OKO-HI (A sushi restaurant, co-owned by Jim Kerr of Simple Minds)

Ingram Street Merchant City (Glasgow's answer to Greenwich Village) Glasgow (European City of Culture (1990), City of Architecture and Design (1999) and the largest city in Scotland)

My trails in the Wild Wild West have taken me far and wide, but every now and again a man has to get away from the dust, endless plains and cacti. Particularly if you have a deep desire for the quality sushi that OKO-HI is famous for. Do yourself a favour and head this way sometime. Scotland is a great place (even for a cowboy!) and Glasgow and Edinburgh are two cities that are transforming themselves at a heady pace. Both are currently developing waterfront properties like old docks, shipyards, etc. Actually, the two companies leading the developments, Forth Ports Plc (Edinburgh) and Clydeport Plc (Glasgow), are worth investigating as investment propositions. Don't be blinded by the accounting earnings, which are not too shabby, but concentrate on what counts - CASH FLOW! Also, try and get a handle on the underlying property values, which is as good excuse as I've ever come across to make a trip to whisky country. If you don't know where to go, try Granny Blacks for a good malt whiskey. You definitely won't be the first to go there, as the place has been quenching thirsts since 1820.

The other night I was having a bit of a chat with a mate of mine at Granny Blacks, over an 18 year old Glenmorangie Single Malt, of course. I was explaining the concept of investment being the art of buying $1/?1 for 50c/50p. You see, in the previous letters we covered the mind frame, discipline and general investment issues that are usually neglected. Now we are moving closer to the actual valuation of a company. However, there is another important distinction to be made - one that is also neglected very often.

The subtle distinction is between what you pay in price and what you get in return in the form of value. Simply put, this is the difference between the $1 and 50 cents I mentioned above. Most energy is expended in the valuation of an entity to establish whether it is worth $1. However, for successful investment it is not sufficient to establish that what you are buying is worth $1 or ?1. That is the field of investment research (what analysts are supposed to do). For successful investment you must establish the value of $1 AND only pay 50 cents for it! Obviously, buying $1 of value at a price of 50 cents isn't always achievable, but the point is that your returns will be determined by the price that you pay. The correctness of your assessment of the value actually being $1 is obviously important but you will be surprised how many investors (and laypersons) can quite easily establish value. The problem is that they then go ahead and pay way too much. So, make the distinction!

Again, your investment returns will be determined not only by what you get in value but also by what you give up in price.

Warren Buffett once said that the most important words ever written about investment are:

MARGIN OF SAFETY!

This is actually the most important part of the price you pay. It determines your room for error. It is not possible to determine the exact value of a company. Whether you are Warren Buffett, Benjamin Graham or Jim Slater you are still only going to make an educated guess. However, some people obviously make better guesses than others. This is why investment is referred to as an art rather than a science - because you can (at best) only determine a range for the value of an investment.

The first part of the value of an investment will be a function of the existing facts, i.e. the accounting estimates of the value of the assets and the liabilities. Remember, when an accountant signs off a company's books, which state that the fixed assets are worth ?100m, it is only an ESTIMATE of the value of those assets. It simply means that the accountant concurs with the opinion of the bookkeepers of the company that the fixed assets are worth approximately ?100m. It does not necessarily mean the assets are actually worth ?100m!

The other part of the value of an investment is made up of uncertain future events that will determine the future cash flows of the company. Certain assumptions are made about the future of the company and they are factored into the price. So, once again, you can see why this is an art.

The trick is to rather be almost wrong than almost right. If, after much research and deliberation, you determine that the company is worth $1, the next step is that the market is going to charge you a certain price for it. So, if you your goal is to earn a return of 10%, you would pay in the region of 91c for $1 of value. However, if anything goes wrong you will earn less. If the market allows you to pay 85c you are allowed 6c worth of mistakes - this is your margin of safety. If you are fortunate enough to pay only 50c a lot can go wrong. The company's valuation can get close to only halfway of your guesstimate of ($1) over the long term and you will still earn your 10%. However, you also stand to make 100% if all goes according to plan. When you pay 50c you are buying room for error and you can still make money. This is why this is known as the margin of safety. Now that is not too difficult is it? It also happens to be extremely important to successful investment!

So I say once again, your investment returns will be determined by what you receive in value compared to what you give up in price. One part of that value is made up of uncertain future events. You can increase the number of mistakes that can be made by the company by reducing the price you pay. Simply put, you can increase your margin of safety. With that the odds for you to achieve the required returns are increased and that, my friend, is the art of investment.

Now the conversation in Granny Blacks did not exactly progress as set out above. It is best to keep things simple when kicking back in Granny Blacks with a rowdy Scot. It is not really that the above is complicated, it is just that things.........now how shall I put it?.........work a bit slower in Granny Blacks.

What can I say...Glenmorangie makes a damn fine whiskey!

Whatever you are up to, I hope it is profitable and ethical.

Mr. B

mail_mrb@yahoo.com

Posted: 2002/10/14 08:03 View Archive