Value investors are looking for good business in the capital market, which is also one of Buffett's core investment logic. In Buffett's 2002 letter to shareholders, he talked about how to evaluate business models, what is good business, and what is bad business. Munger said that all investments are value investments. By reading Buffett's letter to shareholders, the author understands and analyzes from the perspective of understanding assets, capability circles, certainty, and safety margins.
Understand what assets are
The assets invested are different from the property
Graham wrote in his book 'Securities Analysis' that investing has three meanings. One is to invest money into a business; The second is to apply it in a similar way to the financial field. There is no difference between the above two, while the third meaning of investment is more strict, which is opposite to speculative buying and selling.
Similarly, assets also have several meanings. Firstly, we believe that assets are property and wealth, such as houses and cars; The second is accounting terminology, where assets correspond to liabilities on the balance sheet. The third layer of meaning is also a more strict connotation, corresponding to the meaning of property.
In the eyes of Buffett and Munger, assets are things that can generate cash flow, and do not generally refer to assets or assets expressed in the balance sheet of accounting. For example, stocks are equity that can generate interest, while company development can generate cash flow; Deposits, with interest rates, are also an asset. So, according to this definition, gold is not an asset because gold itself cannot generate cash flow. Buffett said at the shareholders' meeting that gold is not an asset. If you place 10 kilograms of gold under the bed, it will still be 10 kilograms after 10 years without any changes or cash flow returns. The price increase of gold only reflects long-term inflation. Holding gold for a long time reflects a price difference, but it has anti inflation properties and can be understood as property. Art and antiques are similar, but they can be lent to museums for exhibition and have certain asset characteristics. The relationship between assets and non asset wealth is like that of a laying hen and an iron rooster. Assets are like hens that place orders, not only can they lay eggs but also grow up, while gold non asset wealth is an iron rooster that cannot lay eggs or grow up.
Assets also have a distinction between excellence and mediocrity, which can be judged by the effectiveness of generating cash flow. Excellent and mediocre assets can be seen as cows and beef cattle. Cows (excellent assets) continuously produce milk, which can generate profits that can recoup the initial cost of buying cows. At the same time, cows are also constantly growing, and ownership of cows always belongs to themselves. But beef cattle (mediocre assets) cannot produce milk, and can only be bought back and raised for sale to generate benefits and have commercial value. However, the ownership of the sold beef cattle has already been given to others.
There is another story that can better understand the exact meaning of assets. Legend has it that in ancient times, there was a king who rewarded a hardworking farmer with an elephant. Because elephants are bestowed by the king, farmers cannot refuse or let elephants work, let alone sell them. And the elephant has a big appetite and needs to eat a lot of food every day, which the farmer cannot afford and is very painful. Following this line of thought, if you own a non-profit enterprise that cannot be sold, you will have to spend a lot of money to maintain it. This company is not an asset, but a cash "black hole". Even if this type of enterprise can sell above cost, it only earns a price difference. From this, it can be seen that the behavior of investing in assets to obtain returns is investment, and the behavior of always considering selling assets to others to obtain price differences is a speculative game. This example also demonstrates that whether one holds a portion of the company's shares through purchasing stocks or starts a business to fully control a company, the key is whether the assets are cows that produce high-quality milk or hens that can lay golden eggs.
Buffett measures the quality of a company's assets based on intrinsic value. In his letter to shareholders, Buffett stated that intrinsic value is the sum of the discounted future cash flows of a company. At the Berkshire shareholders' meeting, Buffett talked about how to estimate the intrinsic value of a company, and some of them said so, If we can gain insight into the future of any enterprise, such as the cash inflows and outflows between the enterprise and its shareholders in 100 years or when the enterprise collapses, and then discount them at an appropriate interest rate, which I will discuss later, we will obtain the intrinsic value value. This is similar to calculating the value of a bond with many coupons posted and maturing in 100 years. If you know how many coupons there are, you can Calculate its intrinsic value by discounting it at an appropriate risk rate, or you can compare a bond with a coupon rate of 5% to a bond with a coupon rate of 7%. The value of each bond is different because their coupon rates are different. In fact, companies also have coupons, which will change in the future, but they are not printed on stocks. Therefore, the future coupon of a company needs to be estimated by investors themselves. The intrinsic value is completely related to future cash flows, and the job of investors is to understand what future cash flows will look like
The intrinsic value of a company is simply the sum of the discounted value of future cash flows. Discounting can be understood in this way, for example, ten years later, if you receive 10000 yuan from someone else, how much money are you willing to pay now? If you offer 10000 yuan now and take back 10000 yuan in the next ten years, you will definitely lose money because the currency depreciates, so you need a discount rate to convert 10000 yuan in the next ten years to the current number in order to exchange it equivalently, which is called discount.
This is a good thinking framework for investing in assets. The only reason you invest in cash is to obtain more cash that can be withdrawn in the future, and to gain greater purchasing power in the future with your current purchasing power. Just like running a business, the first consideration is how long it will take to recover its capital. From the perspective of assets, profit is an investment, not a speculation of selling the company at a high price to others for price differences. Speculation is a game of touching each other's pockets, as Buffett mentioned in his letter to shareholders, earning a price difference is a complete "who beats who" game.
Find assets in the capability circle
Ignore emotions and macro
Discounting cash flow is not difficult to understand, but it is not easy to estimate. Although the intrinsic value of a company is unique, different people estimate different data due to different understandings of the company and different discount rates used. Estimating half is science and half is art. There are two prerequisites for evaluating the intrinsic value of a company. Firstly, it is necessary to understand what assets are, as analyzed above. Secondly, it is necessary to confirm that investment assets should be within one's own ability circle, such as an understanding of the return on investment in real estate, apartments, and farms, as well as an understanding and insight into the business model of the enterprise. Otherwise, as a value investor, investing in assets beyond the capability circle is prone to making mistakes!
In his letter to shareholders, Buffett said, "Like high-tech companies, we have no idea what their future coupons will be. But when we find a company that we think we understand quite well, we will try to examine its future and calculate how much its future coupons will be." "You must lose the opportunity to not pass the screening." Munger said, "I don't understand something, and no matter how much money you make, it has nothing to do with me.
Companies that are not familiar with are prone to making mistakes, which is a truth that everyone knows. But it's difficult to do it from a human perspective. Think about whether you have had such an experience. When people around you make a lot of money in an unfamiliar field, do you also feel itchy and want to give it a try or directly challenge it, but always fail in the end. Just like standing on the side of a river, you always feel that the scenery on the other side is more beautiful, but in fact, you have a better understanding of the riverbank under your feet.
After figuring out that the investment target is in our own ability circle, we also need to understand the certainty of the invested assets, which depends on whether the cash flow return is stable, that is, how much cash return we can receive each year, such as interest, dividends, rent, etc. Obviously, the interest on deposits is fixed, the equity dividends of excellent companies are fixed, and the rent is also fixed. In addition, it also depends on the long-term situation, such as whether the company's equity dividends (cash flow generation ability) will increase over time, whether rent, and farm operating returns will increase.
But even if we understand these, we cannot accurately calculate the intrinsic value of a company. When answering shareholder questions, Buffett responded in this way, We don't know the value of some companies in 10 or 20 years, and we can't even provide a reliable guess. Obviously, we don't think we can estimate the value of a company to the second or third decimal place. However, for some companies, we are still quite certain. The purpose of designing screening criteria is to ensure that we invest in the right company (with certainty), It is still emphasized to focus research on the certainty of the enterprise itself, rather than predicting transaction conditions and prices.
The focus of investment research is on enterprises (assets), rather than keen on studying the market, macroeconomics, and predicting trading conditions and prices. A popular saying in the field of value investment is: "Don't look foolish, look at the land!" Looking at the land refers to paying attention to the output of agricultural land. Although there are good and bad output in each year, in the long run, positive and negative factors will offset each other. And fools only bid on land based on emotions rather than output, so other bids are useless except for occasional extreme bids made by fools. When a fool offers an extremely low price, we will buy. When fools report exceptionally high prices, which exceed the amount of money sold to fools in the bank and far exceed the output of agricultural land, we sell agricultural land to fools.
Use risk-free interest rates as a benchmark
Domestic evaluations can be more conservative
To convert cash flow, the concept of risk-free interest rate, also known as the discount rate, should be introduced. Although the risk-free return rate is a dynamic change (caused by changes in the economic environment), it is still the benchmark used to compare different investment opportunities and is just a ruler of change.
When Buffett predicts a company's cash flow, he uses the current interest rate on risk-free Treasury bonds as the discount rate. When shareholders ask why they don't use the concept of opportunity cost to choose a discount rate, such as the historical average of 12% for American companies' equity returns, or a return target of 15% or a reference to Coca Cola's equity return.
Buffett's answer is this:, We use risk-free interest rates only to compare different investment objects with each other, in other words, we are looking for the most attractive investment object. In order to calculate the present value of investment objects, we all need to use discount rates, as we can always purchase Treasury bonds, so the interest rate on Treasury bonds becomes the benchmark interest rate. This does not mean that we want to buy government bonds, nor does it mean that if we have to The present value of the best investment object indicates that the annual yield of the investment is only 0.5% higher than that of Treasury bonds, and we will purchase Treasury bonds. But we believe that this is an appropriate benchmark interest rate, and we only use this rate to compare all investment opportunities - companies, oil wells, farms, and so on. The use of risk-free interest rates as discount rates is also related to the degree of certainty, which is a benchmark interest rate. Throughout the entire valuation process, it is equivalent to a constant
It can be seen that the risk-free return rate is risk-free. In China, this ruler can be treasury bond or five-year 10-year deposit interest rate, or the yield of monetary funds, Yu'ebao and other yields.
Due to the fact that the sum of the discounted values of future cash flows refers to the sum of the sustainable operating cash flows of the enterprise, and predicting the sustainable operation of the enterprise is highly uncertain, the discounted value is not an absolute value. We also need to measure it based on the actual situation of the capital market. In China, I believe it can be considered more conservative, and there are differences in specific investment cases. Because many of the companies Buffett invests in are fully controlled, and the cash flow generated by these companies can be completely self controlled. In China, it is difficult to achieve this. Firstly, there are few such investors in the capital market; Secondly, from the perspective of dividends, listed companies have varying returns to shareholders, especially small shareholders who cannot control the return on the company's cash flow.
Although many domestic companies also distribute dividends to shareholders, not all of the money on the company's books is distributed to shareholders, such as Maotai. Although the dividend rate is as high as 50%, there is still a lot of cash on the books. So, if you want to discount cash flow, you still need to be more conservative. The author tends to discount dividends, and on this basis, a "residual value" calculation can be added.
For example, if you plan to invest in an asset for 10 years, the intrinsic value should be: discounted cash flow obtained during the investment period+discounted residual value of the asset. Cash flow discount refers to the discount of dividends, such as the discount of rent for properties and apartments, the discount of rental rent for farms, and the discount of operating cash. If the invested property has a mortgage, the cash flow is rent mortgage interest. Therefore, the intrinsic value evaluation framework is also suitable for evaluating the investment value of real estate, apartments, farms, and other assets besides stocks and bonds.
The residual value of an asset can be the discount of the total value of the asset after 10 years, the total value of the purchased asset, and the maintenance cost (such as the maintenance cost, depreciation, reinvestment, etc. of the property). And the total asset value=asset size xPB=profitability xPE, and the house=area x unit price (or evaluated using the property of the house). Among them, asset size refers to the growth of the company's size (such as the growth of cows) and profitability (such as the milk production ability of cows), while PB and PE represent the market sentiment. This is to discount the cash flow of sustainable operations and make segmented value investment estimates. The advantage is that on the one hand, the thinking framework of intrinsic value can be applied to evaluate the investment value of real estate apartments other than stocks and bonds; On the other hand, dividends (rent) are used for discounting, which is a portion of the return that investors are certain to receive and is more conservative than using cash flow. In addition, those undistributed cash flows remain in the company, assuming that they can be cashed out 10 years later when the assets are sold, that is, the meat is rotten in the pot.
The more you understand the enterprise, the smaller the safety margin
Familiarize yourself with assets and benchmark opportunities
Investment is to obtain higher purchasing power in the future, so the purchase price needs to be discounted based on the intrinsic value of the asset, while also paying attention to preserving the margin of safety. In Buffett's words, it means buying assets worth $1 for 40 cents. Buffett said, "It's strange to say that people either understand the concept of 'buying assets worth $1 for 40 cents' or completely reject it." In any case, investment is a prediction of the future and there is uncertainty, so investment requires us to reserve a margin of safety based on estimating intrinsic value.
The margin of safety is one of the cornerstones of value investment. Speaking of the margin of safety, Buffett wrote a letter to shareholders in 1992, If you have a good understanding of a company and an insight into its future, the safety margin you need is obviously very small. On the contrary, the more fragile a company is or the greater the likelihood of its change, the greater the safety margin you need if you still want to invest in the company. If you are driving a truck carrying 9800 pounds of goods through a bridge with a load capacity of 10000 tons and the bridge is only 6 feet above the ground, you may I think it's okay. However, if this bridge is located above the Grand Canyon, you may want a larger margin of safety, so you may only drive 4000 pounds of goods through this bridge. So, the margin of safety depends on the potential risks Munger also said, "Investment is the comparison of opportunity costs in the capability circle
If you have an opportunity to place a large bet and prefer it over the 98% chance you see, you can filter out the other 98% opportunities and bet on the investment you are optimistic about. Finally, a highly concentrated investment state was formed. Buffett once said, "Diversification is the self-protection law of the ignorant, but for those who understand what they are doing, diversification is meaningless. Put eggs in one basket and be optimistic about it." Munger once said: In the end, investment games are about making more accurate predictions about the future than others. One way to do this is to compete in a limited number of areas. If you try to predict the future of everything, then too many attempts will fail due to a lack of expertise
So for small and medium-sized investors, the author believes that diversified investment cannot diversify risks, it can only diversify one's own ignorance. To resist risks, one relies on deep research and a safety margin determined based on risk. However, the degree of concentration matches one's own cognitive depth. Graham's "cigarette picking" investment requires moderate diversification.
Everyone has their own circle of abilities and deterministic investment opportunities, which can be used as a benchmark, such as real estate, a company, or fixed income assets! For example, from the perspective of opportunity cost, Buffett used Coca Cola as the standard in his early years. Buffett once said that many people have talked about promoting other companies to him, and the first thing he thinks about in this situation is: "Are we willing to buy this company or are we more willing to increase our holdings of Coca Cola?" Because Buffett is very familiar with Coca Cola, he uses Coca Cola as a benchmark to measure opportunity costs. It is very practical to compare the opportunity cost between an unknown new enterprise and one that you are very certain of. Because in investment, there are not many companies that have excellent prospects within the capability circle that you can find. Through this method, you can filter out many seemingly tempting investment traps around you. Munger once said, Opportunity cost is a basic screening criterion in life. If you have two suitors who are crazy about pursuing you, and one is tens of millions of times better than the other, you don't have to spend time on the other person (Buffett laughs) . We also do the same when screening investment opportunities. The screening criteria we use are the most basic ideas, they are so simple that people keep asking us what lies behind these standards
Understanding opportunity costs and a reasonable expected rate of return can prevent fraud. Buffett said that even if you have something you are very familiar with and are very certain that you will receive an 8% return, in fact, if someone tells you that there is an investment opportunity with a possible 8.5% return, it will not attract you.
The above is my analysis of the logic of asset valuation after reading Buffett's letter to shareholders. I believe that if the value to investment ratio
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