If we're trying to figure out what we should charge for, say, the chances of a 6.0 earthquake in California, we know that in the last century I think there've been 26 or so earthquakes in California that registered 6.0 or greater. And let's forget about whether they occur in remote areas. Let's just say we were writing a policy that paid off on a 6.0 or greater quake in California, regardless of whether it occurred in a desert and did no damage. Well, we would look at the history and we'd say, "Well, there've been 26 in the last century."
And we would probably assume a little higher number in the next century. That'd just be our nature. However, we wouldn't assume 50 - because if we did, we wouldn't write any business. But we might assume a little higher. IfI were pricing it myself, I'd probably say, well, I'll assume that there are going to be 30 - or maybe 32 or something like that.
And then when I'm all through, I'll want to put a premium on it that incorporates a margin of safety. In other words, if I were to figure that the proper rate for 32 was $1 million, I would probably want to charge something more than $1 million to build in that margin of safety. But I want to be conservative at all the levels - and then I want to have that significant margin of safety at the end.
What can john reasonably expect the store to be worth?
How much should John pay for the store? What future free cash flow can rationally be expected? How much cash can John take out and when?
Warren Buffett says, "You'd try to figure out what you were laying out currently and what you're likely to get back over time, how certain you felt about getting it and how it compared to other alternatives." He continues: "For our discount rate, we basically think in terms of the long-term government rate... But in times
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of what seem like very low rates, we might use a little higher rate." Buffett also says, "And that discount rate doesn't pay you as high a rate as it needs to."
In 2003, Warren Buffett said, "We love owning common stocks - if they can be purchased at attractive prices... Unless, however, we see a very high probability of at least 10% pre-tax returns, we will sit on the sidelines."
Let's assume based on the store's history and expecting the same conditions in the future, John estimates that he can take out $300,000 in cash every year. Knowing he can always buy a risk-free government bond, John uses a bond rate of 6% as the discount rate. He also knows he can reinvest whatever cash he can take out from the store at 6%. The value of the store is then $5 million ($300,000/0.06).
Whatever he can pay below this figure increases his expected return. But since cash from a business can't be as certain as cash from a government bond, why should John pay $5 million? Why should John take time and effort investing in something that gives him the same return as doing nothing? And since John can't know for certain whether expected cash flows will turn out as he expects, he should buy the store at a price that gives him a huge margin of safety.
If John's required rate of return is 10%, the value of the store is $3 million.
Each person should use his own required rate of return. But whatever discount rate we use, we should always require a substantial discount from the estimated value in order to justify making the investment.
We shouldn't engage in false precision. Warren Buffett says, "We believe that if you can pinpoint it, you're kidding yourself. Therefore, we think that when we make a decision there ought to be such a margin of safety - it ought to be so attractive - that you don't have to carry it out three decimal places." He continues: "We are very inexact ... How certain we are is the most important part... You'd be amazed at how inexact we are." Charles Munger says, "We never sit down, run the numbers out and discount them back to net present value... The decision should be obvious."
We can use whatever discount rate we require and we can always compare investment opportunities with the long-term Treasury rate. But there is no point in calculating the value of the unpredictable. We need some certainty. Ask: How much confidence do I have in the numbers?
We can't compensate what we can't predict with a higher discount rate. Warren Buffett says:
When we look at the future of businesses, we look at riskiness as being sort of a go/no-go valve. In other words, if we think that we simply don't know what's going to happen in the
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future, that doesn't mean it's risky for everyone. It means we don't know - that it's risky for
us. It may not be risky for someone else who understands the business.
However, in that case, we just give up. We don't try to predict those things. We don't say, "Well, we don't know what's going to happen. Therefore, we'll discount some cash flows that we don't even know at 9% instead of7%." That is not our way to approach it. Once it passes a threshold test of being something about which we feel quite certain, we tend to apply the same discount factor to everything. And we try to only buy businesses
about which we're quite certain.
Should john always take out whatever cash he can?
That depends on if the return for keeping the cash in the business is higher than the return John gets if he takes it out and invests somewhere else. Why should John want to take it out if he could reinvest the cash in the business at a higher return than 6%? And why should he not take the cash out if he can't reinvest it in the business at a higher return than 6%?
Here is a big difference between a company controlled by John and a public company where John only owns a part of the business. He doesn't control when to take the cash out in a public company. Both in private and public companies, cash may be reinvested at a mediocre return or into ideas that don't work. History has shown that many times reinvested cash has been wasted money and that a pay-out would have been better.
How much cash flow the store will generate is mainly determined by three variables: (1) Sales - how many units of ice cream will be sold at what price? (2) Operating costs - how much does it cost to make the ice cream and conduct the business? (3) Invested capital - how much capital is needed to conduct the business? To what degree is this capital financed with debt rather than equity and at what cost?
These variables determine what return the business earns on the capital that is invested in the store. Sales, costs, and capital need are largely determined by demand, competition from similar or substituting products, advantages against competition and their sustainability, cost and capital efficiency, and operational effectiveness in execution. What does this mean? Let's translate it into a simple question: Does the ice cream store have something people need or want now and in the future (demand), that no one else has (competitive advantage) or can copy or get now and in the future (sustainable) and can these advantages be translated into business value?
For example, why do customers choose to buy ice cream from this store rather than from somewhere else? Is it location, assortment, taste, service,
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price? What do they associate the store and its products with? What is important to customers? Why do they come back? Have their motivations changed over the years or are they likely to change over the next 10 years? What incentives can cause customers to switch to or away from the store? What threats are there?
Warren Buffett illustrates his thinking:
If you and I were looking at the chewing gum business (and we own no Wrigley's, so I use it fairly often in class), you'd pick a figure that you would expect unit volumes of chewing gum to grow in the next 10-20 years and you'd give me your expectations about how much pricing flexibility Wrigley's has and how much danger there is that Wrigley's market share might be dramatically reduced-you'd go through all of that... We're evaluating the moat, the price elasticity that interacts with the moat in certain ways, the likelihood of unit demand changing in the future or management being either very bright with the cash that they develop or very stupid with it...
I would say you can almost measure the strength of a business over time by the agony its managers go through in determining whether a price increase can be sustained .
.. You can learn a lot about the durability of the economics of a business by observing the price behavior.
Can competitors make the store's product obsolete or copy its advantages?
If someone puts a store next to John's and customers don't see any difference between two stores products and services, then customers are likely to buy the ice cream in the store with the lowest prices.
Could John still make money having the lowest price? Yes, if demand exceeds supply or if John can produce and sell his ice cream at a lower cost than competition assuming of course competition doesn't want to run its business at a loss. John must run the store with extreme cost and capital efficiency relative to the competition. Lower costs and better use of capital allows him to keep the lowest price and still make money.
How important is store management?
How much cash and when John gets it is also a function of the ability and integrity of management. Management can influence owners' return by influencing the return of the business. It can influence where capital is being employed, and under what conditions money is to be reinvested.
When it comes to integrity, Warren Buffett says it best:
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One friend of mine said that in hiring they look for three things: intelligence, energy, and character. If they don't have the last one, the first two will kill you because, it's true, if you are going to hire somebody that doesn't have character, you had really better hope they are dumb and lazy, because, if they are smart and energetic, they'll get you in all kinds of trouble.
A business may look to have a huge margin of safety in price but without an able and honest management this margin may end up as an illusion. History is filled with stories about great businesses that were destroyed by poor management. Ask: Is the company equipped with a competent and honest management that focuses on value? Will they use free cash flow for the benefit of the owners?
But in some businesses, not even brilliant management helps. Warren Buffett shares his experiences:
My conclusion from my own experiences and from much observation of other businesses is that a good managerial record (measured by economic returns) is far more a function of what business boat you get into than it is of how effectively you row (though intelligence and effort help considerable, of course, in any business, good or bad). Some years ago I wrote: "When a management with a repuration for brilliance tackles a business with a reputation for poor fundamental economics, it is the reputation of the business that remains intact." Nothing has since changed my point of view on that matter. Should you find yourself in a chronically-leaking boat, energy devoted to changing vessels is likely to be more productive than energy devoted to patching leaks.
Let's take another example of "what happens". This time we describe a model from chemistry and give an example of a misused word - entropy.
At 3.54 a.m. the city of Los Angeles woke up to a 6.5 earthquake.
Why does an earthquake crush so many structures and cause so many deaths? Why doesn't hot coffee stay hot? The answer to these questions gets to the heart of every spontaneous (means in chemistry "by itself, without energy input") physical or chemical event in our lives. The warmth in a hot beverage is due to fast moving molecules. They collide with slower moving molecules in the (relatively colder) environment and cause the slower ones to speed up. Energy is spread out from the hot liquid to the cup, the air, and by the currents of the air, to distant places. That is the nature of energy.
The instant we drop a ball on the floor its energy becomes kinetic energy or energy due to movement. But the term isn't important. What happens is. All
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energy tends to spread, to become dispersed, if it is not hindered from doing so. That explains why iron rusts, why there are hurricanes, why objects break, etc. Why does a speeding truck running into a brick wall cause enormous destruction? Its kinetic energy not only tends to spread out; it spreads out catastrophically.
The same with the earthquake. Stress in the earth caused by the slow movement of the earth's crust floating on its hot molten energy-filled core suddenly spreads. Its potential energy is instantly changed to kinetic energy as the earth moves. When such gigantic energy spreads, it shakes everything for miles around an epicenter. Because of that energy dispersal, not only buildings collapse, but lives are cut short.
Our lives are based on energy dispersal. Each second, chemicals in our body (converted within us from the food we eat and oxygen we breathe) keep our hearts beating. Our lungs pump oxygen into us and carbon dioxide out. We are energy processing machines. We must keep spreading out energy so that we are warm and keep making chemicals so our hearts beat and muscles work and our lungs function. If these processes are seriously interrupted - as they are in any major accident like an earthquake - we die.
What does it mean (what happens) when we hear it was a magnitude 6.5 earthquake? The Richter scale is a logarithmic scale developed by the geophysicist Charles F. Richter and measures the amplitude (size) of an earthquake from the recording of earthquake waves made on a seismograph. Each unit increase in the scale corresponds to a 10-fold increase in ground motion. A magnitude 7.5 earthquake produces 10 times more ground motion than a magnitude 6.5 earthquake. But since energy causes the damage, the important difference lies in the energy release. For every unit increase, energy release increases by a factor of about 32. A 7.5 earthquake releases about 32 times more energy than a 6.5.
Since 1900, the biggest earthquake in the U.S. occurred in Alaska in 1964. It had a magnitude of 9.2. What is the difference in strength or energy between a magnitude 9.2 earthquake and a 6.5 earthquake? About 11,220 times. This means that it would take 11,220 earthquakes of magnitude 6.5 to equal the energy released by a 9.2 earthquake. This explains the destructive power of big quakes.
"Follow the energy. "
Entropy measures how much energy is spread out in a process, or how widely spread out it becomes - at a specific temperature. Entropy is a misused word,
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often used to explain all kinds of "disorder." Disorder is certainly characteristic of many of our situations in life - failed relationships, social problems, messy desks, disorderly bedrooms, etc. However, entropy has no relevance to these things. Only to the scientific measure of physical energy flow from being concentrated to being spread out.
A room doesn't have a tendency to get messy by itself. Some outside energy is needed. It is the energy concentrated in our muscles that is being spread and causes our desks to be messed up. There is no energy being spread out in the papers themselves. As Chemistry Professor Frank Lambert says, "There isn't any 'tendency of objects to become disorganized' in nature any more than bank tellers have a 'tendency to give money to robbers' without a gun."
That energy tends to spread explains why metal rusts, why things break and wear down. Since energy always flows from being concentrated to less concentrated; physical objects and chemical systems deteriorate, break or become destroyed. But these things don't happen immediately or spontaneously. The repetition of time and energy must be considered. A small push (or activation energy) is needed to start a reaction. Gasoline needs a spark or flame to react with oxygen. We need a match to light a fire. For example, it took a single spark to initiate the reaction between hydrogen gas and oxygen, causing the airship Hindenburg to burn. It takes movements of wind and warm moisture from a tropical ocean to form a hurricane. It takes oxygen and moisture to make iron rust. It takes energy to make wood rot. And this process can be delayed. This happens if we for example paint iron to prevent rusting. Painting keeps oxygen away from the iron so a reaction can't happen.
These examples show how by observing "what happens" we can better understand reality.
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- THREE -
SIMPLIFICATION
We have a passion for keeping things simple.
- Charles Munger
john fears that being simple reduces his importance.
Former General Electric CEO Jack
Welch said: "You can't believe how hard it is for people to be simple, how much they fear being simple. They worry that if they're simple, people will think they're simple-minded. In reality, of course, it's just the reverse. Clear tough-minded people are the most simple."
Warren Buffett agrees: "We haven't succeeded because we have some great, complicated systems or magic formulas we apply or anything of the sort. What we have is just simplicity itself." Charles Munger adds: "If something is too hard, we move on to something else. What could be more simple than that?"
Simplify the way we do things
It's amazing how people even today use a computer to do something you can do with a pencil and paper in less time.
- Richard Feynman (from No Ordinary Genius)
Make problems easier to solve. Turn complicated problems into simpler ones. Eliminate everything except the essentials. Break down a problem into its components but look at the problem holistically. Draw a picture of the problem. Put down on a paper the key factors and their relationship. Charles Munger says: "I generally try to approach complex tasks by first disposing of the easy decisions."
Be problem-oriented. Not method-oriented. Use whatever works. Why?
Because the result is what matters, not the method we use to arrive at it.
Look for good enough solutions appropriate to the problem at hand. Not perfection and beauty.
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