Investing: The Rules of the Road

Investing money can seem a little rudderless at times.

One day you hear that stocks are risky and the next that they’re indispensable. Some days it seems like stocks only go up and sometimes that they only go down. Real estate used to seem like an automatic path to wealth, and then the housing crisis hit. For the uninitiated, it sometimes seems there are no central truths. And unlike certain fields, we all have to deal with money. We can’t “opt out” from financial concerns unless we plan to live in a monastery, and it is useful for all of us to understand the basic ideas.

Investing is not a science but a craft, and a craftsman needs tools. In the case of investing, the tools are mostly mental. If we accumulate a few simple mental tools, we can start evaluating the claims of experts, salesmen, or simply well-intentioned friends.

The Rules of the Road

(1) The value of an asset depends entirely on the net cash it will

generate from now to the hereafter.

This goes for a stock, an apartment house, a convenience store, a bakery, or an iPhone app startup. An asset only has value (in a financial sense) if it can generate net cash flow to its owner. The amount and timing of that cash determines the value of the business. The more cash to be expected and the sooner it’s expected to come, the more valuable the asset is today. This is the fundamental truth about investing. Nothing escapes the orbit of future cash flows.

The other determinant of value is interest rates: The average future interest that could have earned if you bought a “risk-free” asset is the opportunity cost of the asset you’re considering purchasing today. That risk-free interest rate determines the value of an asset’s future cash flows to you today. (Although we don’t recommend trying to compute the figure out to three decimal places.) If average risk-free interest rates are 6% over time and I offer you a chance to buy an apartment house that pays you 4% on cost, is that a good buy? You better feel confident that the 4% will grow over time, right? This basic form of reasoning can be applied to all types of cash-producing assets.

This is the thing you should be thinking about when you’re instead thinking about what the Fed will be doing or what Jim Cramer said on TV or what the hot industry is or what the CEO of some company had for breakfast. Do you have any idea what the business or property will earn over the next five, ten, or twenty years in relation to what it earns now? This Grand Unifying Theory of investing gets discussed surprisingly little.

It also generates some sub-conclusions that aren’t always recognized by lay investors and are frequently forgotten by professionals.

(A) What an asset has earned in the past does not determine its value. In stocks, looking at the last ten years of earnings is a useful exercise in trying to understand what type of business you’re dealing with, but while it’s a good guide, past earnings do not generate value. Future earnings do, and that goes for all types of assets. This means you must develop a view about the future, which we’ll address again in point (2) below.

(B) An asset that never earns any net profit after all expenses has no financial value. Please let that sink in. It is common for businesses to obscure this basic fact, and promote all sorts of alternative methodologies with which you’re supposed to see value. Book value, EBITDA, number of page views, number of users, brand recognition, and years of managerial experience do not, in and of themselves, tell you about the value of a business or an asset. The bare fact is that an asset must eventually generate net cash flows to its owner which are commensurate with the price paid in order for the investment to be worthwhile. Investing on another basis is, by definition, speculation.

(C) If you have no idea what an asset will earn in the future (at least in a general sense), then you have no idea what it’s worth. And if you do not know what the asset is worth, then you have no idea whether you are over-paying or under-paying for it, and as an intellectually honest person, you should consider both possibilities at least equally likely.

(D) Any future cash flows out of an asset must also be subtracted in determining today’s value. If a business is going to lose money for 10 years and only then start making it, it’s worth a hell of a lot less than one which will make the same amount of money starting this year. This is another idea which gets surprisingly little play in relation to its obvious importance.



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(2) Buying a share of stock is a buying share of the underlying business.

Although we’re discussing general investment concepts, the stock market needs a bit more attention because of its seemingly abstract nature. No one gets confused as to what they’re buying when they invest in a local dry-cleaner. Most fixed income instruments are priced in a fairly straightforward manner. But when it comes to businesses traded on the public exchanges, which we call stocks, all sorts of weird theories abound.

Stocks, for all of their labels and all of the strange fears and speculations around them, are no more than a piece of an underlying business pie. When you buy stock in a business, you are buying the right to the net cash flows that its assets produce. Stocks do not escape the orbit of financial gravity no matter what the Fed is doing or what CNBC is saying. And buying into an index fund that owns many stocks means that you’re now part-owner in all of the underlying businesses; your return comes from the success of their business operations. If American business as a whole keeps on trucking, the index fund will reflect their success, assuming you paid a rational price. That’s why averaging into the indexes is such a common recommendation for non-professional investors. Buying individual businesses in the form of stocks carries a heavier burden of proof and much more specialized work.

One corollary to this idea is that stock prices tend to move around much more than intrinsic business values. If you were to take the ten year business record of any of a number of very stable corporations and then guess their high and low stock prices in the same period, you would almost certainly be surprised at the degree of variation. The reason for this can be found in point (3).

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(3) Investing in any asset with uncertain cash flows requires an

element of speculation about the future.

Discerning an asset’s cash flows requires that we make intelligent guesses about a cloudy future. This idea has some deep corollaries:

(A) The more speculation needed to determine the value of the asset, the riskier it is all else equal, due to the higher probability of getting our estimates wrong. In the case of a 1-Year U.S. Treasury bill, we don’t have to offer any speculation beyond assuming that the U.S. government will be solvent and paying 12 months from now and that the U.S. dollar will continue to be accepted as legal tender. (If this ceases to be true, we’re all in big trouble.)

In the case of a biotechnology startup, on the other hand, our entire valuation is going to be based on speculation. In essence, the whole exercise of valuing such a start-up would be making difficult guesses about the future. The probability that we get all of our guesses correct approaches zero, although if we’re correct enough about one or two important factors we might still make money. But we’ll need great luck in doing so, whereas with the Treasury bill, we hardly need any luck at all.

(B) Investing in uncertain assets, including any kind of business-based investment like a farm or a technology stock, involves some difficult speculation, so it’s easy to predict that at times, investors will get caught up in their enthusiasms and mis-price assets. Charlie Munger has commented that stocks are valued partly like Treasury bonds, with obvious cash flows estimated and discounted at rational rates, and partly like art or collectibles, with speculation that the price will go higher or lower because of popularity, trend, or hope. The riskiest assets are the ones valued primarily on speculation because of our lack of ability to see into their economic future. That’s why a corporate bond tends to be less risky than a stock — you only need to establish that the corporation will be solvent for the bond to be a good investment, whereas with the stock, you must make much more complicated estimates.

(C) We know from watching horse-race betting, casino gambling, and lottery participation that people are frequently willing to speculate on odds-against bets that can only hurt them financially in the long-run. We observe the same behavior in the stock market and in other markets as well. (There was, for example, a speculative farming boom in the 1980s.) Financial markets cannot be perfectly efficient because of the speculative element. As with (B) above, more uncertain assets tend to have a greater speculative element attached.

(D) Assets with predictable cash flows tend to be inherently lower-risk than ones without predictable cash flows. Let’s use two different types of businesses to understand this point.

We can be essentially certain that over the next year, Visa and MasterCard will make a tremendous amount of money which is closely related to the amount they made last year — their cash flows are based on the number of transactions made on their cards and the amount of money they collect per transaction. Both elements tend to be extremely stable on a day to day and year to year basis, with a tendency towards growth as new cards make it into circulation. Unless hundreds of millions of people stop using their credit and debit cards or million of merchants find a way to pay a lot less to these intermediaries (who collect very little to start), the businesses will maintain a useful degree of economic predictability. The number of transactions you made on your card last month and the month before pretty closely predicts how much you’ll use it this month and the following one.

As we move out further to year 2, we can still be pretty sure that these characteristics will continue to hold, and thus we can predict with useful accuracy the kind of money Visa/Mastercard will make. The same goes for year 3. However, the longer we continue this exercise, the more our accuracy declines. Although things look pretty good this year, next year, and the year after, what about 30 years from now? By then, one can speculate on the possibility of certain changes to the financial system which might affect the economics of Visa/Mastercard. Our earnings estimate 30 years out is certain to be inaccurate even for a predictable business.

The opposite case is Twitter. Twitter has never shown a net profit to its shareholders and has not established a consistent business model which would allow it to do so. Thus, it would be very difficult to say what Twitter’s earnings might be in the next year, let alone 30 years from now. On this basis, investing in the common stock of Twitter contains a much larger speculative element than Visa/Mastercard. An investment in Visa/Mastercard at a fair price in relation to future earnings can be said to have far less risk than an investment in Twitter. Notice that we don’t come to this conclusion by saying that Visa/Mastercard are riskless, that we can predict their earnings forever, or that Twitter will never be a profitable investment. We are simply ranking potential investments on a sliding scale based on the predictability of their future cash flows. Any estimates will be necessarily imprecise, but they still have great value to us as investors.

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(4) The price you pay determines the return you get.

Lower prices = higher returns.

You’ll often hear fables about how now is the time to invest because “The market has done really well over the past few years” or because “My friend has made a lot of money on this stock, I think it’s a good investment,” or some similar statement about other kinds of financial assets; real estate properties, oil royalties, McDonald’s franchises, etc.

Conversely, one frequently hears things like “That stock’s gone way down recently, it seems pretty risky” or “My friend bought a bunch of real estate that went way down, I think real estate is risky” and other notions to that effect.

These thoughts are 180 degrees wrong because they fail to understand the point that low prices create high future returns and that high prices create low future returns. (“High” and “low” being in relation to underlying value.) If a stock trades at 50% of its recent high price, then you are buying the same future cash flows for half the price. If a stock trades at 200% of a recent low price, then the opposite is true; you’re getting exactly half the value you would have before.

You should seek to buy assets with future cash earnings you can (roughly) estimate at prices that offer a fair return. The rest is almost always noise.



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(5) Everyone has a unique circle of competence which allows them to

understand certain things best and other things not at all.

We discussed above in point (3) that certain investment situations are inherently speculative, as with the case of Twitter common stock. But even within the realm of knowable investment choices, each investor has his or her own unique circle of competence which they bring to the analysis. In the circle are the things that, through life experience and/or accumulated study, one can fairly evaluate and expect to end up in the right ballpark. Outside of the circle are things we don’t have the experience to understand.

Although this point seems simple to the point of banality, it is constantly violated even by smart and financially-savvy people. Many an expert in construction businesses or plumbing businesses or restaurant businesses have tried their hand at buying apartment houses or energy stocks only to find out that their expertise did not carry over. And it is thus for all of us: We are prisoners to our talents, and we’re wise to think long and hard about what we really know and don’t know.

For example, if you do not have the ability to read financial statements, understand microeconomics, and assess the future underlying cash flows of an individual business, are stocks truly in your circle of competence? If you don’t know cap rates from Captain America, is it wise for you to try to get rich buying real estate properties? Unless and until we learn to be honest with ourselves, we will make mistakes that we don’t need to make.

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Investing does not have to be rocket science. Once you understand the central concepts and begin learning to apply them, all it takes is discipline and intellectual honesty. Anyone can be a successful investor, broadly defined, by sticking to their circle of competence and not straying outside of it, by not speculating when they think they’re investing, and by always looking to pay a fair price in relation to what they’re buying. These three central tenets, closely followed, can allow any intelligent person to operate safely in the financial world.

Still Interested? Read more about Warren Buffett and Charlie Munger, whose ideas on investing have influenced generations of wise and successful investors. The best books we know of on the topic are The Intelligent Investor, Poor Charlie’s Almanack, Berkshire Hathaway’s Letters to Shareholders, and John Bogle’s book The Little Book of Common Sense Investing to learn about indexing.