Over the years we have spent quite a lot of time thinking about the question: “What makes a good investment?” We often get the following type of responses when we pose this question to others:
“We believe it is successful if it pays a good dividend,” or
“We believe it is successful if it goes up in price.”
We counter with:
“Well, suppose it is a private company, and there is no share price discovery.”
Or, alternatively, we say:
“Suppose that the business (investment) is confronted with so many good reinvestment opportunities that they pay no dividend.”
What are we left with in trying to answer this question?
We have concluded that the only real way to measure the success of an investment is by identifying the real growth in economic value per unit of ownership.
We speak in terms of “per unit of ownership” because aggregate growth in economic value can completely elude the individual holder if accompanied by commensurate growth in the units of ownership, leaving the individual owner without any individual growth in value.
In the public markets, where we spend the majority of our time and attention, we examine the balance sheets of interesting businesses to see if we can make general evaluations of the growth in this real economic value per share. Sometimes it is quite easily measured by the growth in book value per share. Other times this easy approach is altogether without value due to the oddities of accounting rules.
For example, take our holdings in Markel Corp. and Enstar Group. These two businesses lend themselves well to the importance of growth in book value per share, and both prominently display that information in their published financial reports. In our view, this growth in book value per share is tantamount to their actual real economic earnings and it allows us to establish our valuation calculations based on this per share growth in book value. In both cases, we examine what the historical growth in book value per share has been and make an estimate of what we think growth is likely to be over the next five to ten years, on average. We assign an estimate to the forward year and relate it to the current share price, giving us a multiple which is often very different from the normal Wall Street earnings estimate multiples.
Our calculation frequently suggests the business is much cheaper than conventional methodologies indicate. We believe this gives us an edge.
In many other businesses that we own, book value per share calculations are largely distorted by share buybacks and other accounting applications. For a strong business, book value typically understates economic value. Warren Buffett famously wrote a piece many years ago identifying what he called “economic goodwill,” an item which has no tangible value (and no precise relationship to accounting goodwill), but nonetheless creates earnings. Accounting gives us some guideposts for gauging real economic value, but we are left to figure out the details using our own interpretation of what is actually occurring in the business.
Clearly, there are many considerations we make along the way, like the quality and sustainability of the business, the skill and quality of the people, and the availability of reinvestment opportunities.
When all is said and done, no matter how we arrive at the calculation of the future growth in real economic value per share, we ask, “What is the best value and opportunity today?”
It all comes down to rate of return.
When an individual is confronted with investment opportunities across many different asset classes – for example, art, real estate, precious metals, private businesses, or public securities – the only way in which to make comparisons (apart from the different characteristics of said investments – you can hang a picture on your wall or hang a piece of jewelry around your neck) is rate of return. It is the only standard by which all can be measured!
Further, when thinking about investing in bank CDs, there are often small differences in the rates being paid and the method of compounding used in the calculation, even as all the choices are guaranteed by the U.S. government. So, again, it comes down to rate of return.
In summary, our constant goal, regardless of the opportunity type, is to establish a reasonable expectation of an investment’s rate of growth in real economic value per share coincident with actual experience, and evaluate each and every opportunity by this standard: the bottom line of all investing is rate of return.