Physics Envy
In October of 2003 Charlie Munger gave a lecture to the economics students at the University of California at Santa Barbara in which he discussed problems with the way that economics is taught in universities.One of the problems he described was based on what he called "Physics Envy." This, Charlie says, is "the craving for a false precision. The wanting of formula..."
The problem, Charlie goes on, is, "that it's not going to happen by and large in economics. It's too complex a system. And the craving for that physics-style precision does nothing but get you in terrible trouble."
A monumental example of this problem is the efficient market theory. The result of trying to impose the discipline of a hard science on economics, which is not a hard science—it is a social science. Equity markets are about human behaviour and while the markets are very efficient at valuing data, they are certainly not rational. They are much too complex and reactive to lend themselves to the kind of discipline that rules the hard sciences.
Overweighing Numbers
When you combine Physics Envy with Charlie's "man with a hammer syndrome," the result is the tendency for people to overweight things that can be counted.
"This is terrible not only in economics, but practically everywhere else, including business; it's really terrible in business—and that is you've got a complex system and it spews out a lot of wonderful numbers [that] enable you to measure some factors. But there are other factors that are terribly important. There's no precise numbering where you can put to these factors. You know they're important, you don't have the numbers. Well practically everybody just overweighs the stuff that can be numbered, because it yields to the statistical techniques they're taught in places like this, and doesn't mix in the hard-to-measure stuff that may be more important. That is a mistake I've tried all my life to avoid, and I have no regrets for having done that."
“Not everything that counts can be counted, not everything that can be counted counts” Albert Einstein
As Charlie says, this problem not only applies to the field of economics, but is huge consideration in security analysis. Here it can give rise to the "man with a spread sheet syndrome" which is loosely defined as, "Since I have this really neat spread sheet it must mean something." Buffett has defined intrinsic value of a business as the amount of cash that would be generated by that business in the future, discounted by the dollars that would be generated if the cash necessary to buy that business were invested in risk free government bonds.
To the man with a spread sheet this looks like a mathematical (hard science) problem, but the calculation of future cash flows is more art than it is hard science. It involves a lot analysis that has nothing to do with numbers. In a great many cases (for me, probably most cases) involves a lot of guessing. It is my opinion that most cash flow spread sheets are a waste of time because most companies do not really have a predictable future cash flow. This is why, and to some extent how, Buffett limits his universe. (Above information taken from Losch Management Website)
Mohnish PabraiI always write the thesis down. If it takes more than a short paragraph, there is a fundamental problem. If it requires me to fire up Excel, it is a big red flag that strongly suggests that I ought to take a pass.
Intrinsic Value and Discount Rate
Warren BuffettFor Buffett, determining a company’s value is easy as long as you plug in the right variables: the stream of cash and the proper discount rate. If he is unable to project with confidence what the future cash flows of a business will be, he will not attempt to value the company. This is the distinction of his approach. Although he admits that Microsoft is a dynamic company and he highly regards Bill Gates as a manager, Buffett confesses to not have a clue how to estimate the future cash flows of his company. If the business is simple and understandable, if it has operated with consistent earnings power, Buffett is able to determine the future cash flows with a high degree of certainty. The circle of competence that he refers to is reflected in his ability to project into the future ( His 10 year test). In Buffett’s mind, the predictability of a company’s future cash flow should take on a “coupon- like” certainty that is found in bonds.
After he has determined the future cash flows of a business Buffett applies the discount rate. Many people will be surprised to learn that the discount rate that Buffett uses is simply the rate of the long term U.S Government bond, nothing else. That is as close as anyone can come to a risk-free rate.
Academics argue that a more appropriate discount rate would be the risk- free rate of return (the long term bond rate) plus an equity risk premium, added to reflect the uncertainty of the company’s future cash flows. Although Buffett does admit that as interest rates decline he is apt to be more cautious in applying the long term rate, he does not add a risk premium to his formula for the simple reason that he avoids risk. First, Buffett eliminates the financial risk associated with debt financing by excluding from purchase those companies with high debt levels. Second, business risk is reduced, if not eliminated, by focus in on companies with consistent and predictable earnings. “I put a heavy weight on certainty. If you do that, the whole idea of a risk factor doesn’t make sense to me. Risk comes from not knowing what you’re doing.
Buffett does not adjust the discount rate for uncertainty (Uses to the risk free rate (US Treasury Bond), with adjustments upwards if lower than normal, merely to equate one item to another). If one investment appears riskier than another, he keeps the discount rate constant and, instead, adjusts the purchase price. He would in other words obtain his margin of safety not by including a premium for equity risk as CAPM requires but by buying at a lower purchase price to begin with.
Mohnish PabraiQ. How do you calculate intrinsic value? (Question from 2002 AGM)
A. Intrinsic value is easy to describe and hard to calculate. It is defined as the cash the business is expected to generate from now to infinity. Infinity is way out. You could go out 5 or 10 years, and you make an assumption at the 5th or 10th year that the business was sold at some reasonable price. And then you discount it at a risk free rate of return to get present intrinsic value. What I do is I discount it at a 30 % rate of return, which is the target return we look for. And then see if the current price we come up with is below the price the stock is trading at. And most of the time it is not. And if you run intrinsic value numbers on most good companies, you find they are above intrinsic value. (I am assuming the 30% discount includes his margin of safety as well)
Q. What have you been using as a discount rate in your value calculation? (Question from 2003 AGM)
A. I use a 10% discount rate. You are supposed to use a risk free rate. My typical benchmark is that I value businesses that are not growing at about 10 time’s free cash flow. I want to pay about half that -5-6 time free cash flow
Dante told me during the course that Mohnish told him that he uses either 10 or 15% discount rate depending on the company.
“You’re never going to get a precise number on intrinsic value. I always focus on what I call ‘conservative intrinsic value’” Mohnish Pabrai
Professor Bruce Greenwald said most discount rates fall in the 7-12% range
ROIC over WACC/Required return on investment
Berkshire Hathaway’s Owner Principles Number 9
“We feel noble intentions should be checked periodically against results. We test the wisdom of retaining earnings by assessing whether retention, over time, delivers shareholders at least $1 of market value for each $1 retained. To date, this has been met. We will continue to apply it on a five year rolling basis. As our net worth grows, it is more difficult to use retained earnings wisely.”
“We continue to pass the test, but the challenges of doing so have grown more difficult. If we reach the point that we can’t create value by retaining earnings, we will pay them out and let our shareholders deploy the funds.”
Warren Buffett “The ultimate value to Berkshire depends on how the retained earnings are reinvested and what that reinvestment produces in future earnings”
Warren BuffettThe weighted average cost of capital (WACC) is:
(Equity percentage of the capital structure x (its cost + equity premium)) + (debt percentage x its cost (1-TC))
Example- If a company’s capital structure was 60 percent equity and 40 percent debt, and if the equity cost was 15 percent and the interest rate on the debt was 9 percent, the company’s WACC would be 12.6 percent.
If the company went on to earn 15 percent return on capital that cost 12.6 percent, it would be said that the company is adding value. On the other hand if the company earned 10 percent it would be destroying value.
Buffett has a different measuring stick. He measures a company’s hurdle rate by its ability to grow its market value by a rate that is at least equal to the value of the company’s retained earnings (Over a period of time). For every dollar a company retains, Buffett argues, it should create at least one dollar in market value.
All of Berkshire Hathaway’s subsidiaries are charged for the capital they request from Buffett. He acknowledges that he doesn’t use complex formulas rather “We just figure it’s simpler to charge people a fair amount for the money and then let them figure out whether they really want to buy a new splitter or whatever it may be. It varies a little depending on the history of when we came in and what the interest rate was when we bought it, but generally we charge people something like 15 percent on capital. We find that 15 percent gets their attention, but shouldn’t be such a high hurdle rate that things we want to do don’t get done”
All Buffett’s managers compensation is linked to this hurdle rate as well. If they can’t find anything to do with the money they send it to Omaha because if they squander it below Berkshires cost of capital there salaries decrease (No incentive for this to happen). If they can find ways to use it above the cost of capital there salaries increase which provides a very good way to make sure shareholders money is spent wisely.
It is important to keep in mind that Buffett’s internal benchmark for Berkshire Hathaway is that the company overall needs to grow at a minimum rate of 15 percent annually. Therefore 15 percent is also his hurdle rate for capital, which is also the rate that he mentioned he will start returning shareholders money if he can not achieve instead of squandering it below his own internal “cost of capital”
Personally I like Buffett’s system of charging a number higher than just WACC for his subsidiaries. This is due to the opportunity costs that are missed by just using WACC. Example is a company with a WACC of 10% always using that as a benchmark and making whatever investment it feels warrants a better than 10% return even though it is maybe not allocating this money as efficiently as it would if it had a higher required rate of return on investment. If it upped its standards and was patient, it would eventually get a great ball to hit right down the middle of the plate that meets its required investment high standards.
Eddie Lampert “Our culture around capital is intense and it is not simply about not spending. It is about investing well. Like any investment of capital, the return on that capital over time will determine the wisdom.”
Free Cash Flow
Mohnish PabraiQ. What are the major line items that you adjust to get from cash flow to free cash flow? (Question from 2004)
A. Free cash flow is pretty straightforward. You’re going to add depreciation and you’re going to subtract capital expenses and get to the FCF number for most businesses.
Warren BuffettFree Cash Flow/ Owner Earnings- (a) Operating earnings plus (b) non-cash charges such as depreciation and amortization less (c) normalized capital expenditures or required reinvestment in the business. (a)+ (B)-(c) = “owner earnings”
Circle of Competence
Mohnish Pabrai “My take has always been that you’re likely to make the most money with the ideas that are the simplest. IT may all be perfectly fine and it may all be low risk but it just fails the simplicity test for me. There are enough simple businesses one can run into which might be trading at half price that are pretty straight forward to understand that if you were successful in putting all your capital into those businesses, you’d have very spectacular long-term returns. From my point of view that modus operandi makes more sense to me than going out side my circle of competence lured by amazing returns possibilities.
I want to just share a story very quickly of something Charlie Munger had shared at this year’s Wesco Meeting. He mentioned a friend of his, John Ariaga. John, over the last 30 years, has only invested all his money in commercial real estate within four to five blocks of Stanford University. He made no other investments over that period. Munger was saying he was worth between 400-500 million today.
In the mid- 90s, he got goosy about real estate, and leverage and he significantly delevered all his properties. When the dot com boom came in ’98 and ’99, all his real estate went through the roof. Then a year to 18 months later, occupancy was at 60%. There were a large number of foreclosures all around Stanford and at that point he levered up and he bought all the real estate.
The point that I took home from that discourse Munger gave was that to get very wealthy you don’t need a large circle of competence. In the case of John, he probably got approached in the last 30 years to put money in Chine, to put money in oil, to put money in stock, to put money in India, whatever. All his rich friends telling him what to do and he probably rejected all of them and he didn’t eve go 10 blocks from Stanford. He stayed very close. John’s circle of competence is extremely small, but he’s wealthier than most of us in this room.
My take has always been that you are better off with a very, very narrow circle of competence and a very focused set of investments which you understand inside and out and not rely on a bunch of Chicago MBA’s to tell you what to do. I always felt that you’re better off with a smaller circle of competence than a bigger circle of competence. It is way better to be very narrowly focused, but being very disciplined and very patient."
Warren BuffettA girl in a convertible is worth five in the phonebook. Obviously, we can never precisely predict the timing of cash flows in and out of a business or their exact amount. We try, therefore, to keep our estimates conservative and to focus on industries where business surprises are unlikely to wreak havoc on owners. Even so, we make mistake: I’m the fellow who thought he understood the future economics of trading stamps, textiles, shoes and second tier department stores.
Closing Point about Intrinsic Value
Warren BuffettThough the mathematical calculations required to evaluate equities are not difficult, an analyst- even one who is experienced and intelligent- can easily go wrong in estimating future “coupons”. At Berkshire, we attempt to deal with this problem in two ways. First we stick to businesses we believe we understand. That means they must be relatively simple and stable in character. If a business is complex and subject to constant change, we’re not smart enough to predict future cash flows. Incidentally, that short coming doesn’t bother us. What counts for most people in investing is not how much they know, but rather how realistically they define what they don’t know. An investor needs to do very few things right as long as he or she avoids big mistakes.
Second, and equally important, we insist on a margin of safety in our purchase price. If we calculate the value of a common stock to be only slightly higher than its price, we’re not interested in buying. We believe this margin- of- safety principle, so strongly emphasized by Ben Graham, to be the cornerstone of investment success.
“Valuation is counting cash, not hopes or dreams” Warren Buffett• People will probably notice that Buffett says he uses the US Treasury Bond rate and also 15% for his cost of capital or discount rate. I believe that he uses US Treasury Bond to discount (adjusted upwards if low or usually around 10%) and then the 15% comes from his internal high standards with regards to the purchase price and eventual rate of return.
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Please debate this as much as you can…. Just thought I would take some stuff Buffett and Pabrai had said and combine it with what we learned and so we could debate over it.
