business.[1]
Berkshire judges its own retained earnings by asking whether, over time, each dollar kept has produced at least a dollar of market value.[2] In Buffett's view the best business can reinvest large amounts of capital at very high returns, while the worst keeps absorbing more capital at very low returns.[4] Growth helps investors only when the incremental returns are attractive.[4]
See's Candies shows another path: Berkshire bought it for $25 million when it needed about $8 million of capital, and it has sent almost all of its later earnings to Berkshire.[3] After taxes, that cash was used to buy other attractive businesses.[3] A business with a strong moat but few places to reinvest can still compound its owner's wealth when someone redeploys the cash well.
Read next: Owner Earnings, Moats.
Owner Earnings
Owner earnings is the measure Buffett set out in his 1986 letter for the cash a business actually produces for its owners.[1] It equals reported earnings plus depreciation, amortization and similar non-cash charges, minus the average annual capital spending the business needs to fully maintain its long-term competitive position and unit volume.[1] Any extra working capital needed for the same purpose is also deducted.[1]
Buffett treated owner earnings, not GAAP earnings, as the relevant figure for valuation, both for buying stocks and for buying whole businesses.[1] When the required maintenance spending exceeds those non-cash charges, reported earnings overstate what owners really earn.[1] This is the cash that intrinsic value discounts, since Berkshire defines value as the cash that can be taken out of a business over its life.[2]
The weak point is the maintenance spending figure, which has to be guessed and is sometimes very hard to estimate.[1] Buffett accepted that imprecision, quoting Keynes: "I would rather be vaguely right than precisely wrong."[1] See's Candies, which needed only $8 million of capital when Berkshire bought it, shows how a business with modest capital needs leaves more of its profit for its owner.[3]
Read next: Intrinsic Value, Capital Allocation.