This post was originally published on December 18, 2015
"Investors should remember that their scorecard is not computed using Olympic-diving methods: Degree-of-difficulty doesn't count. If you are right about a business whose value is largely dependent on a single key factor that is both easy to understand and enduring, the payoff is the same as if you had correctly analyzed an investment alternative characterized by many constantly shifting and complex variables." —Warren Buffett
Whenever I am evaluating an investment opportunity, I always like to ask myself "is this Investing or Speculating?" This is a question I have learned to ask myself from studying great investors like Ben Graham, Warren Buffett and Seth Klarman.
To give you an idea of one way I distinguish between "Investing" and "Speculating" take a look at the two investment options below:
Which of these two investments is the better investment? Those of you who are really quick at math or who have a financial calculator handy will see that both investments have the same IRR of 10%. So based on this observation alone, one might conclude that the investments are equally good opportunities.
The pitfall here is in the timing of these cash flows. For Investment B, the entirety of the investment return is being driven by the terminal value payment in Year 10. By contrast, Investment A returns a significant amount of cash through the payments received during the interim years. We can quantify the difference between the two by using a Net Present Value (NPV) analysis to isolate how much of the return is driven by the interim cash flows versus the terminal value. I show the outcome of this analysis using a 10% discount rate for both investments in the chart below:
The conclusion here is that a majority of the present value returned in Investment A is driven by the interim cash flows while all the present value of Investment B is driven by the Terminal Value. To put it simply: you get your money back faster with Investment A. We could take this a step further by calculating the "Duration" of both investments but I don't want to get bogged down in esoteria.
Years ago, as a junior analyst working at an investment bank, I would frequently pull all-nighters building intricate Excel spreadsheet models where I would forecast a business' operations, balance sheet and cash flow many years out into the future. I would run around the floors of our midtown Manhattan office collecting supposedly "objective" data inputs like "equity beta" and "risk-free rate" and use them to calculate WACCs and NPVs. As you can imagine, the whole exercise was always fraught with myriad assumptions, any of which could lead to significant variations in the analysis outcome. Invariably, the results would somehow always indicate that our client was paying a "fair" price, but if one looked closely, it was almost always the case that 70% or more of the NPV was derived from the Terminal Value. Well, as John Maynard Keynes said:
“It is better to be roughly right than precisely wrong.”
Any introductory finance student learns how to do the relatively simple calculations above. Yet every day I see investors who are chasing after returns from Investment B-type opportunities. Of course, no one likes to call this "speculating" so Wall Street likes to employ its own jargon when discussing these matters, such as:
- balloon payment
- strategic exit
- liquidity event
This is not to say that investing in securities like Investment A is without risk. One still has to do plenty of homework to see if the cash flows are sustainable and whether or not principal value is at risk of future impairment. This all requires a significant amount of due diligence.
This is also not to say that Investment B investments can't be profitable; many fortunes have been made in this way. However, all else being equal, Investment A is considerably less speculative than Investment B. For this reason, I like to look for investments with:
- significant, high-quality, recurring cash flows
- healthy return on invested capital
- substantial "Margin of Safety"