I received a lot of positive feedback on my two-part article on Glenn Greenberg. It is clear that Greenberg is a very talented investor, not in a flashy way but in a way similar to Buffett. They both have a knack for getting to the core issue and for being able to explain a complex reality in a way that anyone can understand.
One of the parts of Greenberg’s talk that most impressed me was where he talks about dropping the use of discounted cash flows when analyzing and valuing businesses.
Investing is about trying to predict what will happen in the future. Our ability to do this is very limited. The future of most businesses is highly uncertain, because they operate without a durable competitive advantage and are therefore bounced about and pummeled by the waves of relentless competition and creative destruction.
On the other hand, there are a select few businesses where you can make meaningful predictions about where they will be in ten years. You are able to see that the conditions that led to their success over the past ten or twenty years – or, in rare cases, one hundred years – are likely to remain in place for the next ten or twenty years.
All this leads me to back to Greenberg saying that, in lieu of doing discounted cash flows, he feels the most important elements in valuing a business are to have a very clear view of why a company is a good business and a very clear view of where the business will be in a few years. The problem with cranking out discounted cash flows is that they create the impression of false precision – that we can actually look into the future and plainly see a company’s free cash flows for the next decade or more.
Greenberg prefers to spend his time and energy on what really matters and what is doable. Remember that there are things that are important and knowable and there are things that are important and unknowable. A company’s stream of cash flows over the next ten or twenty years is very important but for most businesses falls into the column of unknowable.
If you don’t get the part right about whether it’s a good business and where it will be in a few years, the investment most likely won’t work out as planned.
In my judgment, it is not that discounted cash flows per se are flawed; it is, rather, how they are often used – or misused.
Many successful investors use them. The great ones are well aware of their limitations. I believe they are useful to the degree that they make you think about the issues that will drive future cash flows, which brings us right back to Greenberg’s two fundamental questions.
Notice too that Greenberg says he wants to arrive at a “very clear” conclusion. He sets the bar high. This reminds me of when Buffett and Munger were asked at the 1996 Berkshire Hathaway shareholder meeting why they did not buy shares of Pfizer or Johnson & Johnson, seeing that both had a long-term track record pretty much equal to that of Coca-Cola. Munger answered that he and Buffett thought they understood Pfizer and Johnson & Johnson, but they knew they understood Coca-Cola. (1)
They simply decided to invest where they had greater clarity.
Finally, with regards to having a clear idea of where the business will be in a five to ten years, few businesses offer – or offered, when Buffett made his investments – better clarity than Geico and Coca-Cola. It is no surprise that Buffett singled these two out. My suggestion is that you use these two companies as a measuring stick when thinking about the competitive advantages and growth prospects of your potential investments.
Go back and read Buffett’s article on Geico, “The Security I Like Best”. Buffett lays out the growth prospects for Geico in simple, crystal-clear terms. Can you do that for each of your investments?
The same can be said for Buffett’s investment in Coca-Cola. Even after more than a hundred years of superlative growth and execution, they control only around 3% of world-wide consumption of beverages. You don’t need a computer model to see that there is still plenty of runway ahead.
The bottom line is to emphasize thinking and, if you can’t figure it out, move on. There are plenty of other fish in the sea. Cast your lot with one where you are certain and the odds are stacked heavily in your favor.
(1) Berkshire Hathaway annual meeting, 1996, Outstanding Investor Digest, August 8, 1996 edition.