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On the notions of under and over valuations


Guest JackRiver
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Guest JackRiver

I wanted to address a question/topic that arose in a previous thread (post), and that is: Is the process of identifying under valuation not the same as identifying over valuation?  That is to say, are the two opposite sides of the same coin?  My response was no.  To be more specific, it's no if the target business is a good business or an excellent business.

 

Let me give an imperfect example:

 

Let's say you are a mathematics professor at a very prestigous Ivy League school.  You teach the highest level mathematics course offered at the school in addition to other lower level math classes.  Your brightest student from your highest level class is a student you've had for many years.  You've gotten to know him well.  Not only is he bright: he's also industrious, very jovial (a team player), he comes from a good family with good manners good genes and long health (he's healthy), he has not taken to the debauchery of drugs and alchohol in any lasting way, he's punctual, sensible, good deal of street smarts, when he says he'll do something he does it, he's also an excellent student in his other subjects, etc etc etc...  He's an all around good kid and smart kid  He's also good looking like me and tall. 

 

Now, what if I came to you at the end of this young mans senior year and offered you 50% of this young mans earnings per year for life with the caveat that you will have to pay, upfront, 5 times the the average salaries of a specific profession pulled from a broad based random sampling of professions placed in a hat with 4 chances/passes to pull a different profession from the hat if you don't like the one you're holding (5 maximum)? 

 

Of course your first concern would be a single boys life expectancy.  I offer you a formula to mitigate that, either some version of term insurance or a grace period that we both agree is adequate to cover the risk of early demise within the first 10 years, and with that taken care of you agree to the game and draw your first profession from the hat.

 

Now that first pull can be a school teacher, a nurse, an investment banker, a lawyer, a politician, an engineer, etc, and if on the first pull you draw a high paying profession, you can use 1 of 4 passes to draw again hoping to produce a lower paying profession.  For the sake of brevity let's say you draw investment banker (300 thousand average pay) and quickly use a pass and are lucky to draw school teacher on your next pull.  40 thousand dollars average pay.  Lucky you.  You agree, and pay me 200 thousand dollars and the game is underway.  You smile.  You realize that inflation is now working for you.

 

You don't know what this kid will earn exactly or even what profession he will eventually choose.  All you know is that his personal qualities and his past actions offer a high probability of him being successful in whatever he chooses to do, and in most professions, those at the top make good money.

 

My question is this, if you were not allowed to randomly select professions, but instead I offered 1.5 million up front take it or leave it, how different would your thoughts be of the over or under valuation of that proposition in comparison to pulling the teacher at 200 thousand up front?

 

Yours

 

Jack River

 

 

 

 

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Now, what if I came to you at the end of this young mans senior year and offered you 50% of this young mans earnings per year for life

 

To tie this post in with the previous thread in which you suggest one should never sell an excellent investment, I offer this simple question:

 

Let's say you, JackRiver, own this right to 50% of the young man's earnings per year for life and I come to you and offer to buy it from you for 60% of the young man's earnings per year for life.  Would you sell it to me?

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Let's say you, JackRiver, own this right to 50% of the young man's earnings per year for life and I come to you and offer to buy it from you for 60% of the young man's earnings per year for life.  Would you sell it to me?

 

Tooskinneejs,

 

I take it that if you had bought Geico or See's or WPO at the same price as WEB, you would have happily sold a year later for 50% more? Do you think that would have been a good decision?

 

To answer your question for Jack, whether I sell would depend on what alternatives I had. To the extent that market values tend to move in tandem, chances are I would not be able to find a suitable alternative. Even if I could find an alternative at a cheaper price, I would have to ask myself why you did not buy that cheaper alternative. Since I would already know young man 1 better, I would need a bigger margin of safety for young man 2 which makes it even more difficult to find an alternative.

 

 

 

 

 

 

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I take it that if you had bought Geico or See's or WPO at the same price as WEB, you would have happily sold a year later for 50% more? Do you think that would have been a good decision?

 

I don't think you understand the question I posed to JackRiver.  Read his theoretical example and my response question closely.  He owns the right to 50% of a future stream of cash flows.  I've offered to buy it for 60% of that future stream of cash flows.  My question is very simple: would he agree to sell it to me or not?  (And why or why not?)

 

This question has nothing to do with selling something for X% more than the purchase price, it has to do with selling something for more than the value of it's future cash flows (without regard to one's cost basis).

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I don't think you understand the question I posed to JackRiver.

 

My apologies! I did not read it or Jack's example properly.

 

Having read both properly now, I have a question for you. Since no one really knows what his earnings are going to be, how would you value your offer of 60%?

 

Now assuming that both of you somehow manage to agree on what his future earnings are going to be, then my original answer still makes sense, doesn't it?

 

My Geico/See's/WPO question to you is based on the same premise as yours. My point is that after one year, the present value of the future cash flows would not have gone up by 50%. Let's say it's up 20%. So, someone comes along and offers you 50% more than you paid the year before. Do you accept the offer?

 

Alternatively, consider this. Say, I bought $1m worth of WFC preferreds at a 20% yield because I want to have $200K of income per year forever. Tomorrow, the present value of the future dividends is still the same to me but you come along and offer me $1.2m. Whether or not I sell depends on whether with the $1.2m I can buy something else to give me an annual cashflow of more than $200K a year without taking on more risk. If, as is likely, the reason you are offering to pay more for the same cashflows is because the value of investments have gone up in general, then it is unlikely I will be able to find an alternative. What you seem to be suggesting is that I should sell and hope to buy back the pfds when prices settle back to $1m. My problem with this is that I am giving up the bird in the hand (the $200K p.a. income which is what I want) for two potential birds in the bush (the $240K income I would get if yields go back to 20%).

 

 

 

 

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Guest JackRiver

Tooskinneejs

 

That's a damn good counter, but it's somewhat flawed because even though you're making me a higher offer, we are unable to set a present value on that 60%.  Ironically, your question is actually proving my point.  That a good or excellent business is hard to value in the sense that you don't know before hand just how good or excellent it will be. 

 

Since Berkshire operating units have come up on this topic, think about what Buffett paid for See's or NFM.  These proved to be damn good businesses and both have probably produce way more earnings power than envisioned by the sellers at sale (probably even better than Buffett and Munger figured as well).

 

Real quick and back to your point, if we could somehow come up with a present value for your 60% then my answer would be yes, and I would put the proceeds into government bonds, but fact is, we can't come up with the present value and therefore I wouldn't be capable of knowing wether I sold at a premium or not.

 

I hope my answer is correct, but if my logic is flawed please point it out to me.  Thanks in advance.

 

Yours

 

Jack River

 

 

 

 

 

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Guest JackRiver

Just as an aside, Munger talks about lollapalooza type situations with regards to psychological conditions, but the same holds true for just about anything.  An excellent company is put together in such a lollapalooza type way that over time produces results that far exceed the expectations of the analyst at T=0.  As Buffett has alluded, excellent businesses tend to have positive surprises. 

 

This is important and why I feel that Berkshire itself is proof of my point about never selling an excellent business purchased at a cheap price (BTW the point of this thread is that you can identify a cheap price but maybe not so for an overvalued price on the excellent business).  Outside of float type cash to invest, Berkshire is the living embodiment of Munger (Phil Fisher) building on top of Ben Graham type principles.  The main thesis of that extension is to apply the same principles as Graham, but focus it on excellent businesses (the Munger add on) and never sell because the probability is high it will surprise you to the upside for decades.

 

Berkshire is proof of how powerful this Munger add on is, and that's not to say that Buffett wouldn't have produced an excellent result if he just stuck with Graham, he would have, but nothing near what Berkshire has produced.  I think further proof of my thesis is that the richest people in the world aren't people who spent their lives selling things at a premium price and and buying others at a discount.  I think most of them come from those who never sold an excellent business or at least held it for decades before they sold.

 

Anyway, this is why I suggest an excellent business purchased at a cheap price is optimal. 

 

Yours

 

Jack river

 

 

 

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Guest JackRiver

OEC2000

 

Sorry, I did not read your reply to toosk before my response.  It looks like we came to the same conclusion on not knowing the cash flows before hand.

 

Yours

 

Jack River

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This is a good discussion, but I have trouble wrapping my head around it.  Perhaps the trouble is that Jack thinks the young man looks like himself, but I think he looks like me!  Whoa ... too many warts & wrinkles.

 

Anyway, on a serious note ... maybe the concept of finding cost, eg in oil & gas, comes in.  If there are say 20 punches, ie about one great opportunity every year or two of investing, then having identified one, there should be a substantial threshold before swapping for uncertain alternative.  Nonetheless, if there is a new alternative, and you're really sure, then swap ... sort of Phil Fisher's rule ... sell if have made a mistake, or if current investment has permanent change for the worse, or if something really better appears and you need the extra capital. Fisher wrote that he examined about 250 companies to find one investee, so his finding costs were very high.

 

So ... say have an asset worth X (uncertain number, distribution really), whatever it may have cost initially is irrelevant at this stage as the purchase has already been made.

 

Someone comes along and offers 1.2*X (uncertain, same distribution, but they offer cash = 1.2 * median or other average of distrib).

 

Only question is which is worth more...  present value X (distribution), or

 

cash = 1.2*X (median of distribution), which with investment of Y finding cost/time, can be turned into another X-distribution.

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"That's a damn good counter, but it's somewhat flawed because even though you're making me a higher offer, we are unable to set a present value on that 60%."

 

Who said we need to compute a present value?  I didn't say anything about the timing of my payments to you in exchange for the rights.  Since we don't know the young man's earnings until the year he earns them, let's assume that I'll pay you for each year's earnings at the end of each year (i.e., instead of receiving 50% of his earnings at the end of year 20XX, I'll pay you 60% at that time and you'll hand over the 50% to me).  Will you sell the rights to me?  I believe the answer is an obvious yes.  And the reason is that you will receive more value by selling than by holding the rights.

 

In the real world of investing, we do have other issues to deal with such as present values and uncertainties of cash flows, etc.  But in my rhetorical question to you, I'm trying to first isolate your assertion in the previous thread that one should never sell an excellent business (in this case, an excellent stream of cash flows) for any price.  In this case, one should in fact sell the excellent stream of cash flows if the compensation is greater than the value of the cash flows.

 

Now this is a silly example of course, because no one in their right mind would agree to pay you more than the value of that stream of cash flows, right?  And yet, this is what happens in the stock market from time to time (on a present value basis of course). 

 

 

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oec2000 said: "So, someone comes along and offers you 50% more than you paid the year before. Do you accept the offer?"

 

I'm positing that sell decisions should be based on a comparison of current market price to current value, not on a comparison of current market price to past cost basis.

 

jackriver said: "The main thesis of that extension is to apply the same principles as Graham, but focus it on excellent businesses (the Munger add on) and never sell because the probability is high it will surprise you to the upside for decades."

 

I agree that excellent businesses should be sought and purchased when available at compelling prices.  But just so we get resolution on the theoretical issue of whether to ever sell or not, I offer this admittedly unrealistic and extreme example:  If I offered to buy your Berkshire A shares from you right now for $700,000 each would you sell them?

 

I think the answer is yes, despite the fact that the business is an excellent one.  Why, because I'm offering you more value for selling than for holding.  Second, because you know that Mr. Market won't let this mispricing last forever and that you'll be able to buy the shares back for significantly less in the future (i.e., much closer to their intrinsic value).

 

woodstove - i agree with your thoughts.

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I suspect that syour age has an effect on whether you sell or not.  As I've aged, I notice that if it is a well run company (BRK,COST, FBAK, etc) that I feel comfortable with then I am more hesitant to sell than i used to be.  I will sell part but usually keep the bulk as it allows me to sleep at nights.

jmho

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Guest JackRiver

toosk

 

The counter point you offer has very little, if anything, to do with the point I was trying to make.  Go back and read what I've written and tell me if you still believe you are making a valid counter point, albeit and as you say a silly one.

 

It's not relevant I suspect because you are merely offering a series of discreet swap transactions.  You know, I'll swap you my 10 dollar bill for your 5 dollar bill.  There is very little insight in that that is applicable to my point.  In your example all you are really saying is that you'll pay me 20% more for my earnings from my excellent business.  Which means I'm still enjoying the fruits tied to an excellent business, just 20% more. 

 

In the other thread (post) I did ask that outliers be excluded.  I think i used the example of someone offering you 1 trillion dollars for your Berkshire position.  As you suggest and I concur, surely one should sell.  But the market doesn't offer up softballs like that so in this case using extreme/outlier examples to try and gain insight into this topic is not useful. 

 

Again, go back and read what I'm trying to say (my point).  If I may summarize/further clarify my point again, for a good or excellent business, it is really hard to tell whether you are selling out at a premium price, by contrast, it is really easy to tell if you are purchasing at a cheap price.  That is to say, they are not two sides of the same coin.  That just because you can identify something as undervalued (at a given price) does not naturally follow that you can identify that same thing as overvalued (at a given price).

 

Yours

 

Jack River

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"The counter point you offer has very little, if anything, to do with the point I was trying to make....It's not relevant I suspect because you are merely offering a series of discreet swap transactions."

 

I was working within the confines of the example you posed.  And I believe it is entirely relevant because it differs from a stock valuation only with respect to a NPV calculation (or lack thereof).

 

"If I may summarize/further clarify my point again, for a good or excellent business, it is really hard to tell whether you are selling out at a premium price, by contrast, it is really easy to tell if you are purchasing at a cheap price."

 

Well said. 

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Guest JackRiver

Toosk

 

I'm looking at your response just now, and I'm not sure you correctly interpreted my reply.  I follow your logic about not having to do a present value calculation and that you could just offer me a 20% premium to my cash flow when those cash flows come in.  As you say, I understand that we both know that's silly, but it does get over the present value problem. 

 

I tried to counter your argument with the fact that you aren't really asking me to sell my excellent business (I know the original reference was a boy, but I think it's easier to follow the logic if we revert the boy back to an excellent business).  That you are merely asking me if I would accept 20% more per year on the fruits of my excellent business.  I may be reading into your comments a bit here so tell me if i am wrong, but I viewed your original question as a means to show me that I would sell an excellent business if offered a little more (an alternative that has more cash flow), and if that's what your point was, I don't think its proving that.  It's a damn good counter, but I don't think it is applicable.  The fact that I would agree to your proposition does not prove a point.  An example below:

 

Your proposition could be slightly altered (for clarity) to read as "Jack, you own this excellent business.  I don't want you to sell it to me, but I want to know if you would be willing to accept 1 million dollars per year in addition to what your excellent business already produces for you?"

 

I believe this alteration is totally consistent with your original proposition, but it better highlights the fact that I am not selling my original excellent business.  I'm merely willing to accept additional free money from you.

 

Yours

 

Jack River

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Jackriver, I said that I would buy the right to the cash flow stream.  When i buy the right, I own it.  The fact that the payment for such right is delayed doesn't change that fact that you've sold it.  Anway, I think this discussion has gotten off track.  I was simply making the point that, in theory, one should not "never sell" and "excellent investment" in cases where one can realize more value by selling than by holding.

 

If you really wanted to boil it down to the most extremely simplified case, imagine you paid $0.01 for a business that will provide a cash flow of $1000.00 one year from now and nothing ever again.  That would be an excellent investment right?  And according to your theory, one should never sell that excellent investment because it is so excellent.  Now what if i offered to buy it from you today for $1,100.  Would you sell?

 

Again, please lets not get caught up in the specific facts of the example (for example, that it is only one cash flow, etc.).  I'm trying to simplify the point on purpose to show the obviousness of the argument I'm making.

 

Now you might rightfully counter that a real business with excellent long term economics has - unlike the example above - an unknowable value and therefore, how can one be certain that a sales price today that appears to be in excess of intrinsic value really is?  And I agree to an extent.  My point is only to challenge the absoluteness of your "never sell" theory for the cases in which one CAN clearly tell that current price far exceeds any potential intrinsic value.  And I think that happens quite often.

 

Hope this helps clarify my views.

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Guest JackRiver

Toosk

 

I'm not crazy here.  Go back and look at what my point of the original post to this thread was supposed to be trying to make and tell me if that is not the same thing you just said.  Also, In another post in this thread I repeated the way outlier example were it is obvious you are getting more value, I used 1 trillion dollars for your personal holdings in Berkshire.

 

I don't know what the heck is happening on these boards, but it is frustrating.  Some of us are getting treated like we are total neophytes to investing, this is causing major miscommunications.  Is this how it always is?  I don't think I'm crazy, but I'm feeling that way after these discussions.

 

Yours

 

Jack River

 

 

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Jackriver, maybe it's just a matter of us having different thresholds for concluding when current price far exceeds any potential intrinsic value (thus triggering a decision to do something beside "never sell").  For example, maybe you wouldn't sell Berkshire unless offered $400,000 today, whereas I might sell if offered $200,000.

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Guest JackRiver

Yes, I think that's it.  I think it's easier to tell when to buy than when to sell for an excellent business.  No kidding, I think I too would take the 200k on Berkshire if offered today  ::).  Thanks for taking the time to respond.

 

Yours

 

Jack River

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