From Stephen Penman: “I am not a fan of DCF valuation. It discounts free cash flow with that elusive discount rate, but the problem is worse. Free cash flow is not a measure of value added; it is not appropriate accounting for value. That’s easily seen. Free cash flow is cash from operations minus cash investment, so investment reduces free cash flow and liquidation increases free cash flow. That’s perverse. I can show you a number of very profitable firms that have negative free cash flows because they invest a lot to take advantage of their profitable opportunities. DCF works for long forecasting horizons, but that leaves you speculating about the long-term, or guessing at the “long-term growth rate.” Plugging in an assumed growth rate into a DCF model is dangerous; it results in a speculative valuation that rides on a (speculative) growth rate.“
The way to success
From Mohnish Pabrai quoting Swami Vivekananda:
“Take up one idea.
Make that idea your life.
Think of it, dream of it,
live on that idea.
Let the brain, muscles, nerves,
every part of your body,
be full of that idea, and
just leave every other idea alone.
This is the way to success.”
Addendum to Rules no. 1 & 2
As mentioned in a prior post, Warren Buffett’s first two rules of investing are “Rule No.1: Never lose money. Rule No.2: Never forget rule No.1”.
These rules are so important, I thought they deserved a bit more discussion. The following two quotes and my comments, sort of, follow from the first two rules. They are from an interview conducted with Charles de Vaulx and Charles de Lardemelle of International Value Advisers:
“One of the most effective ways to compound wealth is to minimize drawdowns” -> Large drawdowns really hamper the long term compounding rate. For instance, if your portfolio falls by 20% in value, it requires a 25% return just to get back to breakeven. If the drawdown is 33%, you need a 50% return to get back to breakeven. If the drawdown is 50%, your portfolio needs to go up 100% just to get to breakeven. So avoiding large drawdowns is important.
“For each stock we arrive at an estimate of intrinsic value, but equally important is defining the worst-case value” -> If you can buy a stock below its intrinsic value, you automatically get a margin of safety. Even if the stock price is higher than the worst-case value (but below the intrinsic value), the worst-case value gives an estimate of the drawdown you might face on that stock. Remember that Mr. Market can get fairly irrational at times. Some of the best investment opportunities are created when a stock goes below the worst-case estimate (provided the analysis is sound).
The full interview is here.
Rule No.1: Never lose money
Warren Buffett: “Rule No.1: Never lose money. Rule No.2: Never forget rule No.1”
This is probably the most important rule in investing. But I think it is also misunderstood. The two words that cause confusion are ‘lose‘ and ‘money‘. Here is what I think Buffett really meant with these two words.
‘Money‘ is not the absolute dollar amount. It is the value of your dollars adjusted for their purchasing power over the investment horizon. Buffett explains it beautifully in another place when he says “Unfortunately, earnings reported in corporate financial statements are no longer the dominant variable that determines whether there are any real earnings for you, the owner. For only gains in purchasing power represent real earnings on investment. If you (a) forego ten hamburgers to purchase an investment; (b) receive dividends which, after tax, buy two hamburgers; and (c) receive, upon sale of your holdings, after-tax proceeds that will buy eight hamburgers, then (d) you have had no real income from your investment, no matter how much it appreciated in dollars. You may feel richer, but you won’t eat richer“. It is easy to say that this is simply the inflation-adjusted real return but this statement brings about two new problems. First, each person’s inflation rate is different depending on their individual basket of consumption…and this basket can also vary over time. The official rate of inflation (and it doesn’t matter which official authority one uses) may be benchmarked to a different basket of goods. Secondly, as most governments are incentivized to show lower inflation, I will not be surprised at subtle changes in the way official inflation is measured that understates real inflation. I use two heuristics to come up with an acceptable baseline rate of inflation to measure my personal investment performance. First, I use the official US CPI but adjust it up by 4% as some studies have shown that the adjustments to CPI methodologies over time understate the true inflation by 3-4%. Second, I take a minimum rate of 5% as I believe that my expenses are going up by atleast that much every year. So to actually become richer through investing, I need to beat 5% every year at a minimum. This gives me a heuristic of myCPI = min (5%, official US CPI + 4%). At the end of each year, I can use this to benchmark my investment performance. Note that I am better off overestimating my inflation rate than underestimating it. By overestimating it, I will be richer than I think which is not the worst mistake in the world.
‘Lose‘, I think, is also a misunderstood word. If I bought a stock for $100 today and it went down to $95 tomorrow, did I lose $5 on that investment? The correct answer is – not necessarily. The stock price is only relevant if I choose to act on it. If the fundamental value of the company is unchanged, the fluctuation in its stock price is irrelevant. If you have good reason to believe that the stock price is worth much more than $100, then either ignore Mr. Market’s mood swings or use it to your advantage by buying more. However, this is not a justification to naively double down on a losing investment. If you don’t have a good estimation of the company valuation, doubling down on a losing investment is a great way to throw good money after bad. The valuation estimate need not be a point value. If I think a company’s stock is worth somewhere between $120 and $200 and Mr.Market is giving me an opportunity to buy it for $100, even that wide range of estimates is good enough. You also need to have the capability of holding the stock through Mr.Market’s volatile mood swings. If not, you may end up selling up at an inopportune time and crystallizing your losses. Thus ‘lose‘ should be interpreted as a permanent impairment of capital.
So, to sum up, the first and the most important rule of investing can be awkwardly rephrased as ‘don’t impair your purchasing power permanently’. I have to admit that the original phrase sounds much more elegant as long as it is understood correctly.