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Great Investor 2006 Lecture on Investment Philosophy and Process

Great Investor 2006 Lecture on Investment Philosophy and Process

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A Great Investor
s 2006 Lecture on Investment Philosophy and Process
www.csinvesting.wordpress.comteaching/studying/investing Page 1
Graduate Business School Professor IntroductionWe have heard from several investors who are all highly specialized people like
Li Lu, Paul Sonkin 
Andy Weiss 
and one of the very large cap traditional disciplined value investors. Great Investor (
)has operated in both those worlds. When
Warren Buffet 
was looking for a portfolio manager--forsomeone--to manage a liquid fund called
. Since that time, GI has run very specializedmoney in specialized areas for a small number of investors with focused objectives. He is an exampleof someone who can bridge both worlds. Keep that in mind during the description of what it is that hedoes.Secondly, in a very real sense, he is responsible for this course. He originally funded the Graham andDodd breakfast, which led to the G&D professorship and which led to this course. This course started14 years ago. He has talked to every single class except one since that.I turn it over to GI
 -----Thank you very much for the introduction, professor. It is always a pleasure for me to be here.I just spent an hour with the professor being brought up to date with what is going on (
in this course)
. Iam very pleased to have been responsible for even a small part of this class. Every year, I ask him if Ineed to change my talk. I try to learn and grow each year. Be on guard, there may be a few changeshere.I am retired, and I manage money for family and friends. My daughter works with me. Initially she wasdisappointed when she learned I would teach her all that I knew, and it would take only 30 minutes. Shewould have to make it on her own.Originating and Developing the Value Investing Course at Business SchoolGetting back to the initial idea for this course,
it wasn’t easy to develop a high level course.
All of usinvolved with the program wanted it to be worthy of a program for a major university. It would havebeen all too easy to put together a course that was at a low level
a lot of people coming back orhaving alumni coming back to tell (investing) war stories.
There wouldn’t have been the quality and
substance worthy of the university. It was very important to get a professor of very high stature to dothe work.What I try to do here each year when I come here. Every year I try to become more general. To giveyou specific stock ideas that are timely or investment ideas is beneath this class. I want to elevate theplain and try to maintain a high degree of generality.
I want to talk about ideas, methodologies, and general ways of thinking about investing.
Thesaying is:
To try to teach you how to fish rather than handing you a fish.
Defining My Terms: Value Investing, Intrinsic Value and Margin of SafetyI want to define some key terms as I use them. We may think we mean the same thing, but I want youto understand exactly what I mean when I use the terms:
Value Investing, Intrinsic Value
Marginof Safety.
A Great Investor
s 2006 Lecture on Investment Philosophy and Process
www.csinvesting.wordpress.comteaching/studying/investing Page 2
Value Investing:
Appraising the intrinsic value of businesses and purchasing fractions of thosebusinesses at significant discounts to those appraisals.That is what value investing means when I use the term. What is not to like about value investing?How many people wou
ldn’t wish to be considered value investors
? That is why I want to define termsas I understand them.2.
Intrinsic Value
is the Net Present Value of the future Cash Flows of any business. Anotherway of defining intrinsic value: the value that will be put on a business by two equally informedpeople, neither of whom is operating under duress, who are negotiating a price for that businessfor cash.3. The
Margin of Safety
is, of course, the discount from intrinsic value of the business. Needlessto say, in the case of margin of safety, the bigger is better.What is your investing edge? Who is on the other side of your trade?Combined in this idea of Intrinsic Value and a Margin of Safety is the idea of having an edge. An edge,being the circumstances, that is the opposite of operating on a level playing field. We are all looking foran insight or knowledge edge that allows us to perceive value perhaps where others are incapable ofdoing that.This gets to the question of defining intrinsic value. One thing I want to make sure that you understandis that for some businesses, the intrinsic value is simply not knowable. The array or ranges of possiblefuture cash flows are so wide, so unpredictable, that discounting them back is a fruitless exercise.Additionally, some businesses lend themselves to appraisal by me and not by other people. And forother businesses, some other people are better qualified to assess intrinsic value than I am to make theappraisal. Certain businesses and industries, I feel, I am better able to forecast the cash flows thanother people.There are many, many industries that I am very unqualified to come up with intrinsic value. Or therange of value is too wide to be helpful to me.
In those instances I can’t come up with an intrins
ic valuethat would be helpful to me.This is another way of saying,
stick to what you know
this is
Warren Buffett 
idea to stay withinyour circle of competence.I try to be very humble and modest. I think the investment business is full of very bright, hard workingpeople. I never would be so presumptuous to say I could compete with any of them on any subject. Ithink I am quick to acknowledge that there are other people who know more about certain things than Ido. And I try not to be so egotistical as to try to play their game on their terms. Therefore I avoid beingwhere
I don’t have the
edge.Interrelationships between Intrinsic Value and Margin of SafetyIt has to do with the usefulness of the appraisal of intrinsic value. If I conclude that the Intrinsic Value issomewhere between $100 to $300 a share, that is probably not a useful appraisal.
If I can’t refine it
more than that, then I should move on. If the stock is trading at $150 and the range is $100 to $300,then what do I know? I don
’t know anything of value.
If it turns out it
(the company)
is worth $200 to$300 then there may be a big margin of safety there. But if
I can’t be sure the company won’t be worth
A Great Investor
s 2006 Lecture on Investment Philosophy and Process
www.csinvesting.wordpress.comteaching/studying/investing Page 3
$100 or not, move on to where the odds seem more attractive--where determining the tighter range issomething that I am qualified to determine.One of the old stories about giving a talk on value investing is you come in, stand up and say intrinsicvalue, margin of safety and then sit down. The talk is over. I wanted to pass over it quickly because Iam sure you have heard it from others.
’s Definition of IV: Intrinsic Value (Owner’s Manual 2005 Annual Report of 
Berkshire Hathaway 
pg. 77
Intrinsic Value gives us an all-important concept that offers the only logical approach to evaluating therelative attractiveness of investments and businesses. Intrinsic Value can be defined simply: It is thediscounted value of the cash that can be taken out of the business during its remaining life.The calculation of intrinsic value, though, is not so simple. As our definition suggests, Intrinsic Value isan estimate rather than a precise figure, and it is additionally an estimate that must be change if interestrates move or forecasts of future cash flows are revised. Two people looking at the same set of factsmoreover will almost inevitably come up with at least slightly different intrinsic value figures. That is onereason we never give you our estimates of intrinsic value. What are annual reports do supply, though,are the factors that we ourselves use to calculate this value.How and Why Value anomalies occur.How do these kinds of sizable discounts arise?I did not define for you how big (a discount) is enough. My experience is a Margin of Safety of 25% to30% is something that can be found with some frequency. I could say I would like to find someinvestment at 20% of value or with a 50% or 80% discount to intrinsic value
that may be a perfectlyreasonable idea to have, but I may have to wait until 1932
(or 1973 for those opportunities to buy at 50% to 40% of intrinsic value)
to come around again.
Example from Fisher Black and the Revolutionary Idea of Finance Perry Mehrling by John Wiley &
Sons 2005, p. 236: ―We might define an efficient market as one in whic
h price is within a factor of 2 ofvalue; i.e. the price is more than half of value and less than twice value. By this definition, I think
almost all markets are efficient almost all of the time. ―Almost all‖ means at least 90%.‖ (Fischer Black,
1986, Journal of Finance 410). $4 stock can move between>$2 and <$8.I gave you quotes from these book excerpts, an excerpt from
Fisher Black 
that most markets areefficient. Most sell for ½ of value and twice (2x)
value. I can’t address the twice value
part of that claim.I have almost had no success in many, many years of my investing career of finding companies tradingat ½ of value. Usually when I find them, I go back and try to figure out what happened. That is not to
say they don’t happen, but they are s
o infrequent. The people who tell you they find values at ½ ofvalue are probably deluding themselves.I know such people. People who tell spell-binding stories about incredibly cheap stocks they havefound. If a cheap stock is at a 50% discount--usually, I find they are wrong.

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