Fox Business Network Buffett Special

I received an email from a representative of Fox Business Network telling me about the special they are doing at the meeting this weekend. I agreed to publicize it for them, but have to wonder why Liz Claman didn't request an interview with me as part of the show. CNBC would have. :)

For Warren Buffett watchers…FOX Business Network is presenting a live special this Saturday night (5/3) at 7 pm EST after the billionaire investor’s annual shareholder meeting in Omaha, Nebraska.

FOX Business Network’s Liz Claman will anchor a live hour of news and analysis after the Berkshire Hathaway annual meeting, which draws about 30,000 attendees.

Look for an interview with Warren Buffet himself, as well as the first ever television interview of Buffett’s long-time stockbroker, John Freund of Citigroup.

Wrigley Deal and the Annual Meeting

I have been hesitant to jump to many conclusions about the Wrigley deal because I think there are still a lot of unanswered questions about Berkshire's involvement in it. Hopefully many of the details will be explained this weekend at the annual meeting. I do have some initial thoughts, however.

Wrigley is a company I have owned for about two years now, and have done very well with it. I like bragging about investments like this because lately most of mine have been losers, not winners like Wrigley. My original purchase price was $46. At the time the company simply seemed undervalued. And anytime a family-run business with a huge moat and extremely consistent operating history sells at even slightly less than intrinsic value, I thought, it is a good time to get in. And that is exactly what I did. It was shortly after Wrigley had acquired the Kraft confectionary group. The market was worried Wrigley would have trouble integrating it into its existing business. Ultimately, these concerns proved unfounded.

So when I heard the company was being acquired at $80/share in cash, my reaction was mixed. I enjoyed the nice one-day pop, but as with many cash or taken-private transactions, this also means the party is over. I will not be able to own Wrigley and share in the company's success any longer. In that sense, I was not happy to hear of the acquisition.

But perhaps most striking is the way in which the media has described the deal as a joint venture by Mars and Berkshire. So far as I can tell, it is not. This is where the discussion this weekend should be informative. It sounds to me like Berkshire is supplying a mere $5 billion in debt capital. This is far from a Berkshire acquisition. Moreover, it is quite possible the $80 bid was way too high, and that Wrigley stock was more appropriately valued before the deal was announced, at $65. Berkshire, by supplying only debt, wouldn't necessarily balk at Mars offering an arm and a leg.

Nonetheless, it is always comforting when Warren Buffett is involved in a transaction in any way. And having decided a while back Wrigley was a good investment, I enjoy being proven correct, if that is the appropriate way to interpret this. There is now doubt that Wrigley is a Buffett-type investment. I just wonder if it really is a Buffett investment.

Another Hilarious Screen Capture

Could someone tell me how this headline ended up on Google Finance?

To Whom it May Concern:

This blog is not dead. I am just taking a break. Lots of personal stuff going on, including the recent birth of my first son. I had hoped to work out a combination of names such that his initials would be BRK, but in the end we named him David Andrew. (I checked, DAK is not a ticker that I am aware of.)

Anyway, don't give up on me. I will post again soon.

Buffett Videoconference at MU on Friday

I thought I might help publicize the University of Missouri Trulaske College of Business' 2008 Forum on Emerging Issues & Trends in Real Estate. That is mouthful. What it means is that on Friday as part of a symposium on real estate that we have every year, Warren Buffett will be videoconferencing with us for an hour in the auditorium. He has asked for student questioners, but I don't know how strict that rule is. The symposium is free and open to the public, but registration is required. Here is a link.

A few thoughts on the Bear Stearns situation

The first lesson that came to my mind when I heard about this debacle was straight from Buffett: Don’t buy what you can’t understand. Was Bear a simple and understandable business? Of course not. Their investments were so complex that it is not unlikely that no single individual at the firm understood them all. If this is true, then it is even less likely that ordinary investors understood them.

But the lesson for the Bear employees heavily invested in Bear stock should have already been learned. Remember Enron? Remember the sketchy (ultimately fraudulent) ways they seemed to be making money out of thin air? The Enron employee didn’t understand how the company was making money. If he had he would have known it was all a farce. But nonetheless many, many hardworking people put their faith in their employer’s stock and in many cases invested their entire retirement in it. Big mistake.

But it need not have even be an issue of understanding the company. From a pure diversification standpoint any employee is better off keeping his investments out of company stock since his human capital (read: income) is already 100% invested in the company. Instead, these folks have lost not only their jobs but also their savings.

I don’t mean to take the high road, nor do I mean to downplay the tragedy that this has caused families. Indeed, it is not even their fault. It is their employer’s fault for encouraging them to invest their retirement in company stock, since I assume most of them are not financially sophisticated enough to understand the diversification argument while an investment house like Bear certainly should be, and for creating the illusion that the company was strong enough to warrant their investment. It’s a rotten situation all around.

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Much has been made about Bear’s current stock price, which is 200% higher than the JP Morgan acquisition price. It could be that investors are betting that either the bid will get raised before the deal goes through (a highly unlikely notion in my opinion given the Fed’s involvement) or that they think the deal will be delayed long enough for the company to right itself so that it eventually survives as a standalone.

Even considering these possibilities, it remains somewhat puzzling. But I think the explanation is a bit more academic than it might seem at first glance. Specifically, this is a textbook example of behavioral finance. According to theory, there are two requirements for irrational investors to drive prices from intrinsic value and, consequently, for the market to inefficiently price securities. Those two things are a) psychological biases and b) limits to arbitrage. In this case I think both are met.

The probability that the bid will get raised or that Bear will actually survive is not zero. But I think it is low. How low exactly I am not sure, but it is certainly not high enough to justify a stock price three times that of the most likely outcome – that the JP Morgan deal goes through as planned. Rather, the stock price is three times that of the bid price because there are irrational investors betting on the aforementioned possibilities and there is no arbitrage opportunity for more level-headed investors who would otherwise correct this blatant mispricing. At least that is the way it seems to me. Has anyone been able to successfully place a large short sale on BSC shares within the last week? I tried and I couldn’t. The lack of shares available for short is a natural limit to arbitrage and, according to behavioral finance theory, opens the door for irrational investors to control prices.

The investors willing to pay $6 a share for Bear seem to me to be falling victim to the following psychological biases:

Overconfidence – These irrational investors are overconfident in their own assessment of the situation, so much so that they are willing to pay a price far in excess of what would seem logical. They are also likely overconfident in Bear’s ability to weather this storm. This is understandable since big storied companies like this typically don’t just vanish overnight. But that doesn’t mean that can’t.

Endowment Effect – The investors who already have an equity interest are valuing their shares at a price much higher than the $2 bid. This too is understandable. Most people are reluctant to sell a stock for next to nothing when it was worth $150 as recently as a year ago, even if a price of $2 seems reasonable given today’s information set.

Disposition Effect – If these investors give in to the current offer, they will feel a tremendous amount of regret. Regret for not selling at $50, regret for having ever invested in a company with subprime exposure. To mitigate this regret, they are willing to increase their stakes by buying more shares, all while convincing themselves that since they liked the stock at $60, they should really like it at $5.

These biases create the environment in which mispricing might occur and the inability to short sell creates the limit to arbitrage that allows it to persist. So behavioral finance should explain the bizarre mispricing we are witnessing. Unfortunately, inherent in a situation like this is the inability for the rational investor to take advantage of it. Said differently, the stock would never have become mispriced if it could be arbitraged, so clearly there is no way for us rational investors to arbitrage it now. What a bummer.

Empirical Finance Research Blog

If you are interested in financial research you may want to check out a new project I am starting with a friend of mine who is a PhD student at the University of Chicago. It is called Empirical Finance Research:
http://empiricalfinanceresearch.blogspot.com/
Our goal is to review for the non-academics any literature that may be of practical use to the investor. There still isn't much on the blog yet but expect more in the coming weeks.

Bullish on TMA

I captured the following screenshot from Yahoo Finance shortly after the market closed today:

This was kind of surprising to me given the performance of TMA stock:

Thoughts on the 2007 Chairman's Letter

As usual, Mr. Buffett touches on both classic and contemporary issues in this year’s letter. Two stand out to me as worth quickly addressing.

The classic issue most interesting to me is his discussion of See’s Candies (see page 7). It lends support to an argument I made on this blog last spring that it is return on equity, or in some cases return on capital, that is the crucial ratio to the value investor. See’s exemplifies this perfectly, since it requires hardly any invested capital. As Mr. Buffett notes, See’s needs only $40 million to continue to operate, yet in 2007 the company earned pre-tax profits of $82 million. Since it was acquired in 1972, See’s has reinvested only $32 million to maintain its operational growth. The rest of its earnings, about $1 billion, has been deployed elsewhere. Earning huge returns on little capital investment is the definition of a good business. Yet investors rarely consider it.

Returns on capital are, in my opinion, horribly underrated by the investing public. Evidence of this can be found in the public’s fascination with companies like AT&T, GM or any airline. These are businesses that, while they may generate large earnings, do so only after investing large amounts of capital. Why not skip over these businesses whose hurdle is so high that only the most outstanding performance will yield the investor a decent return? That is what Berkshire has done over the years.

The contemporary issue that interests me is the one everyone has been talking about. Much has been and will be made of Berkshire’s derivative positions, but little was said in the letter about them. Personally I think Mr. Buffett is missing out on a see-I-told-you-so opportunity. It was in the 2002 letter that he, noting the role they played in LTCM’s implosion, warned derivatives were “financial weapons of mass destruction,” at which time he began to wind down the derivative business of the newly acquired General Re.

Since then I think he earned the right to boast a little about recognizing this fact but he did not in this year’s letter. For instance, this year he only mentions in passing the key aspect of Berkshire’s derivatives that set it apart from other companies drowning in credit-default swap failures and such. “In all cases we hold the money, which means that we have no counterparty risk,” he says. This is huge and deserves more attention. After all, it is the reckless and poorly capitalized bond insurers that have contributed the most to this mess.

The new bond insurance arm of Berkshire, Berkshire Hathaway Assurance Corp, was established in December which probably means the letter was already complete at that point. But I must assume the creation of BHAC had been planned for some time before that and thus it seems like a missed opportunity that Buffett doesn’t point out in the letter how well positioned Berkshire is to pick up where the MBIA’s and Ambac’s of the world failed. Especially with those companies’s refusal to grab Berkshire’s lifeline, I think responsible underwriting in this area will prove to be a big opportunity for Berkshire.

Warren Buffett Exposure

It sure seems Mr. Buffett is more willing than ever to appear publicly. Next week he will be on CNBC discussing the new letter to shareholders. Here is a link to details on that:

http://www.cnbc.com/id/23359277

On March 14 (which is coincidentally my birthday) I will be accompanying 150 students from our college on the annual trip to Omaha. This is the largest group we have ever taken and, given the extraordinary events in the economy over the last year, should be one of most interesting question and answer sessions we have had. This year, I am coordinating the questions we will be asking ahead of time, to ensure we get the most information possible from this 90-minute session.

I post this in the hopes that the students participating in the trip watch the interviews next week so we don't unnecssarily duplicate questions from it. For that matter, do any other readers of this blog have any questions you would like us to ask Mr. Buffett? Please feel free to submit such questions via the comment feature on this blog.

Bill Belichick and Employee Stock Options

Here is another sports-related post…

To me, the biggest justice of the Patriots’ losing of the Super Bowl was not that Tom Brady had snickered with overconfidence at Plaxico Burress’ ultimately accurate prediction or even that Bill Belichick had stormed off the field before the game was over, it was the fact that the Patriots are a team of admitted cheaters! Am I the only one to feel that “Spygate” taints the Patriot’s “perfect” regular season just a little? Admittedly, I am a Rams fan, and the possibility that the Patriot’s squeaking by the Rams in Super Bowl XXXVI was the result of cheating does kind of irk me. But the larger question should concern any sports fan: Why does it seem that professional athletes these days are always doing something crooked?

In baseball we have steroids, in the NFL we have spygate (and steroids too I guess although it hasn’t been as publicized as in baseball) and in basketball we have referees being bribed by mobsters. Doesn’t it seem a little ridiculous to be dealing with these issues in an arena as inane as sports? These are silly games played with bouncy balls for pete’s sake.

To me, this is just an outstanding illustration of the power of financial incentives. When there is money at stake, everyone’s attitude changes. It is no longer just a matter of pride, there are dollar bills waiting for these players should they perform well. What else, besides money, would entice anyone to go to such lengths to get a leg up, particularly given the risks? In the spygate scenario, the risk is getting caught and the humiliation and condemnation that comes along with it – call it “negative pride” perhaps. That is, Bill Belichick saw the expected financial return as being appropriately balanced against the enormous amount of disgrace that getting caught would cost.

Baseball is where this is most obvious. Not only is there a large amount of shame associated with being known as a doper (see Roger Clemens), using steroids will actually shorten the user’s life! Considering these risks taken collectively, clearly the expected return from the use of steroids must be huge. Of course, it is.

It is thus my contention that the rise in sports cheating, whether it be spying, doping or gambling, is the direct result of the huge amount of money that is now at stake – money that was not at stake during a more innocent era of professional sports. It is also my contention that the rise in cheating is not the result of some degradation of American society or a failure in the moral upbringing of our children. It is simply the result of humans acting the way they always have.

With the possible exception of certain biological incentives, there is no other incentive that humans, in general, find stronger than money. This is not inherently a bad thing, of course. Indeed, it is fundamental to the functioning of a capitalist society. But I do think that everyone ought to be cognizant of the overwhelming power of financial incentives.

In business the phenomenon is much more obvious, if for no other reason than that employees work for money. But parallels between sports cheating and business cheating are numerous. And if we have seen humans in the locker room take unbelievably large risks in pursuit of money, it shouldn’t surprise anyone to see them do outrageous things in the board room.

Enter Jeff Skilling. Having read several accounts of the accounting maneuvers undertaken at Enron, it is hard to believe any of them really thought they could get away with it. I think of this whenever I hear of some idiot trapped in a check kiting scheme. It is unavoidable that he will get caught, yet the lure of the dollar is so strong he tries anyway. Would it be outrageous for me to suggest that it was the rise in the use of stock options as executive compensation that, for the first time, created a financial incentive strong enough to coerce managers to cheat as overtly as those at Enron?

That would likely be a controversial assertion. After all, options are supposed to align the incentives of managers and shareholders. I believe, however, that it is possible to align the incentives of managers with shareholders even while maintaining the incentive to cheat. This is due to the rise of short-term or day trading. When the shareholders of a company are constantly changing, the long-term prospects of the company cease to be of central concern. The day trader doesn’t care if the company ultimately goes bust (as Enron did) because he isn’t maintaining his position for any amount of time. Likewise, Jeff Skilling might not have cared since he planned to dispose of his options long before the day of reckoning.

The corporate governance literature has provided empirical evidence of the problems with option compensation including a) the fact that options reward luck (Oyer (2003)) and b) that the recipients of the options value them at far less than their true cost to the company and therefore demand far more than they would otherwise demand in cash (Hall and Murphy (2003)). But I have yet to hear anyone assert that using options as compensation shifts the time horizon of the relevant parties and is thus detrimental over the very long term to the company as a whole.

I think this is part Warren Buffett’s objection to the use of options. While some Berkshire subsidiaries use them, Mr. Buffett generally has not been a proponent. He was very vocal about the need to expense their issuance, and is adamant that they do the holders the unjust favor or rewarding handsomely for sub-par returns on capital. He has also argued that options don’t expose the holders to any downside risk, since they are typically issued at the money and without any intrinsic value.

The natural alternative to an option compensation program is a targeted stock ownership program. In such a plan the manager is required to own a certain amount of company stock. So long as he stays employed with the company he will continue to be exposed to both the upside and the downside of the performance of the stock. It also stretches his time horizon as far as possible and, if the shares are simply granted to the manager, there is no ambiguity as to their cost. The stock will rise in value at a rate commensurate with the company’s return on capital. Academic literature has been very supportive of these types of programs – see Core and Larcker (2002) – but not necessarily ownership as a mechanism to align interests in general. I think it would be very interesting to investigate this shrinking-of-time-horizon phenomenon.

Now THIS is cool.

Have you heard about this? Cleveland Indians minor league pitching prospect Randy Newsom is securitizing himself by selling off 4% of any future major league earnings he may realize. For $20 you can buy one share which entitles you (the shareholder) to 0.0016% of his big league earnings. By doing this, Newsom will raise $50,000 in capital. He has even established a company to facilitate future transactions - his own "investment bank" if you will.

The best discussion I have read about this is from Steven Levitt of Freakonomics fame. Professor Levitt conjectures that, assuming Newsom is risk neutral (a big “if” by the way), this price implies Newsom believes his future earnings will equal less than $1.25 million. I just wonder what is going on; if Newsom is simply in need of cash now or if he doesn't think he has a shot at the big leagues anyway. After all, there is enormous information asymmetry between Newsom, effectively the owner-manager, and the shareholder, so I assume we are adapting an extremely high expected return to our valuation. Alternatively, maybe he is most interested in the business and is using his own "stock" to help launch it, also a good way to hedge the possibility of never making the bigs.

I know that if I were a minor leaguer and could accurately assess my own probability of major league success, this scheme would have enormous appeal. Just think about the earnings differential between minor league and big league baseball. I mean, to a 25-year old who has spent his career playing minor league ball $50k is quite a bit of money, but to a millionaire superstar, the 4% of his million dollar salary is comparatively insignificant.

Finally, a post about the economy.

I don’t claim to be a macroeconomist, so take what I have to say with a grain of salt. And I am certainly not a market prognosticator, so please don’t interpret what I say as a prediction for the direction of the stock market. But the more I hear about the state of the U.S. economy, quite frankly, the less confident I can be that it will flourish in the near (5-10 year) term. Let me detail several stylized facts that, taken collectively, lead me to this conclusion.

#1. The dollar continues to weaken.

#2. At this time last year the yield curve was flat, portending recession.

#3. Housing price run-ups have historically preceded recession. Need evidence? Check out this new NBER report.

#4. The nation is addicted to debt, both at the individual and governmental levels. The federal government’s chronic deficit spending has, in effect, caused us to sell of a great portion of the wealth to which we as Americans once had claim simply to finance our overspending. This appears to be driven only by political pressures and not by any level-headed economic analysis. As individuals we have an insatiable desire to consume, making even the wealthy prone to borrowing. This high leverage leaves us in a precarious position, as it eliminates any buffer against the inevitable downturns of the economic cycle.

#5. The subprime meltdown was caused by greed, on both the lender and borrower sides of the transactions. The widespread securitization of mortgages meant mortgage brokers, underwriters and even guarantors had little concern for traditional loan-approval criteria (like income!). This is because they were completely severed from the mortgage after the transaction giving them an incentive to make the deal happen at any cost. Thus, with no ultimate culpability, the consequences of defaults and resulting CDO failures will be shared among all players in the financial markets.

#6. The Fed cannot solve this problem with rate cuts. It can solve liquidity problems with monetary policy, but the problems this time around stem from outright insolvency. In fact, short-term stimulus initiatives – including Fed rate cuts – will only encourage further debt-financed spending. So while the issue of liquidity may be resolved in the short term, we have not gained any ground since presumably we would experience even more insolvency. Thus, we have cut off our nose to spite our face.

#7. Psychological factors (while relatively unimportant in the long term) will weigh heavily in the short term. The advent and popularity of mortgage backed securities creates an environment of uncertainty, as judging the credit quality of the underlying mortgage becomes close to impossible. This breeds contagion.

#8. Interest rates, in general, have no where to go but up. Especially with the recent cuts we are at very low historical rates. The long bull market that began in the mid-80s and is now coming to a conclusion coincided with an enormous fall in rates. This juiced the returns on equities in an economy that, while growing, was not keeping up with the growth of its equities. This is because as rates fall, the discount rate used in cash flow valuation falls, giving us higher present values. This corresponds to higher stock prices and helped pushed earnings multiples far beyond where they have historically resided.

When I consider all of these things collectively I can’t come up with any convincing argument that we won’t end up in recession. What is more, there is a decent amount of evidence that what happens will be even worse than recession, a prolonged economic downturn.

The financial markets, and in particular the credit markets, have changed tremendously in recent years. Americans more and more feel no moral obligation to repay their debts. Bankruptcy has lost its stigma, and with enormous worldwide lenders making loans, there is little personal or social pressure to behave responsibly financially. This trend has the potential to completely uproot our existing financial system. That disruption is reason enough to expect the worse.

I don’t mean to sound like a complete doomsayer, because I do think that this country will continue to thrive in the end. And I will continue to invest in American stocks. I just think we are in for some unpleasant surprises in the near future. So why not take the good with the bad? This upheaval will undoubtedly produce some bargains when investors panic. Maybe we will even have the chance to pick up some Berkshire on the cheap.

The Agony of Defeat

This is one of those times when I just don’t know what to say. Perhaps it’s my relative inexperience, perhaps its just human nature. But the market is tanking, I am losing money and I can’t help but second guess my past decisions. It is important not to make emotional decisions, but to tell you the truth it is hard to tell if the decisions I am making even are emotional. By that I mean, it’s tough to know whether I am rationally changing my own perceptions, or whether I am allowing the pundits that pervade the news sources from which I get my information to sway my opinion.

I know not to let fear or greed influence my decisions, but how do I know if they are? I know to let the market be a tool, not a guide, but it is hard to rely solely on my own interpretation of available information. After all, how arrogant must I be to assume I am right while everyone else in the market is wrong? Bottom line: this is the type of environment when investing is most aggravating.

Of course the biggest losses have come from the financials. Those are the easiest to brush off too, since it was much more of a macroeconomic phenomenon than a company-specific one effecting these losses. It is the individual picks that cause the most distress.

For me, the one individual stock for which this frustration is most pronounced is Sears Holdings. I’m not really sure what to think about this investment anymore and at times I struggle with the question of whether my original purchase of the stock was an emotional one, or one based on a rational consideration of the facts. The question is justified. Ever since Business Week asked in November 2004 if Eddie Lampert was “the next Warren Buffett,” folks started jumping on the SHLD bandwagon. Maybe that was reason enough for me to stay away. But I didn’t. I jumped right alongside them. Now, it seems, they are all jumping off that bandwagon. Why? Let’s talk about that.

A year ago, the theory was that Lampert would use Sears as a vehicle by which to invest in other businesses (a la Warren Buffett and Berkshire). Folks debated this issue, but the theory that Lampert saw the company as merely a turnaround lost out to the competing theory from the bulls who had more faith in Lampert’s investment prowess. As such, the story went, whether or not the retail business really grew (Lampert claimed he wanted it to nonetheless) was not of top concern, since the plan was to merely use the cash flow from Sears’ current operations to make better investments outside the company.

But now, it seems, the retail business is so bad that it isn’t even generating that cash flow! So Lampert is left with no cash to invest, at precisely the time when the market might be creating the best bargains. Remember, this is a company directly competing with Wal-Mart, not an enviable position in which to be for anyone.

In addition, everyone thought Sears’ real estate assets were a hedge against the performance of the company’s retail operations. Ha. What does the market for commercial real estate look like these days?

The plan appeared to be working because Lampert did, to his credit, do a great job cutting costs and boosting profitability. So even as sales lagged income rose. But the benefit of cost cutting is limited by the company’s sales. Don’t get me wrong, Eddie Lampert is certainly one of the most successful hedge fund managers in recent years and obviously a very bright and astute businessman. I love the way his shareholders’ letters are written and the obvious parallels we can draw between them and Berkshire’s. But that doesn’t change the fact that he must begin by making sure the utterly lousy retail business he is burdened with doesn’t completely fail.

Part of me feels foolish for even writing about this. It has been written about to death. And 99% of that writing is motivated purely by the hope that Business Week was right. Nobody knows at this point if the company will survive long enough to turn in to a new Berkshire. But we hope it will.

Note the word “hope.” This is an emotion. And if I bought SHLD “hoping” that it would become something huge then I was greedy, because there was not a whole lot of evidence indicating it would be. There reasonable speculation, but no solid evidence that would afford the margin of safety that I should have demanded. There was a lot that could have gone wrong that I should have considered, but I didn’t because I let the dollar signs blind me. Ah, hindsight.

I think the lesson from all of this is the following; Emotional discipline is the number one most important factor affecting investment performance. Warren Buffett has been successful because he has that emotional discipline. I think he would have passed on Sears Holdings, even as great a guy as Eddie Lampert is. But just as it is so difficult to change one’s personality, if we don’t already have emotional discipline we can’t expect to obtain it easily. And this might just make some type of structured investment philosophy that disallows the influence of emotion preferable.

Expectations Investing

After the interview I recently gave CNBC, as I typically do, I began rethinking the sound bites of mine the show’s producers included and how I could have better said what I did. One quote of mine that was included in the show but I really don’t think came out right is the following:

“It is an appreciation for all things that make a good business, not just the financials. Warren Buffett has been the best at allowing us to understand what makes up a good business.”

Here is what I meant, said far more eloquently:

Warren Buffett has a unique ability to assess a business holistically, or on an integrated functions basis. This allows him to recognize attributes and/or assets that may have been overlooked by Wall Street, where analysts are often more concerned with short-term trends or earnings announcements than with underlying business economics.

My point is that a stock represents a share of ownership in a business, not merely a security that trades on a large national market. Thus, there are many things that happen outside of the stock market that affect the stock’s value. Some people ought to be saying right now, “Well duh.” -- I never said this was rocket science.

I recently read a fantastic book describing an investment strategy that embraces this attitude while preserving a structured and disciplined approach to stockpicking. It would be perfect for the investor not confident enough in his own intuition about the future of individual companies to focus on only a few businesses, perhaps for the “know-nothing” investor that Mr. Buffett has referred to.

The book is called Expectations Investing and was written several years ago by two academics, Alfred Rappaport and Michael Mauboussin, and published by Harvard Business School Press. I should point out that I was not asked to review this book by anyone nor do I have any interest in the book’s success. I just bring it up because I liked it.

The book begins by making the assumption that outguessing the market is too difficult. A better method by which to make decisions uses the information provided by the market to infer expectations and then judges the reasonableness of those expectations. I think of it as a bottom-up-bottom-up approach. Not only are we analyzing the company on a fundamental basis first, but we are actually using the current price of the stock to read the market’s expectations for how those fundamentals will change.

For instance, a few months ago I blogged that although I do not know if Google is overvalued or undervalued, an investor in the company ought to be aware of what its current stock price implies. Namely, that at $700/share, the expectations of the market implied by this price are that Google will eventually become the largest company in our economy. I don’t know if that will happen or not, but that is what will need to happen lest Google’s stock will underperform.

The book describes how “value drivers” and “value factors” work to affect shareholder value. While, for example, sales growth will drive shareholder value, it is the value factors such as volume and pricing that affect sales growth. So by starting with the stock price and working backwards we can infer what the market seems to expect to happen to volume and pricing. At this point we can ask ourselves if these expectations seem reasonable and also if we should expect the market’s expectations to ever change. With a good holistic perspective of the business like that which makes Buffett so successful, we should be able to answer this question easily.

The book also makes the case that a discounted future free cash flow model is the only legitimate way to measure shareholder value. Frankly, I don’t see how anyone can argue with them on this point, but clearly many people cling to short-term metrics such as PE ratios even though such metrics incorporate only information about one period’s performance. Only future free cash flow directly affects changes shareholder value since it is this cash flow that represents the return on the shareholder’s capital investment. Of course, plenty of things indirectly affect shareholder value and these are the things about which we are trying to infer information when we employ the expectations investing methodology.

Alas, we have taken an alternative approach to answering the same question. Instead of deciding on an intrinsic value to which we will compare the current price, we infer from the current price what the market’s expectations must be in order for the current price not to exceed the intrinsic value of the business. Taking this backwards approach strikes me as much more judicious application discounted cash flow valuation because it allows us to focus on what we do know for certain (the market price) rather than what we don’t necessarily know (the intrinsic value of the business).

Although he probably has never thought of it in quite these terms, I am fairly confident this is the same type of intellectual exercise Warren Buffett engages in when making an investment decision. Nonetheless, this commonsense type of analysis does not happen very often in the market. Perhaps investors are just creatures of habit.

FD: No position in GOOG