50 cent dollars???

"Psst...Hey buddy! You wanna buy a dollar?"

"Buy a dollar? Why would I want to buy a dollar??"

"I can get you a great price - 50 cents, take it or leave it!"

While this sounds like a rather improbable exchange, a certain class of (mostly wealthy) people have been having these types of conversations for many years.

Who are these mysterious buyers of discounted currency? They are a group known widely as "value investors." Who exactly are they talking to? An often irrational, manic-depressive person that the late great Benjamin Graham called "Mr. Market." Sometimes (such as 1933 or 1982) Mr. Market will offer to sell dollar bills (or even $10 bills!) for 50, 40 even 30 cents. Other times (such as 1999), Mr. Market would demand (or pay) as much as $10, $20 or even $100 for that same dollar bill.

What are these dollar bills that "Mr. Market" is so fascinated with? They are simply stocks, bonds, timberland, apartment complexes - any financial asset. Since nobody knows exactly how much one needs to pay for that dollar bill, sometimes the consensus opinion (known as the market price) can miss the mark.

While the concept of buying dollar bills for 50 cents is obviously appealing, the financial press, academia, and most of the publicly managed money ignore this concept when it comes to investing in common stocks of businesses. Why? There are too many reasons to list right now, although I will touch upon them in later columns. However, the biggest reason is understandable (to a point) - its difficult. Most 50 cent dollars have had bad news. Everybody is selling. Nobody has anything nice to say about them. Buying these $1 bills is psychologically punishing and requires patience and a lot of research.

Still interested? Great! Let's take a little walk together. I don't know exactly know where we're going, and I don't know when it will end.

I will give you some guideposts to help find these companies - what I call my first principles.

1. Investing is appraisal of a business to determine its value (cash flows, assets). Trading is an appraisal of other people's opinions of a business' value (price trends). Investing is a financially-driven profession. Trading is a psychologically-driven profession. Most "investing" is really trading in disguise. I don't deny that traders can be successful, but I don't play that game (see About Me for my painful awakening to this fact.)

2. Act as if you are buying the entire business. Look at the cash flows, assets, profits, competition, industry outlook, etc. Most private buyers don't deal with the nonsense of price, because there is no price! They negotiate the price, and have to live with the results. Investors in publicly traded common stocks of businesses have the advantage of getting an instant price quote. Therefore, you can wait until "somebody does something stupid," as Warren Buffet likes to say.

3. Think in terms of after-tax returns. When you buy a common stock, you don't pay taxes until you sell, so it is to your advantage to find companies that can compound their profits over time and exponentially increase tax-deferred value. Transaction costs and taxes from rapid trading will eat you alive over time.

4. Buy the business for less than its value. Business create value in many ways: they build assets, they generate cash and pay dividends. You can define value in several ways a) Present Value of dividends paid over the life of the business (John Burr Williams) b) Price paid by the average private market buyer (Tweedy, Browne and others) c) Net Asset Value, valued at market, or replacement cost (Marty Whitman)

5. Use a wide "margin of safety" to protect against being wrong or other nasty surprises. If you appraise the value of a business at $10 per share, and the price is $9.80, there is not enough of a margin of safety to be sure that you will get a satisfactory return.

6. To paraphrase Peter Lynch (who was a closet value investor) "Spend more time studying a business than you would spend buying a refrigerator." Know what you are buying!!! Read annual reports. Talk to customers, suppliers. Listen to conference calls. How exactly does this company make money? Tweedy, Browne has a great list of 17 questions to answer when appraising a business.

7. $1 bills sometimes turn into $10 or even $100 bills over time. If you find one, don't let it go! Warren Buffett is the second-richest person in the world in large part due to his buying only a few of these "wonderful companies."

8. To paraphrase Benjamin Graham, "any business can be cheap or dear - at a certain price." Keeping that in mind, you can buy businesses in several ways and be successful:

a. A great business at a fair price
b. An average business at a very good price
c. A below-average business at a great price (i.e. less than liquidation value)

9. Have fun! If you don't like this kind of work, you won't be successful. Invest with some fund managers who buy 50 cent dollars (see Great Value Funds) and don't sell until you need the money!

So what am I going to do? Every few days I will post short commentary about what is happening with the markets, and how a true value investor would look at the situation. Once per week or every two weeks, I will look at what I think is a promising company and walk everyone through the appraisal. If I like the company enough to buy a piece of it, I will let you know. If I already own it, I will also let you know! Given the lofty levels of the market these days, I probably won't be buying too many shares of businesses, but you never know!

Comments

[ryan]

Thanks for the interesting picks and commentary. Keep it up.