The force of air resistance against the falling horse is much greater than the force against the mouse. This happens because the horse plows through more air than the mouse does. The heavier horse falls faster through the air, increasing air resistance even more. The horse falls faster than the human before the air drag equals its weight and will therefore reach the ground first.
The horse has a greater surface area than the mouse, but the mouse has a greater surface area for its volume than the horse has. A mouse obeys the same law of gravitation as a human, and also the same law of air-resistance. But gravitation is key for humans, while air-resistance is all-important for the mouse. On the other hand, due to surface tension, the mouse will have problems when climbing from a pool of water. Haldane tells us a wet mouse has to carry its own weight of water. Imagine how hard it would be to get out of the bathtub if we
carried on our body a weight of water equal to our weight.
These examples show how we can better deal with reality by observing and ask "why" things happen. So look around, ask questions and remember the words of inventor and engineer Charles Proteus Steinmetz: "There are no foolish questions and no man becomes a fool until he has stopped asking questions."
197
Assume that the big ideas are true until learning otherwise. All knowledge is subject to change as new evidence arrives. This mean we have to continuously learn and re-learn.
Keeping knowledge alive and adding knowledge over time comes with an extra benefit. "Just as iron rusts from disuse, and stagnant water putrefies, or when cold turns to ice, so our intellect wastes unless it is kept in use," wrote Leonardo da Vinci. Research by Integrative Biology Professor Marian Cleeves Diamond at the University of California, Berkeley, reveals that a stimulating environment, curiosity and education are nourishment to the brain and therefore healthy. The more stimulation we give our brains, the better off we are. In Psychology Today (1984) she says, "I looked for people who were extremely active after 88 years of age. I found that the people who use their brains don't lose them. It was that simple."
Remember, knowing a definition or memorizing an idea is useless if we don't understand its meaning. Alfred North Whitehead said in The Aims of Education: "Education should be useful, whatever your aim in life."
198
- Two -
MEANING
Bad terminology is the enemy ofgood thinking.
Warren Buffett
Words, definitions, propositions, statements, or goals don't tell us anything. We need to understand what they mean. It is the same with knowledge. Knowledge is only valuable if it's useful and something is only useful if we understand what it means.
Richard Feynman's father, Melville, taught his son, the difference between knowing the name of something and knowing what goes on:
See that bird? It's a brown-throated thrush, but in Germany it's called a halzenfugel and in Chinese they call it a chung ling and even if you know all those names for it, you still know nothing about the bird. You only know something about people; what they call the bird.
Now that thrush sings, and teaches its young to fly, and flies so many miles away during the summer across the country, and nobody knows how it finds its way.
Doesn't this tell us something in the sense of learning? Words or names don't constitute knowledge. Knowing the name of something doesn't help us understand it. Since understanding implies action and accomplishment, one way of understanding is to see what happens. Feynman illustrates:
There is a picture of a dog, a windable toy dog, and a hand comes to the winder, and then the dog is able to move. Under the last picture, it says "What makes it move?" ... the answer I was trying to learn is that "energy makes it move." ...
It would be equally well to say that "God makes it move," or "spirit makes it move," or "movability makes it move." (In fact one could equally well say "energy makes it stop.")
Look at it this way: That's only the definition of energy. It should be reversed. We might say when something can move that it has energy in it, but not "what makes it move is energy."...
If you ask a child what makes the toy dog move, you should think about what an ordinary human being would answer. The answer is that you wound up the spring; it tries
199
to unwind and pushes the gear around. What a good way to begin a science course. Take apart the toy; see how it works...
I think, for lesson number one, to learn a mystic formula for answering questions is very bad.
Feynman gives another example of an empty definition: "the soles of your shoes wear out because of friction." Real knowledge is: "Shoe leather wears out because it rubs against the sidewalk and the little notches and bumps on the sidewalk grab pieces and pull them off."
Feynman provides a test we can do to check our understanding:
Without using the new word which you have just learned, try to rephrase what you have just learned in your own language. Without using the word "energy," tell me what you know now about the dog's motion.
Understanding "meaning" requires that we observe and ask basic questions.
Examples of some questions are:
Meaning of words: What do the words mean? What do they imply? Do they mean anything? Can we translate words, ideas or statements into an ordinary situation that tells us something? An expression is always relative. We have to judge and measure it against something.
Meaning of an event: What effect is produced? What is really happening using ordinary words? What is it doing? What is accomplished? Under what conditions does it happen? What else does it mean?
Causes: What is happening here and why? Is this working? Why or why not? Why did that happen? Why does it work here but not there? How can it happen? What are the mechanisms behind? What makes it happen?
Implications: What is the consequence of this observation, event, or experience? What does that imply?
Purpose: Why should we do that? Why do I want this to happen?
Reason: Why is this better than that?
Usefulness: What is the applicability of this? Does it mean anything in relation to what I want to achieve?
Danish physicist Niels Bohr said: "Never express yourself more clearly, than you are able to think." When describing something, tell it as it is and use words that people understand, and in terms of ideas with which they are familiar. Albert Einstein said: "If you can't explain it simply, you don't understand it well enough." Get to the point. Ask: What do I want to say? One reason for
200
miscommunication can be that the words mean one thing to you and something else to the person you're talking to.
Ask "What happens?"
Why have Warren Buffett and Charles Munger successfully compounded the book value of Berkshire Hathaway 3700 times over the last 42 years? Why do many people lose money investing?
The reason we invest in an economic asset like a business, apartment building, farm, or bond is to make money. But what does that mean? What is making money? What happens when we make money?
Follow the cash. "How much cash do I get and when do I get it?"
What happens when we make money is that we get more money back in the future than we invest today. For example, we invest $100 and get back $150.
What determines our return from investing in an economic asset? The price we pay, how much money we get back, and when we get it back. It makes a huge difference if we get $150 back in 2 years or 10 years. The difference in yearly return is 22% versus 4%. Our return can be measured against the expected returns from other available investment opportunities. This means that the value of an economic asset is influenced by interest rates. If interest changes, value changes. The higher the rates, the less the value.
If we knew for certain we would get $10 in cash every year for 5 years and we use a risk-free government bond rate of 6% as the discount rate, then the asset has a value of about $42. This means that if we pay $42, we get a 6% average yearly rate of return. If we pay $30, our r
eturn rises to 20%. The larger the difference between an economic asset's value (e.g. $42) and the price we pay, the higher our yearly return becomes.
Warren Buffett says, "We use the risk-free rate merely to equate one item to another. In other words, we're looking for whatever is the most attractive. In order to estimate the present value of anything, we're going to use a number. And, obviously, we can always buy government bonds. Therefore, that becomes the yardstick rate... to simply compare all kinds of investment opportunities across the spectrum: oil wells, farms, whatever it may be."
Don't pay more than what you get back in value.
Benjamin Franklin said: "I conceive that great part of the miseries of mankind are brought upon them by the false estimates they have made of the value of things, and by their giving too much for their whistles." One of Francois Due de
201
la Rochefoucauld's maxims was: "The height of ability consists in a thorough knowledge of the true value of things."
The key question we should ask when investing money in economic assets is: What is the expected future cash we can take out and when does it appear? How else can we know what an asset may be worth and what kind of return we can expect at a given price? Warren Buffett says: "In the end, what you have to decide is whether you're going to value a business at $400 million, $600 million or $800 million - and then compare that with the price."
john wants to buy an ice cream store (it doesn't matter if it is a small ice cream store or 100 shares in a billion dollar business, the relevant reasoning is the same).
Is this a good deal? It depends on the price John pays, and the discounted value of the cash that can be taken out of the ice cream store during its remaining life. How much cash can John take out? When can he take it out? This depends on the amount and timing of the free cash flow that is generated by the store or how much cash he can take out (and when) without hurting the store's present position against competition.
Warren Buffett says of the "cash flow" numbers that are often set forth in Wall Street reports:
These numbers routinely include (a) [reported earnings] plus (b) [depreciation, depletion, amortization, and certain other non-cash charges] - but do not subtract (c) [the average annual amount of capitalized expenditures for plant and equipment, etc.] Most sales brochures of investment bankers also feature deceptive presentations of this kind. These imply that the business being offered is the commercial counterpart of the Pyramids - forever state-of-the-art, never needing to be replaced, improved or refurbished.
Some cash is always needed for reinvestment in capital expenditures for plant and equipment and working capital merely to enable a business to stay in business or maintain its unit volume and long-term competitive position. A classic example is a retail store that needs to install air-conditioning because other stores have made the investment. It doesn't generate any extra business, but without it, the store may lose customers to competition.
Buffett also says that we have to watch out for certain figures: "When companies or investment professionals use terms such as "EBITDA" and "pro forma," they want you to unthinkingly accept concepts that are dangerously flawed."
202
He continues:
Trumpeting EBITDA (earnings before interest, taxes, depreciation and amortization) is a particularly pernicious practice. Doing so implies that depreciation is not truly an expense, given that it is a "non-cash" charge. That's nonsense. In truth, depreciation is a particularly unattractive expense because the cash outlay it represents is paid up front, before the asset acquired has delivered any benefits to the business. Imagine, if you will, that at the beginning of this year a company paid all of its employees for the next ten years of their service (in the way they would lay out cash for a fixed asset to be useful for ten years). In the following nine years, compensation would be a "non-cash" expense - a reduction of a prepaid compensation asset established this year. Would anyone care to argue that the recording of the expense in years two through ten would be simply a bookkeeping formality?
But isn't it earnings that matter for stockholders? John Burr Williams wrote in his 1938 book, The Theory of Investment Value:
If earnings not paid out in dividends are all successfully reinvested at compound interest for the benefit of the stockholder ... then these earnings should produce dividends later; if not, then they are money lost.... Earnings are only a means to an end, and the means should not be mistaken for the end. Therefore we must say that a stock derives its value from its dividends, not its earnings, In short, a stock is worth only what you can get out of it... for we are discussing permanent investment, not speculative trading, and dividends for years to come, not income for the moment only.
Warren Buffett adds, "If somebody's reinvesting all their cash flow, they better have some very big figures coming in down the road because a financial asset has to give you back a lot more cash one day in order to justify your laying out cash for it now."
Is value a precise figure?
Warren Buffett says:
Intrinsic value is an estimate rather than a precise figure, and it is additionally an estimate that must be changed if interest rates move or forecasts of future cash flows are revised. Two people looking at the same set of facts, moreover - and this would apply even to Charlie and me - will almost inevitably come up with at least slightly different intrinsic value figures.
203
Using precise numbers is, in fact, foolish; working with a range of possibilities is the better approach.
Is there a difference between how we value different businesses?
No matter whether a company makes telecom equipment, cars, or candy, it's still the same question: How much cash do we get and when? The name attached to the cash doesn't matter. Warren Buffett says:
What you're trying to do is to look at all the cash a business will produce between now and judgment day and discount it back to the present using an appropriate discount rate and buy a lot cheaper than that. Whether the money comes from a bank, an Internet company, a brick company...the money all spends the same. Why pay more for a telecom business than a brick business? Money doesn't know where it comes from. There's no sense in paying more for a glamorous business if you're getting the same amount of money, but paying more for it. It's the same money that you can get from a brick company at a lower cost. The question is what are the economic characteristics of the bank, the Internet company or the brick company. That's going to tell you how much cash they generate over long periods in the future.
What ifJohn needs to invest more cash in the store?
We have to consider the amount and timing of both cash into and from the store. As many investors in "growth" companies are well aware of, some businesses seem to need a never-ending supply of new cash. Warren Buffett says, "Growth can destroy value if it requires cash inputs in the early years of a project or enterprise that exceed the discounted value of the cash that those assets will generate in later years... Growth is simply a component- usually a plus, sometimes a minus - in the value equation."
But isn't it easy going wrong in estimating the amount and timing of future cash flows in and out ofa business?
At Berkshire, they deal with this problem in two ways. Warren Buffett says:
First, we try to stick to businesses we believe we understand. That means they must be relatively simple and stable in character. If a business is complex or subject to constant change, we're not smart enough to predict future cash flows. Incidentally, that shortcoming 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
204
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 principl
e, so strongly emphasized by Ben Graham, to be the cornerstone of investment success.
Warren Buffett also says that, "we try... to keep our estimates conservative." He continues:
... take all of the variables and calculate 'em reasonably conservatively... don't focus too much on extreme conservatism on each variable in terms of the discount rate and the growth rate and so on; but try to be as realistic as you can on these numbers, with any errors being on the conservative side. And then when you get all through, you apply the margin of safety.
It's the same thing Berkshire does in insurance. Buffett gives an example:
Seeking Wisdom Page 28