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Welcome to Episode 47 of Special Situation Investing, where we bring you real time investment research to help you better analyze your own stock picks.
In today's write up we will deviate from our standard analysis of a specific company and instead cover one of the broad concepts that impact each of our investment decisions.
To begin, complete the second half of this statement as it relates to investing and financial independence, “In order to win, …” The statement could end in several different ways. It could end with, “In order to win you must ride your winners, or in order to win you must be smarter than the crowd,” or “In order to win you must be a contrarian.” None of those endings are wrong and in fact there is wisdom in each, but for me, the statement has always ended with “In order to win, you must first survive.”
Survival, hinges on the elimination of game-ending outcomes and is not a weighing of probabilities. Life gave me a visceral education in this concept over a decade ago in the unrelated field of fitness. A co-worker highlighted the danger involved in my then sport of choice — road-biking — and I remember casually brushing the warning off to a friend during a long weekend ride one beautiful spring day. “What are the odds of being hit by a car?,” I said half laughing with an air of invincibility.
I remember that moment, that statement, that casual dismissal of what could happen as clear as if it had happened yesterday. The cool morning air, the bright blue sky, and the feeling of a healthy and bullet proof young man are forever imprinted on my mind. It stands out so clearly because, within months of the statement, I was airborne, bones broken, and seconds into what would be years of recovery.
It wasn’t the odds of being hit by a car that mattered, it was the degree of damage it could inflict. It was an exposure to a game-ending risk. Up until that point, I viewed risk in probabilistic terms. What are the odds of a plane crash, a rock climbing accident, a stock going to zero? Nothing wrong with understanding the odds, but the more important question is, What is the worst case outcome of this decision?” and “Can this end the game?”
Of course, this doesn’t imply that we can eliminate all risk from our lives. It doesn’t even imply that we can eliminate all serious risk from our lives. Rather it should teach us that we can control some exposure to some risks and that we must be fully aware of what the risks are when we take them.
In life, we might be forced to drive through a snow storm and all we can do is control the risk of an accident as best we can. We can reduce our speed, clean our windows, and avoid other drivers, but in the end, we must still except some risk. In investing, however, this isn’t the case. We aren’t forced to make decisions or commit capital but quite conveniently can pass on opportunity after opportunity just waiting for the obvious “no brainer” decision to come along.
The idea of waiting for the easy pitch, the obvious win, or the fifty cent dollar bill, dates at least as far back as Ben Graham’s book, Margin of Safety, and carries all the way through Buffett’s teachings and Seth Klarmin’s book by the same name. The idea, of course, is simply to invest when the difference between intrinsic value and the price you pay is massive. Assuming you’ve underpaid by enough the amount you can lose is limited and your upside should take care of itself.
Within the broad margin of safety concept, however, there are several specific things an investor can do to ensure he’s honoring the overriding principle. For starters, know how to evaluate the business you’re purchasing.
Valuing a business is a topic that could fill volumes and one that certainly won’t be exhausted in this brief write-up, but it should be clear that you can’t purchase a business for less than it’s worth if you’re unable to determine what it’s worth in the first place. There are countless resources to help you learn this skill and they include all of Buffett’s partnership and shareholder letters, anything written by Joel Greenblatt, and the list goes on and on. However, no amount of reading can replace doing the actual work yourself.
By “doing the work yourself,” I simply mean you have to roll up your sleeves and start to evaluate businesses. If you’ve never done it before, begin with the most basic of business models, a child's lemonade stand, a man selling flowers on the street, or a rental property. Ask yourself questions as you go, questions like, “How much does it cost to start the business? How much will I make? How stable is this market? and What happens if I use debt to fund the business?”
As you learn through doing, identify the accounting terms that apply to what you’ve discovered so that you can take the concept from one business evaluation to another. Once you’ve internalized concepts like free cash flow and return on equity, you can apply the concepts across a range of business to quickly compare them to each other.
We began this write up with the idea that risk is not a probability question but rather the identification of game-ending outcomes. In the field of investing, game-ending outcome’s, must be avoided regardless of the probability. Avoiding these outcomes, can be accomplished using several different tools to include portfolio construction (which we talked about in a previous episode), but how does the ability to value a business fit in to risk assessment?
Let’s illustrate the connection with an extreme example. How much thought would you give to an offer to purchase all of Google for a single dollar? Conversely, would it take you long to reject an offer to buy a rental property for one trillion dollars? You would reject the rental property immediately knowing that no property could ever yield enough rental income to repay the trillion invested. On the other hand you’d purchase Google for a dollar without a second thought even if you couldn’t precisely value the business because you would understand that its value must be well in excess of one dollar.
With those examples in mind, how much risk did you take purchasing google for a dollar? The answer is zero, because the probability of losing all that you have is non-existent. You can asses this risk even though you don’t know exactly what your return will be because you know that the possibility of game-ending loss is non existent.
As you learn to value business with greater and greater precision you can make less obvious, but still spectacular purchases. You can pick up fifty cent dollar bills over and over again in a very low risk way. Low risk not because you know the probability of achieving a range of outcomes but because you’ve identified the worst case outcome and avoided purchases that would expose you to it.
If an investment offers the potential of game-ending loss then it’s a pass. Again, that doesn’t mean every decision must be, or can be, risk free, only that your decision shouldn’t expose you to ruin. Bitcoin, for example, has a real possibility of going to zero, but if successful, could yield many times your initial investment. In such a scenario risk can be controlled through position size, a total loss on a 500 basis point investment isn’t a game ending loss and yet it still exposes you to significant upside.
On the other hand a solid and debt free business available for purchase at well below its intrinsic value is very unlikely to go to zero and can therefore justify a significant investment of your capital. To put it simply, each of the specific investment skills you pick up should be coordinated in application such that they collectively filter out as much risk as possible. Prudently purchase undervalued business with limited to no downside for long enough and your results will be quite satisfactory.
Well, that does it for today’s episode of the podcast. I hope you’ve gained some knowledge or have been offered a slightly different perspective on risk and how to mitigate it. As always, we will be back again next week with another write-up and we appreciate all of your support.
SUBSTACK-ONLY BONUS
In the above write-up, we addressed how its necessary to learn accounting terms in order to evaluate and value a company. One of the our favorite sites for getting easily understood definitions to terms we don’t know is Investopedia.com.
Investing and risk