Certainty at a Discount

Searching for the light when clouds are forming!

In a recent interview on The Investor’s Podcast, there was a great quote from Robert Hagstrom who stated; “it’s long been said that Warren’s investment approach is to buy certainties at a discount”. Hagstrom is the author of the investment classic ‘The Warren Buffett Way’ and, after studying him for several decades, is considered an expert on all things Buffett. As such, I think his ability to distil and summarise Buffett’s investment approach into this incredibly succinct idea; ‘certainties at a discount’, is very telling and prompted me to want to explore this mental framework in greater depth. 

What makes it even more noteworthy, is that this idea is also one of the salient points made in Mary Buffett and David Clark’s book, ‘Warren Buffett and the Interpretation of Financial Statements’. As the authors go through each line of the financial statements, discussing the ways in which Buffett thinks about each line item, the overriding theme that is conveyed to the reader is consistency. Buffett is hunting intensely for the small subset of businesses that have demonstrated consistency across a range of financial metrics for a very long duration of time. It is this high level of historic consistency that leads to any sense of predictability and therefore at least some level of certainty about the future returns of the investment. The authors package this idea up under the mental framework of ‘The Equity Bond’. In other words, Buffett is looking for businesses he can own (equities), where he has such conviction in his certainty to predict their future cash flows that he can mentally treat them like fixed income securities (bonds) where the coupon is a certainty. The final piece of the jigsaw is waiting patiently for the rare opportunity to present itself where the market inefficiently prices one of these high quality assets to a depressed level. 

It will be no surprise then, that these two factors; the certainty of business performance, and paying the right price, lay the foundation for all that Buffett thinks about in his assessment of investment risk. In Hagstrom’s book, ‘The Warren Buffett Way’, he gives a concise breakdown this;

“Warren’s view on risk is the possibility of injury or harm to the intrinsic value of the business…In Buffett’s view, harm or injury comes from misjudging the primary factors that determine the future profits of your business. 1 / the certainty with which the long term economic characteristics of the business can be evaluated. 2 / the certainty with which management can be evaluated, both as to its ability to realise the full potential of the business and to wisely employ its cash flows. 3 / the certainty with which management can be counted on to channel the rewards from the business to the shareholders rather than to itself. And four, the purchase price of the business”

An observation from Kyle Grieves on The Investor’s Podcast, and one that is worth reiterating, is Buffett's obsession with certainty. Three of the four points start with ‘the certainty with which’. Grieves astutely notes though that the issue with certainty is that you almost always have to pay up for it. The market is on the most part efficient; if everyone is aware, understands and believes in the certainty of the future business performance then that will naturally get baked into the price and as such diminish the attractiveness of the opportunity as well as increasing the risk if something unexpected did come from left of field. It is of course these moments - where something does come from left of field - that provide the rare entry opportunity for the shrewd investor to gain ownership of these businesses at attractive prices. There was a great passage from Christopher Begg’s interview on the RWH podcast series, where he uses the analogy of storm clouds forming to allude to this idea. He talks about searching for where the clouds are today, and thinking about whether the clouds are blurring people's vision, obscuring some of the really extraordinary parts of a business that may be leading to a valuation opportunity.

This, of course, is far easier said than done. It firstly requires a big temperamental advantage. Unrelenting patience to wait for these few-and-far-between miss pricings to crop up requires high levels of discipline in combination with an intense focus to be ready to strike whilst the iron is hot. It also demands the ability to distance yourself from the crowd, and keep your head when others are panicking and losing theirs. On top of the temperamental edge, it requires an incisive analytical edge. The difficulty is that when these great businesses come up at a discount, it is almost always because the certainty of those future cash flows come under threat. Maybe the most illustrative example in recent years was in 2022 where Meta - previously considered a cash printing machine - came under threat from TikTok which was gaining market share through its short video format. The stock price was heavily depressed and the business traded at a very modest multiple of earnings. I myself couldn’t figure out whether or not Meta’s moat had been permanently eroded or whether it was just temporarily under siege, but for the informed investor, it presented an opportunity for which they would have been rewarded handsomely. As Buffett has famously put it; ‘“The best thing that happens to us is when a great company gets into temporary trouble...We want to buy them when they're on the operating table”. It is my feeling that the key word here is temporary. It is the investors ability to decipher whether or not the current headwinds are going to beleaguer the business indefinitely resulting in a permanent decline in its competitive position, or whether in due course the problems will pass by the wayside, the clouds will disperse,and a brighter future will ensure for the business and investor alike. 

Thanks for reading. In the next post I wanted to build on this mental framework of ‘certainty at a discount’ or ‘ the discounted equity bond’ - whichever one you want to call it - and give an overview of current investment idea that I am digging into that I feel may embody some of the core characteristics of this nature of opportunity. Until then, thanks for reading and hopefully see you soon.