The next Monday, when the fathers were all back at work, we kids were playing in a field. One kid says to me, “See that bird? What kind of bird is that?” I said, “I haven’t the slightest idea what kind of a bird it is.” He says, “It’s a brown-throated thrush. Your father doesn’t teach you anything!” But it was the opposite. He had already taught me: “See that bird?” he says. “It’s a Spencer’s warbler.” (I knew he didn’t know the real name.) “Well, in Italian, it’s a Chutto Lapittida. In Portuguese, it’s a Bom da Peida. In Chinese, it’s a Chung-long-tah, and in Japanese, it’s a Katano Tekeda. You can know the name of that bird in all the languages of the world, but when you’re finished, you’ll know absolutely nothing whatever about the bird. You’ll only know about humans in different places, and what they call the bird. So let’s look at the bird and see what it’s doing—that’s what counts.” (I learned very early the difference between knowing the name of something and knowing something.)
- Richard Feynman
You may find the above quote a little odd in anarticle posted on a value investing website. After all, how is the name of a bird in different languages related to value investing? Well, it’s not on the surface. However, if we ponder very deeply from another level, Richard Feynman’s above quote could have profound impact on how we think about investing. My own thinking has led me to this conclusion: There is a huge difference between knowing the terms of investing and facts (especially numbers) of a company and knowing the meanings and implications of the terms and facts.
Let me use Facebook (FB) as an example. When an analyst was promoting the stock of Facebook on CNBC earlier this year, he cited the following numbers:
802 million daily active users
609 million mobile monthly active users
1.27 billion monthly active users
And based on the above numbers, he had no problem with projecting out a couple of years of more growth to conclude that Facebook’s stock is still attractive at this price.
I don’t have a problem with his number quoting behavior. My problem with promotions like this is that they ignore the most important questions: What do these number mean? And whether/how are they reflected in the valuation? The fact that Facebook has 1.27 billion monthly active users means very little to me as an investor if I don’t know how to incorporate that into valuation. Same goes for daily active users and mobile monthly active users. You can know all the different numbers about a company, just like you know all the names of a bird. But you are doing yourself a great harm if you don’t know the implications of these numbers, or if the implications are too hard to figure out, or if you pretend to know the implications of the numbers.
This also applies to valuation terms. We often apply a multiple such as P/E or P/B to a business. We hear statements like Markel is cheap at 1.2 times book, or Bank of America is cheap at 0.7 times book. Warren Buffett (Trades, Portfolio) said book value is a good proxy for Berkshire’s intrinsic value and buying Berkshire up to 120% book value makes a lot of sense. So we know Berkshire is cheap below 1.2 times book. But what’s so special about book value and why 120%? Do we just know the name of the multiple to use? Do we just know the numerical number? Do we understand why?
Now I feel obligated to confess, for a very long time, I don’t understand the why's. It was upon deep reflection that I came up with the idea of this article. Investing buzzwords such as P/E, EV/EBITD and P/B are so popular that we assume we understand what they are and how to apply them because we know the names. This is dangerous. We should start cultivating the habit of exploring the meanings and implications of investment terms and company (industry) specific numbers.
But how do we do that? I propose we begin by trying to make sense of the numbers. And how do we do that? Fortunately we have two great examples. One is from Richard Feynman and his father, and one from the Oracle of Omaha:
“We had the Encyclopedia Britannica at home and even when I was a small boy my father used to sit me on his lap and read to me from the Encyclopedia Britannica, and we would read, say, about dinosaurs and maybe it would be talking about the brontosaurus or something, or tyrannosaurus rex, and it would say something like, ‘This thing is twenty-five feet high and the head is six feet across,’ you see, and so he’d stop and say, 'let’s see what that means. That would mean that if he stood in our front yard he would be high enough to put his head through the window but not quite because the head is a little bit too wide and it would break the window as it came by.’ Everything we’d read would be translated as best as we could into some reality and so I learned to do that - everything that I read I try to figure out what it really means, what it’s really saying by translating.”
- Richard Feynman
“I will say this about gold. If you took all the gold in the world, it would roughly make a cube 67 feet on a side… Now for that same cube of gold, it would be worth at today’s market prices about $7 trillion dollars – that’s probably about a third of the value of all the stocks in the United States… For $7 trillion dollars… you could have all the farmland in the United States, you could have about seven Exxon Mobils, and you could have a trillion dollars of walking-around money… And if you offered me the choice of looking at some 67-foot cube of gold and looking at it all day, and you know me touching it and fondling it occasionally…Call me crazy, but I’ll take the farmland and the Exxon Mobils.”
I would say exercise like this is hard, but not impossible to do. The key is to cultivate the habit of doing it routinely. Again, this is easier said than done. But if you can, it will give you a tremendous edge in the world of value investing.