Most of us have heard of the Buffett Rules For Investing. Rule # 1 is never lose money, and Rule # 2 is never forget Rule #1. I came across a note which questioned if these are truly the right rules that investors should follow. If you are curious, you can read HERE. The reason for this post is not to criticize or disagree with the writer. Investing is an incredibly personal journey, which requires a personal framework with ultimate buy in. It is part science and part art. There are some common building blocks - but the ultimate framework - is unique to each investor.
So, what does “never lose money” really mean?
Here’s an example: I purchase shares of Company XYZ for $100/share. I believe that Company XYZ is worth $140 – 160/share. My assessment is based on the following. It is based on competitive moats of the business - which are strengthening. XYZ has a great product and is on the cusp of dominating its end market. It is also entering other adjacent markets. Business XYZ is the rare breed - that gets stronger and faster as it gets bigger - not slower and bureaucratic like the rest. It is based on the capital allocation prowess of its CEO – who is astute at choosing between 1) acquisitions, 2) buybacks, 3) debt issuance, and 4) equity issuance, based on present circumstances. It is based on an ownership mindset of not only the top management team, but one that runs deep in the company. To think like an owner, one must be an owner; and many in the company own stock in the business. The business also generates oodles of free cash flow, which is great, because it can be put to good use by the smart CEO. Lastly, this management is incentivized to maximize long term value, but not near-term earnings. In other words, near term stock price performance is not a focus. And here comes the best part. Not only is business XYZ undervalued today, I believe the business value should compound at 15-20% annually over the next 3-5 years. Therefore, the value of business X could potentially grow to $300/share in 5 years.
But right after purchase or during some point of ownership, the stock price declines. Management of Company XYZ makes a strategic decision - which is great for the long run - but not so much for the short run. Now the gap between Price and Value is even greater. But now I also have a paper loss. Have I violated rule # 1?
Here is my interpretation. An investor, over time, will invariably have stocks that will go down in price. That is inevitable. But rule # 1 is a guide post that directs us to own assets where the value is greater than or equal to the price paid and where value is growing at a nice clip. It guides an investor to focus more on the assessment of the intrinsic value of the business, and less on the randomness of the paper value of the stock. If business XYZ falls within my circle of competence, and I am confident in its long-term prospects, I can ignore the paper loss. Because, over time, value of the business will continue to grow, and the stock price will have no choice but to catch up.
Rule # 1 is also a leap of faith. For example, in a recession, the cash flow of business XYZ will decline, and stock price will most definitely decline even more. But it is a leap of faith that all recessions are temporary, and Business XYZ will come out even stronger, the stock price will recover, and go on to higher levels.
It’s not for everyone, but if you follow Rule # 1, it will lead to riches over time. I believe in Rule # 1.
This material does not constitute an offer or solicitation to purchase an interest in Latticework Partners, LP (the "Fund"). Such an offer will only be made by means of a confidential offering memorandum and only in those jurisdictions where permitted by law. An investment in the Fund is speculative and is subject to a risk of loss, including a risk of loss of principal. There is no secondary market for interests in the Fund and none is expected to develop. No assurance can be given that the Fund will achieve its objective or that an investor will receive a return of all or part of its investment.
This material contains certain forward-looking statements and projections regarding the future performance and asset allocation of the Fund. These projections are included for illustrative purposes only, are inherently speculative as they relate to future events, and may not be realized as described. These forward-looking statements will not be updated in future.
I am an investor and these are my personal thoughts on investing, behavioral finance, markets, and sports viewed through the prism of a Latticework