Value and Growth are Joined at the Hip

Warren Buffett famously said that growth and value are joined at the hip. Both are areas of fundamental analysis. I think most business owners wouldn’t even understand what you mean if you would ask them if they focus on growth or value in their capital allocations. They just allocate capital to the projects with the highest expected IRR, irrespective of any category. 

Personally, I really like the framework put forth by the late Marty Whitman. In his opinion, there are are 5 main areas of fundamental finance: 

  1. Value Investing (limited to minority positions in public co’s) 
  2. Distress Investing
  3. Control Investing
  4. Credit Analysis
  5. First and Second Stage Venture Capital Investments

Buffett, as an example, has been active in all of those categories, either directly or indirectly. Singleton, as well, is someone you could not classify as a value investor specifically. He just went where he thought the highest IRR was at any given time.

How to Invest like Warren Buffett?

If you are asking yourself this question, you are asking yourself the wrong question. At the very least, I would propose you implement a minor tweak to it: How would Warren Buffett be investing if he were in your shoes? 

The thing is that the investing style of Warren Buffett has changed immensely over time. That’s just because he is extremely smart and extremely adaptable. And you wouldn’t want to mimic Buffett’s investments today, for the simple reason that he is severely disadvantaged compared to yourself. 

If Buffett were in your shoes, he most definitely wouldn’t be looking at Berkshire Hathaway for copycat ideas. You see, one of the things that is not talked enough about, when people are discussing Buffett is that he has been extremely adaptable. 

There are assets worth a total of $788 billion on the Berkshire Hathaway balance sheet. If the company would want to deploy 1% of its assets base to one investment, that investment would have to be valued at $7.8 billion. By comparison, the smallest company in the S&P 500 index has a market cap of $1.5 billion.

Therefore, if Buffett wants to make an investment that actually moves the needle today, his universe of available investment opportunities is actually tiny. 

The Buffett Partnership

So, how did Buffett invest early in his career, when he was a much smaller fish in a much bigger pond? This question brings you to the the Buffett Partnership, which Buffett managed from 1956 to 1969. When Buffett dissolved the Partnership in 1970, he kept his stake in Berkshire Hathaway, which the Partnership had had a controlling shareholder in. The rest is history, I guess.

First of all, during the Partnership years, Buffett invested in smaller, less liquid companies. Secondly, Buffett was a relatively concentrated investor, focusing on a few high conviction ideas. Nonetheless, this does not mean he didn’t try to diversify the Buffett Partnership Portfolio. The way he did it was not through quantity of exposure, but through the quality of exposure. 

By quality, I don’t mean that the stocks he chose were of higher quality than the stocks in the general market. But rather that he managed the stock portfolio by allocating its capital into three buckets that each had exposure to qualitatively different factors. 

The Three Arrows of Buffett’s Capital Allocation

His objective, as I understand it, was to be able to keep his options open and be flexible under different market conditions. For example, if the overall market went up, he would be able to allocate capital to the bucket of stocks that were not driven by the overall market, and vice versa if market sentiment was overly pessimistic. 

But you don’t have to take my word for it. Here is Buffett’s explanation of the three qualitative areas that he allocated capital to. The following is taken from the 1961 Buffet Partnership Letter Shareholders:


Our Method of Operation 

Our avenues of investment break down into three categories. These categories have different behavior characteristics, and the way our money is divided among them will have an important effect on our results, relative to the Dow in any given year. The actual percentage division among categories is to some degree planned, but to a great extent, accidental, based upon availability factors. 

The first section consists of generally undervalued securities (hereinafter called “generals”) where we have nothing to say about corporate policies and no timetable as to when the undervaluation may correct itself. Over the years, this has been our largest category of investment, and more money has been made here than in either of the other categories. We usually have fairly large positions (5% to 10% of our total assets) in each of five or six generals, with smaller positions in another ten or fifteen. 

Sometimes these work out very fast; many times they take years. It is difficult at the time of purchase to know any specific reason why they should appreciate in price. However, because of this lack of glamour or anything pending which might create immediate favorable market action, they are available at very cheap prices. A lot of value can be obtained for the price paid. This substantial excess of value creates a comfortable margin of safety in each transaction. This individual margin of safety, coupled with a diversity of commitments creates a most attractive package of safety and appreciation potential. Over the years our timing of purchases has been considerably better than our timing of sales. We do not go into these generals with the idea of getting the last nickel, but are usually quite content selling out at some intermediate level between our purchase price and what we regard as fair value to a private owner. 

The generals tend to behave market-wise very much in sympathy with the Dow. Just because something is cheap does not mean it is not going to go down. During abrupt downward movements in the market, this segment may very well go down percentage-wise just as much as the Dow. Over a period of years, I believe the generals will outperform the Dow, and during sharply advancing years like 1961, this is the section of our portfolio that turns in the best results. It is, of course, also the most vulnerable in a declining market. 

Our second category consists of “work-outs.” These are securities whose financial results depend on corporate action rather than supply and demand factors created by buyers and sellers of securities. In other words, they are securities with a timetable where we can predict, within reasonable error limits, when we will get how much and what might upset the applecart. Corporate events such as mergers, liquidations, reorganizations, spin-offs, etc., lead to work-outs. An important source in recent years has been sell-outs by oil producers to major integrated oil companies. 

This category will produce reasonably stable earnings from year to year, to a large extent irrespective of the course of the Dow. Obviously, if we operate throughout a year with a large portion of our portfolio in workouts, we will look extremely good if it turns out to be a declining year for the Dow or quite bad if it is a strongly advancing year. Over the years, work-outs have provided our second largest category. At any given time, we may be in ten to fifteen of these; some just beginning and others in the late stage of their development.

I believe in using borrowed money to offset a portion of our work-out portfolio since there is a high degree of safety in this category in terms of both eventual results and intermediate market behavior. Results, excluding the benefits derived from the use of borrowed money, usually fall in the 10% to 20% range. My self-imposed limit regarding borrowing is 25% of partnership net worth. Oftentimes we owe no money and when we do borrow, it is only as an offset against work-outs. 

The final category is “control” situations where we either control the company or take a very large position and attempt to influence policies of the company. Such operations should definitely be measured on the basis of several years. In a given year, they may produce nothing as it is usually to our advantage to have the stock be stagnant market-wise for a long period while we are acquiring it.

These situations, too, have relatively little in common with the behavior of the Dow. Sometimes, of course, we buy into a general with the thought in mind that it might develop into a control situation. If the price remains low enough for a long period, this might very well happen. If it moves up before we have a substantial percentage of the company’s stock, we sell at higher levels and complete a successful general operation. We are presently acquiring stock in what may turn out to be control situations several years hence.

The Entrepreneur vs The Investor

In this speech by Peter Thiel, he says the following when talking about how to detect patterns when trying to recognizing entrepreneurs as a venture capitalist: 

“You always want to invest in the ones where they speak in definite future tense. You sometimes have to be careful they’re not totally crazy people, but that’s the sort of person you want to invest in. You do not want to invest in people who are talking too much about probabilities or risks or things like that because my experience has been that the people who think they’re involved in some sort of lottery ticket-like dynamic are already setting themselves up to already somehow get the probabilities wrong and invariably lose.”

“There is a similar version of this that I experience as an investor in these ventures. There’s always this very tricky question of the role of luck and chance in these things working. There certainly is this external truth perspective that there is a certain amount of luck that is built into the nature of the universe and you try to model it. You try to account for it. You try to get the probabilities right, as you assess these things. So, when people say that luck is involved, this is a statement about the deep nature of our universe.”

“And then there is this sort of internal truth version. Whenever we have thought that it is a matter of work. Psychologically I can say that this has often been a very bad sign. Where you say, “well, we don’t know if this is going to work. Maybe it works. Maybe it doesn’t. So, let’s just invest a slightly smaller amount for our lack of knowledge.”  And as a pattern, I would say, those are investments that have generally gone very badly wrong.”

“If I had to sort of explain why. When you think you are multiplying a small probability by a big payoff, you sort of psycho yourself into playing the lottery and you psych yourself into losing. Because you somehow are being sloppy and not doing that much work.” 

I think these thoughts do a great job of highlighting the inherent differences between entrepreneurs and investors. The entrepreneurs Peter looks for speak of the future through a deterministic mindset. They have a clear sense of the future and how they are going to shape it. Peter himself, on the other hand, as a venture capitalist does not invest his all his funds in one company. In his role he needs to have a more probabilistic mindset, even though he bets big once he has a high conviction on particular investments. 

The World According to…

The EntrepreneurThe Investor
Deterministic mindsetProbabilistic mindset
Risk is endogenic Risk is exogenic
AnalyticalStatistical
Concentration Diversification
High ConvictionRisk Management
Entrepreneurs vs Investors: Different Characteristics

The Implied Meaning of a Market Cap

Apple is worth $2,000,000,000,000. That is a lot of money” said Anthony Pompliano on Twitter the other day. Dave Collum promptly corrected him: “priced at.” This is a very important and warranted distinction. We talk about the market capitalizations of companies all the time, but less often we think about what it actually implies. 

For Every Buyer there is a Seller

The current price of a publicly traded stock is the most recent point where the most willing seller and most eager buyer matched. So when Apple stocks ended a trading day at $498, the last buyer and seller that were matched were willing to do business for that price. For someone to buy, someone also has to sell. 

But the market price only gives us some information about the marginal sellers and buyers. One an average day, somewhere between 100 to 200 million shares of Apple stock will change hands. That’s a lot of shares. On particularly busy days, this will exceed 300 million. On a slow day, however, as little as 50 million shares will change hands. But Apple has 4.35 billion shares outstanding. So, even on the most hectic days, less than 7% of the outstanding shares will change hands.

The 7% figures is likely deceptive as high frequency trading and other forms of day trading and market making might overstate the fact that the majority of stockholders will not sell on a given day. 

Therefore, the market cap and stock price of a company will tell you where it is priced at by the market. it won’t tell you where the stock is valued at by the market.

Leverage + Arbitrage

I like reading books on business history and biographies of business people. One thing that I feel is often a common thread in there stories is that substantial wealth creation often seems to stem from some combination of leverage and arbitrage.

I’ll elaborate. Often, the initial businesses are created around some sort of arbitrage. The arbitrage might be that the entrepreneurs have some information or ideas that others don’t. But an arbitrage usually doesn’t sustain. Once the word is out the trade gets crowded, which in turn erodes the profitability.

Some arbitrage are more sustainable than others and cane be ridden for longer. And I suapect that there are plenty of business people out there that found powerful arbitrages to take advantage of and did so for a long time. The reason we never heard about them, is because they were constrained. They were not scalable. They couldn’t not be levered.

If you have an arbitrage, however, that is defensible and has the potential to be leverad to a larger scale, you have the components of substantial wealth creation.

Here are a few examples:

  • Sam Walton realized that by buying cheap and pricing low, he would create operating leverage, by maximizing inventory turns. He realized that the big stores would not go to smaller towns, an opportunity that he was able to arbitrage for a very long time.
  • Kirk Kerkorian built his initial wealth through a unique albeit limited arbitrage. After WWII, Kerkorian borrowed money to bid on surplus bombers which he picked up abroad and flew home. At the time, there was a shortage of jet fuel and Kerkorian was able to sell the remaining fuel in the bombers’ fuel tank. Selling the fuel raised enough money to repay the loans he had taken. He essentially got the planes for free.
  • Sam Zemurray made a fortune in the banana trade. In his early days, he took advantage of a brilliant arbitrage opportunity. When banana cargo came to New Orleans, bananas that were spotted were deemed unfit for the travel to metropolitan locations and were discarded at the port. Zemurray bought the ripe bananas very cheaply and sold them locally to grocers within a day of New Orleans. To get the bananas to grocers fast, he leveraged the train system.