Whatever the Chatter, Corn Keeps Growing

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As students of value investing, we’ve all read about numerous businesses that Warren Buffett has invested in the last fifty years.

A number of these names regularly appear in Buffett’s annual letters. Especially the ones which he continues to hold – Coca-Cola, See’s Candy, Nebraska Furniture Mart, GEICO, etc. Buffett never gets tired explaining why these companies are great businesses to own.

Each of his investment is an instructive story with valuable lessons to learn. But whenever asked about his best investment, he’s quick to point out that it wasn’t a stock. He says –

Of all the investments I ever made, buying Ben’s book (The Intelligent Investor by Benjamin Graham) was the best (except for my purchase of two marriage licenses).

That’s the beauty of Buffett’s investment mind.

I learned from him that the activity of investing isn’t limited to money and stocks. The principles of value investing are universal and applicable to everything including self-education, relationships, and life in general.

Benjamin Graham, Buffett’s guru, must have thought deeply before framing the golden words: Price is what you pay; value is what you get.

My biggest challenge while getting started as a value investor was to wrap my head around the idea of value. How should an investor think about the value of a business? Or for that matter, the value of any asset?

For centuries, in many Indian societies, donation of a cow (Go-Daan) was considered the highest form of charity. A healthy fertile cow is nothing less than a small business in itself.

Go means cow and Daan mean donation. The owner of the cow can consume its milk and even sell the extra milk to earn a living. The cow’s offsprings add further value. A male calf grows up and helps the villager in plowing his farms. A grown-up female calf becomes an additional source of milk. In Indian villages, dried up cow dung is still the most prevalent source of fire-fuel.

Growing up in a Hindu tradition, for a long time I believed that Go-daan was just a sacred act. But now I understand that although it might have turned into a ritual, it probably didn’t start as a mere religious practice. Donation of a cow is more than a sacred act.

Give a man a fish, goes the adage, and you feed him for a day; teach him fishing and you feed him for life. Go-daan is akin to teaching fishing.

The receiver of the gift is getting something which is capable of producing an increasing stream of future cash flows. A cow’s real value lies in what it can produce for its owner over its lifetime.

So it makes more sense to think about the value of an asset as a product of its ability to generate future earnings. Which means intelligent investing is largely an act of ascertaining the availability of future cash flows in a business. If you can’t do that with a reasonable degree of confidence, then it’s just speculation.

In Warren Buffett’s words:

We first have to decide whether we can sensibly estimate an earnings range for five years out or more. If the answer is yes, we will buy the stock (or business) if it sells at a reasonable price in relation to the bottom boundary of our estimate. If, however, we lack the ability to estimate future earnings — which is usually the case — we simply move on to other prospects.

In March 2014 Warren Buffett wrote an essay for the Fortune titled – What you can learn from my real estate investments. The article has timeless lessons about how the mind of a successful value investor works. The account of Buffett’s real estate investment is the proof of what Charlie Munger often repeats – All intelligent investing is value investing.

In 1986 Warren Buffett bought a 400-acre farmland near his home in Omaha. True to his ethos of purchasing only an income producing asset, Buffett didn’t make this investment in the hope of flipping it over to someone else. He writes:

It cost me $280,000, considerably less than what a failed bank had lent against the farm a few years earlier. I knew nothing about operating a farm. But I have a son who loves farming, and I learned from him both how many bushels of corn and soybeans the farm would produce and what the operating expenses would be. From these estimates, I calculated the normalized return from the farm to then be about 10%. I also thought it was likely that productivity would improve over time and that crop prices would move higher as well. Both expectations proved out.

More than 30 years later, he still owns that farmland and its earnings have more than tripled. If you were to only look at the price of the farm, which has grown five times since then, it would seem like a mediocre investment. One could argue that had Buffett invested the same money in an empty lot in the middle of a town, maybe it would have appreciated by ten times or even more. But that’s an argument coming from a speculator’s mind.

What if the land price stayed flat for all these years? What if it declined like it had happened in the early 1980s, just before Buffett bought the land? The future price of the land didn’t matter. What mattered was its earning potential and the price Buffett agreed to pay with respect to its earnings.

Do you see the thought process behind the farmland investment? There was no expectation of a future 100 bagger. On the contrary, the expectation was very conservative – merely 10 percent return on capital.

There was no intention of flipping the asset for a quick profit. Any such intentions had a higher probability of backfiring.

If “investors” frenetically bought and sold farmland to one another, neither the yields nor the prices of their crops would be increased. The only consequence of such behavior would be decreases in the overall earnings realized by the farm-owning population because of the substantial costs it would incur as it sought advice and switched properties.

In 1991, Buffett made another real estate investment. This time in the city. Like the farm, this was another situation of panicked sellers giving away cash-generating assets for cheap.

Here, too, the analysis was simple. As had been the case with the farm, the unleveraged current yield from the property was about 10%. But the property had been undermanaged by the RTC, and its income would increase when several vacant stores were leased. Even more important, the largest tenant — who occupied around 20% of the project’s space — was paying rent of about $5 per foot, whereas other tenants averaged $70. The expiration of this bargain lease in nine years was certain to provide a major boost to earnings. The property’s location was also superb: NYU wasn’t going anywhere.

Notice again, all of Buffett’s focus was on evaluating the degree of certainty of future cash flows. Increase in the market price is a byproduct of the quality of earnings that asset produces. It’s a cherry on the cake. However, buying the cake for the cherry is not value investing.

I keep reminding myself that there’s nothing wrong with speculation. But it’s a game I don’t want to play. No value investor would.

Games are won by players who focus on the playing field, writes Buffett, “not by those whose eyes are glued to the scoreboard.” Speculation is a game of betting on the scoreboard and predicting the mood-swings of other scoreboard watchers without bothering to look at the playing field.

I’ll leave you with what Buffett wrote In his 2013 letter to investors:

My two purchases were made in 1986 and 1993. What the economy, interest rates, or the stock market might do in the years immediately following — 1987 and 1994 — was of no importance to me in determining the success of those investments. I can’t remember what the headlines or pundits were saying at the time. Whatever the chatter, corn would keep growing in Nebraska and students would flock to NYU.