How to think like a businessman

Investing like a businessman is an idea that often is only paid lip service by people, myself included.  I will in effect end up parroting Warren Buffett, but my research on ITT made me think of this.  Graham was also fond of saying investing is most intelligent when it is businesslike.  The more I wrote about ITT, the less sense it made.  I think this largely has to do with looking at the split up from the perspective of a businessman - you know, what am I actually buying and what are the return implications.

The biggest mistake I make in attempting to be an investor is grounded in epistemology.  How do I know what I know?  I don't visit companies.  I occasionally email a company for clarification about something they said on a conference call or in a press release and rarely get a response.  Yes, one can look at historical margins, free cash flow, book value, and competitors to get a grasp of what is being bought.  The problem is that many people think of a share as a piece of paper and really have a weak case for knowing if something is cheap - although it rarely prevents people from thinking it.  People mindlessly believe share buybacks are an absolute positive, but it is really just an ordinary business decision that can turn out poorly like any other.  What's important is not how we know what we know, but figuring out what exactly it is that we want to know.  When it comes to understand how to wrap one's arms around the epistemic problem posed in stock selection, I turn to my good friend Warren.

Warren Buffett said this about gold:

“If you took all the gold in the world, it would roughly make a cube 67 feet on a side…Now for that same cube of gold, it would be worth at today’s market prices about $7 trillion dollars – that’s probably about a third of the value of all the stocks in the United States…For $7 trillion dollars…you could have all the farmland in the United States, you could have about seven Exxon Mobils, and you could have a trillion dollars of walking-around money…And if you offered me the choice of looking at some 67 foot cube of gold and looking at it all day, and you know me touching it and fondling it occasionally…Call me crazy, but I’ll take the farmland and the Exxon Mobils.”  

People tend to see what they want and so most people said "but of course, he is saying gold is a bad investment."  It should be looked at differently.  He is just doing what he always does.  He is thinking like a businessman.  The subject matter of gold is irrelevant and practically useless since I think most people who heard what he said already agreed with his conclusion, but it is how he reached it that is important.  

What if he owned all the gold in the world?  He looked at it in totality and compared it to what else he could buy.  While you could dismiss his argument as an absurd reduction, that is the point.  Reducing investment decisions to the absurd seems like the best way to create a genuine understanding of what is being bought.  The logical conclusion is to think as if you owned the entire business.  Selling sugar water in red cans is fundamentally a superior business to selling sugar water in blue cans.  A dry assessment of reality - for whatever reason, people have a nearly unshakeable emotional affinity for sugar water sold in red cans that creates a huge competitive advantage for the seller.  

Just to bring in the perspective of a lesser known, but equally astute businessman.  Here is what Jeff Harp from Trinity Bank, which I've written about, about his decision to buy back some of Trinity's stock (letter here):

"For the second quarter of 2010, Trinity Bank had nearly $20,000,000 in short-term investments earning 1.24%.  That return is even lower today.  For the same time period, each share of Trinity Bank common stock earned 12.35%.  In a stock repurchase, we take dollars earning 1.24% before taxes and buy shares of stock earning over 12% after taxes.  We paid $24.10 for the stock, which is about 1.6 times book value of $14.62.  Since we paid more than book value of the stock, it actually reduces our return to the 8% range.  So would you take $700,000 earning 1.24% before taxes and buy $700,000 of common stock earning 8% after taxes?  That is the economic decision in about as simple an explanation as I can come up with."

It's just a business decision.  Opportunity costs are considered.  The returns are calculated.  That's it.  Simple.  Sound.  No trumpeting EPS growth.  No corporate litany about returning money to shareholders. 

My point is that it is quite easy to get caught up in a lot of noise - gold:silver ratio, EPS growth, total shareholder return - that don't really reveal what I want to know.  It's quite hard to describe how exactly one thinks like a businessman, but Buffett and Harp are articulate enough to provide a nice window into their thinking as businessmen behind capital allocation.  

This will tie into my next post where I apply this thinking to ITT.