Today, we will break confidences in a way. I will tell you about a private discussion I had with a very wealthy man who, perhaps like you, has long struggled with his personal portfolio. He now faces even tougher decisions about how to allocate capital for his business.
Out of all the things I’ve written about over the years, I think you’ll find this discussion might hold the greatest value – if, that is, you’re willing to think carefully about this private discussion.
The message at the heart of today’s essay addresses the very foundation of successful investing. In my experience, the ability to comprehend and internalize the ideas below will be limited to people who have owned or operated their own business. Very few others have grasped their significance.
I hope you will be among the few who do.
I believe understanding – from the beginning – that the strategy we’re discussing below is most suitable for business owners may, in fact, be the key to understanding it for everyone.
The story starts this way:
Several years ago, a close friend, who is the CEO of a major global business, asked me to help him with his personal portfolio. Normally, I’d never even agree to a meeting where I thought the subject would come up. Most people assume, wrongly, that I know something more about securities or investment opportunities that I don’t include in my newsletter. But I don’t. I write up all of the best ideas I discover.
And that is exactly what I told my friend. Besides, I knew he really didn’t need my newsletter.
“There’s no secret to investment success,” I told him. “As the leader of a big, global business, you’ve done dozens of very successful acquisitions. You know exactly what creates business success. And you know the appropriate price to pay for private companies. Just apply the exact same care to your personal investment decisions.”
Two weeks ago, I saw my friend for the first time in a long while. We were talking about investments again. But this time, we were talking about how he manages his company’s tremendous cash flows. He explained that he’d hired a “professional” money-management group.
I asked the logical question: “How’s that working for you?” But I knew the answer before I asked – “Terribly.”
My friend believes that investment professionals – who do not have day-to-day responsibility for operating a business – will prove to have better business judgment than a long-term CEO who has successfully managed dozens of acquisitions and grown his business from $75 million in market cap to more than $1 billion.
My friend has world-class business judgment. He developed it by making decisions every day about marketing, product development, personnel, policies, branding, real estate, partnerships, lawsuits, and insurance – decisions with millions of dollars at stake.
To believe that a money manager, whose chief source of business insight is probably Barron’s magazine, is going to prove more successful as an investor is like believing the local putt-putt champion will beat Tiger Woods in a driving contest.
Yes, I know: A select few money managers have outstanding, world-class business judgment – like Carl Icahn, for example. But you can count these money managers on two hands. And investing with them is extremely expensive.
In other words, whether my friend likes it or not, he’s likely to be far better off managing his company’s excess capital personally than he is entrusting it to a “professional.”
The same is likely true for you, if you have any significant business experience. That experience is your greatest advantage in the markets.
In the mid-1970s, an investor with tremendous business experience, Warren Buffett, became the business “coach” and confidant of the Washington Post’s Katharine Graham. Graham became chairman and CEO of the newspaper company unexpectedly when her husband committed suicide. She leaned heavily on Buffett’s business judgment – especially when it came to the question of how to manage the business fund. Buffett addressed that critical question in a private letter to Graham.
Fortunately, I was sent a copy of that letter late last month. Here’s what Buffett told one of his closest friends about how to manage her company’s pension account:
The directors and officers of the company consider themselves to be quite capable of making business decisions, including decisions regarding the long-term attractiveness of specific business operations purchased at specific prices. We have made decisions to purchase several television businesses, a newspaper business, etc. And in other relationships, we have made such judgments covering a much wider spectrum of business operations.
Negotiated prices for such purchases of entire businesses often are dramatically higher than stock market valuations attributable to well-managed similar operations. Longer term, rewards to owners in both cases will flow from such investments proportional to the economic results of the business. By buying small pieces of businesses through the stock market rather than entire businesses through negotiation, several disadvantages occur: a) the right to manage, or select managers, is forfeited; b) the right to determine dividend policy or direct the areas of internal reinvestment is absent; c) ability to borrow long-term against the business assets (versus against the stock position) is greatly reduced; and d) the opportunity to sell the businesses on a full-value, private-owner basis is forfeited.
[These disadvantages are offset by] the periodic tendency of stock markets to experience excesses, which cause businesses – when changing hands in small pieces through stock transactions – to sell at prices significantly above privately determined negotiated values. At such times, holdings may be liquidated at better prices than if the whole business were owned – and, due to the impersonal nature of securities markets, no moral stigma need be attached to dealing with such unwitting buyers.
Stock market prices may bounce wildly and irrationally, but if decisions regarding internal rates of return of the business are reasonably correct – and a small portion of the business is bought at a fraction of its private-owner value – a good return for the fund should be assured over the time span against which pension fund results should be measured.
[Success] in large part, is a matter of attitude, whereby the results of the business become the standard against which measurements are made rather than quarterly stock prices. It embodies a long time span for judgment confirmation, just as does an investment by a corporation in a major new division, plant, or product. It treats stock ownership as business ownership with corresponding adjustment in mental set. And it demands an excess of value of price paid, not merely a favorable short-term earnings or stock market outlook. General stock market considerations simply don’t enter into the purchase decisions.
Finally, [success] rests on a belief, which both seems logical and which has been borne out historically in securities markets, that intrinsic value is the eventual prime determinant of stock prices. In the words of my former boss: ‘In the short run the market is a voting machine, but in the long run it is a weighing machine.’
This approach – to buy individual stocks in the same way you’d buy whole business operations and to ignore whatever sentiment is prevalent in the stock market – turns out to be both the most profitable way to invest (because of the focus on long-term results and appropriate purchase price) and the safest.
Use your hard-won business judgment. Don’t buy a single share of stock in any company you wouldn’t want to own forever. Don’t judge the investment’s success or failure by its share price, but instead by its business results. Don’t allow popular sentiment to sway you from your course. Instead, use the wild, irrational swings in average share prices to give you opportunities to both buy at great discounts and sell at unwarranted premiums.
As Buffett himself says, thanks to the impersonal nature of the market, you can take advantage of “unwitting buyers” without any stigma.
Few business people invest in the stock market as they would in their own industry. It’s easier to simply wire the money somewhere else – and make it someone else’s problem. But if you’re an experienced business person, you’re not likely to solve your investment challenge by going to “professional” investors. Your business judgment will almost surely be more sophisticated than theirs.