On value investing...

I had the pleasure of getting together with two other value investors in Pittsburgh this evening.  We had a great time discussing a wide variety of topics.  Our conversation drifted from international investments, to nano cap stocks, to how crazy the real estate market is in Pittsburgh.  After I left I was thinking about how great it is to get together with like minded people and speak the same investing language.

To other investors we often make sense, something at "5x EBITDA and below book" is worth looking at, whereas to the non-investing population it doesn't even sound like English.  Maybe it was Munger or some other famous investor who said if you can't explain a concept to a 12 yr old you might not understand it.  In the spirit of that I want to share some analogies I've used to explain investing and how I invest to non-investors.  In all the times I've used my analogy I haven't encountered anyone who didn't have the lightbulb moment and say "oh I get it now."

How I invest

Imagine an area of town with an industrial area, the area is fairly well worn, but not in total disrepair.  There are a number of companies with names no one remembers doing somewhat specialized activities.  The owners of these businesses appear to do well for themselves raising their families in a solid middle class environment.

An owner of one of these businesses decides he's had enough of the stress and daily grind and he wants to sell.  He knows how to make widgets, and isn't much of an investor himself.  He lists his business on a public market.

Investors in town know that the area the business is located is grimy, and when they look at the accounts they see the company isn't all that profitable.  It seems like a lot of work is involved to make such a tiny profit.

I come along and examine the business, I agree with the other investors that they aren't that profitable, but I notice something different.  While they aren't turning a profit they do have a valuable building and the owner has undervalued his warehouse of old inventory.  I purchase the company for less than the property and machinery cost alone.  Once I visit my new purchase I realize what the owner thought was old rusty inventory in the warehouse is actually recently purchased inventory.  The owner was a bit of a pack rat and I start to find envelopes full of cash around the facility he'd stashed for rainy days.  When all is said and done my purchase price for the business is less than the inventory, receivables and cash net of liabilities, I get the building and aging machinery thrown in for free.  The company is marginally profitable, but it's not a big concern considering the discount I already received on my purchase.

To me that's the essence of asset based value investing.  When I've told this story people marvel that these sort of deals actually exist.  I explain they exist in the markets the same place they exist in real cities and towns, not on the main streets, or in the central business district.  Rather these deals are found on the back roads, sometimes far away from town, neglected by everyone often even their owners.

How Buffett invests

Warren Buffett used to invest as I described above but he's changed as he's become more successful.  Buffett buys that restaurant in town that everyone goes to, there are always two hour waits no matter what day of the week or time of the year.  Buffett prefers when these businesses are run conservatively and have strong staying power.  He isn't interested in buying the hottest restaurant this month, he's buying the restaurant that's been hot for a decade.

Buffett will then go on and buy the bank in town, and then the local gas station, and the grocery store, and whatever else is for sale.  Eventually it will be hard for anyone in town to go a day without using one of his products, or services.

How most investors invest

Imagine yourself at a cookout in the summer.  You're standing by the grill and your brother-in-law comes and starts chatting.  He starts talking about how this guy he works with is onto a really great investment.  It's some new technology he doesn't really understand, but it doesn't matter, it's going to sell really well.  Not many people know about it yet so you have to keep quiet.  He thinks it's going to be big, almost everyone in the world needs this product, if they can only capture 1% of that market they'll be billionaires.  It's a good thing you found out about this early so you can get in on the ground floor.  Just imagine being able to pay off the house and pay for the kids college all while sitting on the beach drinking mai tai's.

Final thoughts

I find it fascinating that most non-investors can spot a good local business without a problem.  People instinctively know when someone has a model that's minting money.  Yet a disconnect happens between a local tangible market and the public markets.  Most people wouldn't invest with the wacky science-y guy promoting some new fusion technology down the street, yet they'll pour money into high tech startups.  People are also able to identify when a company has a strong brand and staying power verses a company without it.

I love when people say things like "how did that restaurant go under, it was always crowded?" because it exposes that while people understand a good brand, they don't understand the finances behind a business.  I always say that companies go under for two reasons, too much debt, and mispriced products.  Those two go hand in hand, products priced too low eventually lead to debt problems.  Maybe the restaurant is packed because the prices aren't high enough.

Talk to Nate