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The First Investment Primer

This article was originally published on MastersInvest.com.

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People like to make investing complicated. And the more complicated they can make it sound, the smarter some people think they are. If you stop and think about it, the investment strategies that are marketed today could make anyone’s head spin; Value, Deep Value, Relative Value, Growth, Core Growth, Aggressive Growth, Growth at a Reasonable Price, Alpha Overlays, Quantitative, Momentum, All- Weather Portfolios, etc – they’re all complicated terms that when used can make the dumbest investor sound very smart indeed.

But let’s get back to basics. What is investing really all about? Mostly, it’s about simple common-sense; you outlay money today with the expectation you’re going to get more returned in the future.

So the value of an investment then is the value of the future cash-flows you will receive in the future.

As a dollar in your hand today is worth more than a dollar in the future [because you could invest that dollar today and earn interest on it versus, say a dollar received in a year’s time] you need to discount those future cash-flows back into today’s dollars. The total amount of those discounted dollars is effectively a company’s ‘Intrinsic value’. And Warren Buffett says that this is what businesses and investing is all about.

“The intrinsic value of any business, if you could foresee the future perfectly, is the present value of all cash that will be ever distributed for that business between now and judgment day. And we’re not perfect at estimating that, obviously. But that’s what an investment or a business is all about. You put money in and you take money out.

While most people think of Buffett as a ‘value investor’, the concept of value is often misinterpreted. Buffett uses the term ‘value’ in reference to a company’s ‘intrinsic value’. In short, Buffett wants back more than he puts in.

“I just cringe when I hear people talk about, “Now it’s time to move from growth stocks to value stocks,” or something like that, because it just doesn’t make any sense.Warren Buffett

“Anybody that tells you, “You ought to have your money in growth stocks or value stocks,” really does not understand investing.” Warren Buffett

Among his many skills as an investor, one is keeping things simple. At the Berkshire meeting in 2000, Buffett noted the laws of investing were set out a long long time ago…

“It’s very simple. The first investment primer, when would you guess it was written? The first investment primer that I know of, and it was pretty good advice, was delivered in about 600 B.C. by Aesop. And Aesop, you’ll remember, said, “A bird in the hand is worth two in the bush.”

Buffett noted Aesop was smart, but there were a few more questions that need to be answered to identify an attractive investment ..

“Now, Aesop was onto something, but he didn’t finish it, because there’s a couple of other questions that go along with that.”

And the other things you need to know are; when do you get the other birds? How certain are you that you will get them? And: What are interest rates?

“[Aesop] He forgot to say exactly when you were going to get the two in the bush — and he forgot to say what interest rates were that you had to measure this against.

But if he’d given those two factors, he would have defined investment for the next 2,600 years. Because a bird in the hand is — you know, you will trade a bird in the hand, which is investing. You lay out cash today.

And then the question is, as an investment decision, you have to evaluate how many birds are in the bush. You may think there are two birds in the bush, or three birds in the bush, and you have to decide when they’re going to come out, and when you’re going to acquire them.”

A nice summary of Investing. Buffett appropriated the analogy of buying the bushes for modern day investment.

A bird in the hand is worth two in the bush. Now our question is, when do we get the two? How long do we wait? How sure are we that there are two in the bush? Could there be more, you know? What’s the right discount rate?

And we measure one against the other that way. I mean, we are looking at a whole bunch of businesses, how many birds are they going to give us, when are they going to give them to us, and we try to decide which ones — basically, which bushes — we want to buy out in the future.

It’s all about evaluating future — the future ability — to distribute cash, or to reinvest cash at high rates if it isn’t distributed.”

What that means is you need to work out what cashflows you as an investor will receive from the company you own. When do they arrive, and how certain are you you’ll get them? What can the company do to grow those cash flows? But use conservative forecasts; if you’re uncertain, it may be best to avoid the investment. Then use an appropriate discount rate to discount those cash flows back to a present value.

The key criteria then is, can I buy the stock at an attractive discount to my estimate of intrinsic value? And finally, how does this investment compare to all the other investment choices I have? The latter of course includes, doing nothing.

“When you say a bird in the hand is worth two in the bush, you’re comparing it — you’ve got to compare that to every other bush that’s available.” Warren Buffett

Aesop didn’t use terms like Deep Value or Alpha Overlays. He simply stated that what you hold in your hand today should be be worth more in the future. He kept it simple, and without over-complicating his theory. And Buffett says much the same thing; he even used Aesop’s theory, rather than develop a new one of his own. Which sounds pretty smart to me. It’s a time tested equation that was as relevant 500 years ago as it’s likely to be be 500 years in the future.

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