“We’re generally overconfident in our opinions and our impressions and judgments.”
Different Weather Requires Different Clothing…
In his Partnership Letters Warren Buffett discusses four different investment methods used by him in order to best act in accordance with his investment principles. The methods are: (1) Generals-Private Owner, (2) Generals-Relatively Undervalued, (3) Workouts, and (4) Controls.
In Buffett’s Ground Rules, written by Jeremy Miller, the author provides the following checklist as a tool for evaluating a potential investment in a General, i.e., both Generals-Private Owner and Generals-Relatively Undervalued.
Here is a checklist for evaluating a potential investment in a General: (1) Orient: What tools or special knowledge is required to understand the situation? Do I have them? (2) Analyze: What are the economics inherent to the business and the industry? How do they relate to my long-term expectations for earnings and cash flows? (3) Invert: What are the likely ways I’ll be wrong? If I’m wrong, how much can I lose? (4) What is the current intrinsic value of the business? How fast is it growing or shrinking? And finally, (5) Compare: does the discount to intrinsic value, properly weighted for both the downside risk and upside reward, compare favorably to all the other options available to me?
I enjoy reading Buffett’s Ground Rules, and one third into it I can highly recommend it. In this book the author provides a compilation of the old Buffett Partnership letters, and discusses different investment principles, methods, and digs into some of the investments made by Buffett during the 1956-1969 era.
The author then goes on to provide some insight about what to do when you’re not able to clear each paragraph in the checklist.
If you find yourself unable to make it all the way through the checklist, then write down in a single paragraph the metrics of the investment. If you get caught up along the way, either do more work or simply forget the idea as “too hard” and move on to something else.
“Why should we look to the past in order to prepare for the future? Because there is nowhere else to look.” ― James Burke
Warren Buffett’s investment in American Express in the mid 60’s is well known to a lot of investors that have followed and studied in the footsteps of the Oracle of Omaha.
Yesterday I ran into the American Express annual report from 1964 — follow this link to read it.
I then had an idea that I would read the annual report and try to come up with a reasonable intrinsic value range of the American Express business and then compare it to the purchase price paid by Warren.
Since I didn’t have a clue about the share price – no anchoring bias – I thought it would be interesting to see how my own calculation and reasoning regarding the intrinsic value stood up compared to the price of the business back in 1963 and 1964.
So what do I know at the moment that could influence me? How do I try not to be swindled by hindsight bias?
I know that…
- …American Express found itself in the middle of a fraud, the so-called “Salad Oil Scandal”,
- …Warren Buffett started researching the business fundamentals of the business,
- …Warren Buffett decided from the results of his research to put a great part of his partnership’s money at work by purchasing shares in the company when the price fell in the aftermath of the the scandal,
- …American Express is still doing business as of today,
- …the investment by Warren turned out to be one of his greatest.
I will try to imagine myself right in the 60′ (impossible, I know…) and from reading the annual report get me an understanding of the business of American Express back in 1963 and 1964. From the facts in the annual report I will then calculate a reasonable intrinsic value range per share and see at what price I myself would have been interested in purchasing shares in the business and becoming a part owner in it.
In step two, I will try to find out Warren Buffett’s purchase price and see where my own calculation stands compared to the price he paid.
I will then go back once again, this time to books and articles, to get a better understanding of what happened and how it all played out.
As a final step, I will go back to my own calculation of intrinsic business value per share to see if what I know and if my improved understanding of the Salad Oil Scandal would have had any impact on my thinking and my way of coming up with an intrinsic value.