In this next section of The Essays of Warren Buffett, Buffett talks about the difference between investing and speculating and how sometimes it can really just be a big case of accounting fraud by the owners of the company if you’re not paying attention and sticking to the fundamentals.
Buffett gives one of my favorite investing analogies ever in this chapter when he talks about how investing is simply measuring whether a bird in the hand is worth two in the bush. But, to properly analyze this, you need to ask yourself these three questions:
- How certain are you that there are birds in the bush?
- When will they emerge and how many will there be?
- What is the risk-free interest rate (which is usually long-term US Bonds, or the treasury rate)?
Not going to lie, when I was reading this chapter, I actually laughed out loud at the three questions. The first two continue down the same analogy as the birds and the bush and then the third question just completely ignores that there ever even was an analogy.
But this really is a great analogy if you think about it. The “bird in the hand” is whatever your risk-free interest rate is and then you’re really trying to analyze that if you take the money out of that investment and put it in a company, is your return going to be more fruitful? And if so, how much more fruitful will it be?
In essence, that really is the core thought process of investing – constantly trying to decipher the risk/value of one opportunity over another and making the best decision that you can at that point in time.
If you can’t put out a guess as to the potential reward of investing in a new company, then is it actually investing? No. It’s really just speculating, or to be quite honest, gambling.
You’ll typically see this sort of speculation with newer companies. One that immediately comes to mind to my is Beyond Meat (BYND). When BYND first had its Initial Public Offering (IPO), it was the talk of the investing world because it IPO’d at $25 and within three months it was at $239.71! Holy crap!
It was incredible to see a company almost become a tenbagger essentially within the first three months. But, did anything really change in the company to make it worth 10 times it’s value? NO! It was just speculation. The stock is now sitting around $120, which is still a huge increase from the IPO price, but that would really suck if you speculated and bought at the top, wouldn’t it?
A lot of times when these new companies hit the market you might hear the term “value creation” because the company’s value has increased so drastically in a short period of time, and while that is technically true, has anything actually changed about the company? Again, the answer is sadly no.
The true, intrinsic value of the company is still the same. BYND isn’t selling more vegan patties because their stock price shot up 10X their IPO price. Their earnings aren’t 10X what it was the previous quarter. It’s nothing less than a shift in the money of the shareholders.
As an investor, you need to be careful of situations like these at times, however, because it can open up an area for you to get taken advantage of. Buffett talks about the goals of some companies leadership teams is simply to get the company to IPO.
Their goal is completely to get to a point to reward the leaders and stockholders of the company when it has its IPO rather than to continue to grow the business.
In essence, their goal is to be making money off investors instead of for them.
Now, I want to be very clear and say that I am in no way accusing BYND of doing that, but I am saying that there’s so much hype amongst these newer companies that IPO that it opens up the speculative investor to be taken advantage of by a company that might have that sort of leadership.
You really need to do your due diligence on a company before investing in them, which seems obvious, but I think it applies even more so towards a company that is about to have its IPO. Anytime a company goes public, by definition it means that they were private before and that their financials were held closer to their choice so it might be hard to fully understand the business as an outside investor.
All of this, again, just makes it that much easier for the company to maneuver their numbers in a way to make the stock look even more enticing to a potential investor for the day of their IPO. Again, I am not specifically calling any companies out for this, but in 2019 we saw an IPO frenzy and it really almost felt like a bubble was happening with these IPOs as everyone and their mother was rushing to get a piece of the next, new company to hit the market.
Buffett urges for us to do the opposite of this with our money. With his company, Berkshire Hathaway, they try their best to be conservative. Yes, this is going to likely mean slower growth than you might experience with a growth company, but it also means that you’re likely going to experience sustained success rather than high highs and low lows of these newer companies.
Buffett goes on in the book to say that their best performing bushes have been those where they purchase the entire business because it has allowed them the opportunity to truly make the changes that they deem necessary to make the business flourish.
Now, as an individual investor, we obviously can’t buy the whole business, but we can find companies that run their business in the same way that we likely would, and that’s a way to try to accomplish that goal.
As with any investment, we need to make sure that the company’s goals align with our financial goals. If we don’t do this as investors then we’re likely going to just get frustrated with the returns and move into another position, therefore creating an ‘Opportunity Loss’ of what we could’ve been doing with our money instead.
I urge you to take the time on the front-end to make sure you understand the business and trust that they have the right goals in mind – and that should be to make money for their shareholders.