If something is priced above the value we ascribe to it, it’s overpriced. Fair enough. In the game of investing, which is about making money or generating returns, “price is what you pay; value is what you get.” That was the mighty Warren Buffett. Price is a given. But “value” is complicated. Here’s something they don’t teach you in school - there is no indisputable way to measure Intrinsic Value. There is no law or equation to precisely calculate it. Intrinsic Value is purely in the eye of the beholder. All models and equations, no matter how fancy and complicated, are, at best, guesstimates.
So, how do we know if something is overpriced or underpriced? We can guesstimate using a ROUGH marker of Intrinsic Value. So, we build some cash flow models for bonds or stocks, and we discount those cash flows back to its present value to call it “intrinsic value”. Then we look at the market price, and if it’s significantly below this guesstimate of intrinsic value, we buy. This is the classical way of doing things. Legends like Buffett, Munger and Marks have espoused this, or their own version of it.
But there is a twist to this classical method that has worked much better for us. On a side note, we’re almost certain that these legends have their version of this twist built into their process. They just don’t articulate it all the time. Well, sometimes they do:
“To us investing is the equivalent of going out and betting against the pari-mutuel system. We look for a horse with one chance in two of winning and which pays you three to one. You’re looking for a mispriced gamble. That’s what investing is. And you have to know enough to know whether the gamble is mispriced. That’s value investing.” – Charlie Munger
A horse – or an asset – is overpriced if its chances of winning are 3-to-1 but it pays 2-to-1. That’s it. It’s as simple as that; simple, but not easy. Naturally, some questions come up:
- What is “winning” exactly?
- How do we estimate “chances of winning?”
- How do we estimate payoff?
Winning, to us, is generating high returns whilst sleeping well at night. “What is high?”, you may ask. We keep it simple. Double digits – anything higher than 10% Annualized Returns. We’d love to get 20% or 30% annually, but we’ll take 12% if it comes with much lower stress and much better sleep. How do we get good sleep? By significantly reducing the chances of being utterly wrong in our guesstimates of (you guessed it..):
- Chances of Winning
- The Payoff
How do we do this? In the sections below, we’ll pop open the hood and analyze The Buylyst Portfolio in terms of Chances of Winning and Payoff. Needless to say, we’re always striving to maximize the chances of winning in our portfolio.