Stig Brodersen  07:51

Yeah, so the ways of thinking about investing is that it’s boring. I think Charli Munger has a quote or something like that. He’s been making his money just by waiting. I mean, who thinks it’s fun just to wait? And if you’re looking for action, if you’re looking for a lot of things to happen fast, investing is probably not for you.

As an investor, there is no action at all you would buy a company and you will hold it for 10 to 20 years, perhaps the rest of your life. So think of investing at something that’s that’s boring. That’s that was my key point here. One extremely important point from chapter one to chapter seven is Graham’s discussion about active and passive investing.

I think his definition of a passive investor is interesting in today’s context because for the passive investor, he’s talking about finding high quality picks and then just holding on to them. I think if Benjamin Graham was alive today, he would probably say something like, find an ETF that has a tweak of value in it. That’s how I would assume Benjamin Graham would look at the past investors today.

The interesting thing about passive investing is that when reading “The Intelligent Investor,” the guidelines he provides for solid picks, I think they’re just timeless. When I read that today, I’m thinking, that sounds like a great idea. That’s probably what once you do if you had no opinion about the market, if you have no opinion about the sustainable competitive advantage, find blue-chip stocks with these given criteria in terms of dividend payments, conservative financing, and so on. You’ll probably do better than most active investors,

Preston Pysh  09:27

What Stig is hitting that in the book between passive and active, Graham describes in the book as the defensive investor and the aggressive investor. And so here’s a quote from the book that Graham has for the aggressive investor.

He says, “The aggressive investor will expect to fare better than his passive equivalent, but his results may well be worse.” And he gets into a lot of discussion about that, where he says that these aggressive investors they’re armed with all this information, and they’re actively trading. They’re using the speculative approach if you will. And they’re actively trading and making all these decisions.

And he says, “But so is everybody else that’s armed with that same amount of information.” And what he finds is these guys are going after and trying to get a 12% or 15% return, or the higher end of this return. But what they get is return is lower than the defensive investor who’s just kind of going after maybe call it a 7% return, maybe a little lower in today’s markets than when Graham wrote this as back then there were different interest rates and different multiples and stuff. But now I think if you’re if you’re going for 7%, these days, you might be stepping into something risky.

Stig Brodersen  10:41

I call this the active essay. Actually, if you read the book, he was sometimes called the enterprising investor or the aggressive investor like, I remember the first time I read this book, I was like, how many types of investing are there? And it seems like there’s only two. He just uses a bunch of different terms.

Before we go, I just want to say one quick thing. I respect Benjamin Graham as one of the biggest thinkers in terms of investing. As a writer, I’m not sure that was his forte.

Preston Pysh  11:08

He was bad. I’m glad you brought this up because people need to be prepared. After all, if you’re listening to this, and you go out and you buy his book, it’s not an easy read. It’s quite dry. It’s difficult. If there’s financial terminology that you’re not familiar with, you will probably struggle with this book, even though it’s the dumbed-down version of “Security Analysis.”

I remember the first time I read this because I didn’t have a background in financial accounting and things like that, man I struggled with this book. I mean, it was brutal. I just knew it was an important read because Warren Buffett and all these other guys said it was so important. But man, when I first picked it up and started trying to read it, I struggled. It was very difficult.

Stig Brodersen  11:48

Yeah, and it’s funny because in financial accounting, as many analysts know, we have a lot of different terms for the same things. And obviously, Graham, even though he’s a professor, he’s used to teaching people, he will just use almost like the more different terms for exactly the same thing, the better. So it’s definitely not your average textbook.

But just one quick thing I would like to say about the active investor is that he would be saying you should buy unpopular stocks. And the way that Benjamin Graham looks at this is that he’s showing people a table of PE ratios and he’s saying, and this is I think the reason the book is written in 1949, and already back then he was conducting studies in terms of how well companies perform if there is this in sound terms of PE. He was just so much ahead of his time because he didn’t have a computer or anything like that at his disposal. He just thought this would make sense then he conducted a lot of research and found, “Okay, I should probably buy unpopular stocks.” He measured the PE ratio basis. I think that was interesting.

And the last thing I want to say about the active investor and this is something we return to later in the podcast is that he is always comparing price and quality. He’s saying, as an active investor, well, you might buy high-quality companies, but you might also buy low quality, it depends on the price. So I just think that’s the discussion Preston was referring to previously, when he was talking about discount rate and the earnings, like, all that is good is fine. But we have to speak about what is the valuation. And that’s why we have these conversations between the two of us.

Preston Pysh  13:26

And we’re going to talk a little bit more about intrinsic value later in the episode. And you know, we have a tool for calculating that stuff. We will hand you guys off too. So if you’re wanting that, just stay tuned. We’re going to get to it here later on.

So the next thing we’ll talk about in this group of chapters that we’re discussing right now, which is one through seven, is inflation and corporate earnings. So Graham’s opinion was that stocks or companies were somewhat inflation-proof, not 100% inflation proof. So don’t think that if you buy a stock that it’s going to be protected completely by inflation. But he said that a portion of it is protected.

Now, he doesn’t kind of get into how you would saw or figure out like a mathematical number of how much of it is or is not. But he’s saying if you’re comparing it to a bond, a bond is 100% impacted by inflation. So Jim Rickards talked about that a little bit in our interview where he was saying, you know, if the inflation rate is 5%, and your interest on your bond is 3%, well, the person who owns the bond is getting tore up. They’re just getting crushed because the inflation rate is seeding the money that they’re getting back.

14:38

So with a stock, Graham doesn’t say how much but you’re partially protected from that inflation piece. Now, it’s interesting. I can’t remember the year that Warren Buffett wrote a shareholder letter discussing this exact topic, but Buffett talks about why that exists, why companies are somewhat inflation-protected. And where Buffett gets into it as a company that has a lot of intangible assets on their balance sheet, they’re protected more from inflation than a company that has a lot of tangible assets on their balance sheet. And his reasoning is when the company has to replenish their inventory, or they have to replenish their property or whatever that tangible asset is on their balance sheet when they have to replace that, they have to pay the higher price of the inflated price of whatever it is that they’re replenishing it with. And so that portion of the company’s revenues that then support the balance sheet sustainment and things like that, that’s what’s impacted by inflation.

Whereas if, let’s just say you had an intangible asset like a brand, or maybe digital media that you’re selling on the internet or something like that, the price can just be simply adjusted to the inflated price, and you’re not having to deal with inventory or anything like that, where you’re having to pay a higher price. So that’s where Buffett kind of went and took Graham’s idea and took it to a whole new level. Now here he is taking his professor’s content and just elaborating on more just kind of you can see how he just blossomed from some of this information that he learned as a young kid and just ran with it as an adult later on in his life.

Stig Brodersen  16:13

If you ever heard Warren Buffett talks about “The Intelligent Investor,” he would say you need to reach Chapter 8 and you need to reach Chapter 20. So that’s also why I’ve decided to have these four segments and one of them is Chapter 8 is with this Mr. Market.

Preston Pysh  16:27

So let me just try to describe the way that Benjamin Graham might have described this in his class. So the way he likes to describe it is he’d say, “Imagine that you’re at your house and you’re just kind of sitting there reading the newspaper on your chair and the doorbell rings. And so you go over and you open up the door, and there’s a gentleman there, he’s dressed up in a suit and his name is Mr. Market. And so Mr. market comes to your door literally every single day, kind of the same time. He rings the doorbell and he says, ‘Hey, I’ve got these companies that I want to sell you and I got this one here called XYZ and I’m selling it for $30 today. Yesterday, it was $35. But today I want to sell it for 30.’”

And then he says, “I have company ABC. Yesterday, I was selling it for 90. But today, I want 100 for this one.” And so the way he was describing it is each day, this guy is going to come back with a different price. Sometimes he’s going to want more, sometimes he’s going to want less, sometimes he’s going to want way less. And you as the calm, competent, consistent, balanced thinker that you are, need to listen to what he’s offering you. And then make your own conscious decision on what something is worth. So whenever he comes and says company XYZ and it’s, you know, he wants to sell it to you today for $30. That’s his offer.

Now, what do you think it’s worth? If you think it’s worth $50, well, and he’s offering it to you for $30, well that’s a heck of a deal. And you should maybe buy some of that from him because he’s offering you at a great price.

Now the other company ABC, if he wants $100, and you think it’s worth $75, why in the world would you buy that if he’s offering it to you for $100? That makes no sense. And so this is kind of the example that he would use in his classroom to teach students that it’s a choice. The price that you’re being offered on the market is a choice for you to determine whether you think that that’s a good price or a bad price, using your own analysis of what you think something is worth or the value or the intrinsic value, which Stig is talking about. The price is just that, it’s an offer. It’s somebody saying, “Hey, I’m going to sell you my car for $35,000 even though you could go to a lot right next to and buy for $25k.” It’s an offer. You don’t get upset, you don’t get angry. You just kind of look at it for what it is and be like, hell yeah, that’s a bad offer. No, thanks. So that’s why that chapter is so incredibly important.

19:01

In fact, Stig said in the intro the book that Warren Buffett provides the preface. Warren Buffett made four points. I’m going to read these out loud, the real fast. Warren Buffett says, “Investing doesn’t require a high IQ. Successful investing is a result of implementing a sound strategy and being able to control your emotions. This book, “The Intelligent Investor” provides the strategy and you need to provide emotional control… Pay attention to chapter eight and chapter 20. Outstanding results depend on three factors intellect, effort, research, and the number of market swings, you get the opportunity to experience.” And notice how he says the opportunity to experience a market swing.

So when you have a major downturn or whatever, Warren Buffett looks at that as an opportunity because he knows that price and value are completely out of whack. And that’s his ability to kind of take advantage of the opportunity. So that’s chapter eight. It’s all about Mr. Market. It’s understanding that you’re being offered opportunities that at every single day, there’s an opportunity because every single stock is priced at a different level and all these different emotions.

Stig Brodersen  20:17

Yeah. Now, just want to ask you a quick question here, Preston, because this is a very public question. So given what you have told us about Mr. Market, and I’ve heard, you can’t time the market. So are the two opposites is the paradox or are they two different things?

Preston Pysh  20:32

I don’t see that as being two different things at all. So my opinion is, you’re not timing anything. What you’re doing is you’re looking at all the different opportunities that exist at the time now. So as I look at a bond 10 year Treasury, there are all sorts of different bonds: you got federal bonds, you got corporate bonds, you got mutinies. You got all these things that all have a different level of risk.

But if I was going to do it… Buffett would describe as a zero-risk investment. That’s the 10 year Treasury that’s giving me a 1.7% return or somewhere around in that ballpark. When I look at the US equity market, it’s almost at 17,900 on the 26th of April when we’re recording this. That for me is very high. But when you figure out what return that’ll give you based on the new earnings, you’re at about a 4% return where it’s been for the last year ever since we’ve been recording this podcast. It’s been about a 4% return, it hasn’t moved very much.

So when I’m comparing those two, this is the key point: the yields are drastically different. One is giving you double the return of the other, but you have a lot more risk associated with one versus the other. So now you have to ask yourself, and this is where it becomes different for each person and every person is going to see this differently, is the extra risk associated with owning stock worth the extra 2% return that I’m receiving compared to a fixed income, no zero-risk investment? We were talking about inflation is impacting bonds completely. So if inflation…

What’s inflation at now, Stig? 1.7? It’s about the same yield as the 10 year Treasury. So that now takes my return on the fixed income bond down to zero. And then I have to say that some of that is impacting the stock as well. Now, it wouldn’t be the whole 1.7%. It might be half of that or something.

22:35

So now you’re looking at a zero percent return to a 3% return. This is my thought process as I’m going through that. So then I say, is 3%, and I’m looking at it in kind of real terms here… Is 3% worth my risk of owning the stock market right now, fully knowing that everything’s pretty much being manipulated by central banks at this point? And I would say, maybe not. I mean, that’s kind of I have a hard question. And I think that it’s not something that I can say with a lot of confidence that I feel one way or the other. I just think that there’s a lot of risk in equity markets just because of how much they’ve been manipulated.

When I look at how equity markets have been, and I’m talking about the stock market, when the stock market has been completely manipulated through quantitative easing, those are the things that I think about from a macro standpoint to a micro standpoint, to timing the market, which Stig is kind of getting to with this question. I look at it from what are my other options? You better believe I’m constantly looking across that array of choices, whether it’s fixed income, equities, commodities, currencies. What’s going to give me the best return at any given point in time? And then I’m making that choice. I’m not timing anything. I’m just looking at what’s going to give me the biggest yield.

Stig Brodersen  23:48

Yeah, and I’m happy you said that Preston, because when people listen to on the podcast, hopefully, they won’t be thinking, “Okay, so what Preston was talking about is that if the Japanese central bank does this, then this will have an influence on my portfolio.” That’s not what we’re saying. And that we definitely don’t want to time the market like that.

What I’m saying and what Preston is saying, is that, okay, so when you are buying a car, what’s the value of that car? And what’s the price of that car? And that’s what you’re doing with stocks. We don’t think about whether the stock market due tomorrow and I think a lot of people are thinking the question of, can you time the market? You probably shouldn’t be thinking like that. You should be thinking, what does it cost? And what’s the value and just stop your thought process there. And if you find good bargains, you’re probably better off and time will take care of the rest for you.

Preston Pysh  24:35

And it gets back to the fundamental thing that Graham’s talking about in this book, is, are you speculating or are you investing? Because if you’re investing, you’re protecting your principal. You’re putting your money into things that you have no idea how it could go wrong. That’s investing is when you’re saying, “Hey, this looks like a very good sound investment that has good consistent returns over time.”

That concludes chapter eight. Let’s go to 9 through 19. And kind of hit some of the high points here.

Stig Brodersen  25:05

So if we should label chapter 9 to chapter 19, it’s about how to find the right stocks. And Benjamin Graham is much more specific in these chapters compared to the first seven chapters of risk criteria should you set up. But the first thing we would like to talk about is him explaining what is the discount rate and what is normalized earnings. And why is that important in determining the intrinsic value of a stock?

Preston Pysh  25:30

So the thing that I was kind of surprised within getting kind of to what Stig is referring to here with the discount rates. And when you’re reading “Security Analysis,” which was his big first textbook, a lot of it was all about fixed-income bonds. I’d say what the first 25 chapters are almost all about bonds and fixed-income investments. With “The Intelligent Investor,” it’s kind of focused on common stock. And really, there are some discussions about bonds but really, he’s talking a lot about stock investing. And so he does not come out and say this is how you calculate the intrinsic value of a stock. He doesn’t do that.

But what he does do is he talks about a discount rate. And he talks about kind of just looking at multiples of earnings to price. And so let’s talk about intrinsic value and discount cash flow and all that kind of stuff. So when you talk about the free cash flow of a business, that is the cash that’s left after everything’s paid for, and it’s the cash remaining in the bank account. This number is so important, because, at the end of the day, the money that the company brings in at the top line of their revenue, or that’s what it’s referred to the sales revenue. There’s, you know, different terminology and that’s where accounting kind of gets a little bit confusing because you hear people throw around these terms, and sometimes they mean the same thing.

But your top line that if you had a… let’s just say your business was selling Pepsi and you charge $1 for a drink just to make the numbers easy. That $1 that you would receive is called the revenue or the sales. That’s your top line. Whenever we say the top line, that’s what we’re referring to. That’s the $1. Then after you’d pay your employees, you pay for the metal on the can, you’d pay for the sugar, you pay for all the ingredients that make the drink all that stuff, you pay your taxes. After all, that stuff is stripped away from that $1 in that sale, that top-line number, you get to your bottom line, which is your net income, and that number might be 10 cents, and that that would make your 10% margin. That’s what we’re talking about is that top line, the bottom line number of what the company is able to retain from their sale.

27:42

So when you talk about free cash flow, you’re kind of getting into that bottom number, that net income but you also have depreciation. Tou got all these other things that you’re accounting for, but you’re eventually coming to what is the company able to retain in cash after everything is said and done? That’s the number that’s important for determining the value of the business over time.

So when we look at the company’s free cash flow, let’s say that we’re just going to talk whole numbers of a business. Let’s say that a company is able to have a million dollars in free cash flow this year. And then they had $900,000 of free cash flow last year. And the year before that they had $800,000 of cash flow. So you can kind of see the trend here is that the company is basically adding $100,000 of cash flow every year. That’s a good thing, that’s trending in a good direction. That’s what you’re wanting to see when you’re looking for a business is determining that free cash flow.

So when you see that and there’s no guarantee, there’s absolutely positively no guarantee that that company will have that kind of cash flow moving into the future. But what you’re looking for is a business that has some type of sustainability and stability to it. That gives you a reasonable expectation. And in the future, you can expect the same results.

29:02

So an example that Stig and I like to use is Coca Cola. This is a company that has pretty stable results, you can go back now… There’s going to be some fluctuations here and there. But as you the listener listening to this is your expectation that next year, Coca Cola is going to continue to sell just about the same number of soft drinks? If the answer is yes, then that’s the kind of company that we’re talking about that you can reasonably assess the value of it.

Now, if you were going to say, think of a business that you think would be volatile that you would say, “Yeah, they made a lot of money this year, but maybe next year, I’m not so sure they could maybe pull that off again.” Those are the companies that Buffett doesn’t even try to figure out the value of, or Benjamin Graham tried to figure out the value of, because it’s kind of hard to put a value on it.

Now, if the price is low enough, yeah, they’ll try to value it. But for the most part, they’re trying to find that steady, stable business that they can determine and say, “Hey, I think over the next 10 years they’re going to continue to have this kind of free cash flow.” And because of that, they feel like they can have a lot of confidence in their ability to take those, add up all those cash flows, and then discount them back to today’s present value to try to determine what the value is.

So when we talk about a discount rate, this is the thing you got to understand when you add up all your future cash flows. So let’s just say next year, you’re going to earn a million, the year after that you’ll earn a million and you go 10 years into the future. So you’re going to make $10 million over the next 10 years. But what’s that $10 million overspread across the next 10 years into the future worth today? That’s the key thing you got to figure out: what’s it worth today, opposed to the value 10 years from now?

So, to figure that out, you need what’s called a discount rate to calculate what it is today. We have this in all our books. We talk about this on Buffett’s Books. In fact, we have a calculator that automatically figures this out for you on Buffett’s books. We’ll have a link for it in the show notes if you want to go play around with it.

31:04

But what you’re doing is you’re adding up all those future cash flows, you’re using a discount rate. And so the discount rate that you typically use, or that Buffett recommends that you use is the 10 year Treasury. So when you discount it back at whatever interest rate you choose, and I think the starting point is always the 10 year Treasury, you bring that back, it’s going to say that the stock is worth $100 or $50. And you obviously have to divide out the number of shares outstanding.

So this is kind of a process, if you will, and we have videos, we have detailed videos that teach people how to do this. And to be honest with you, Graham doesn’t get into this level of valuation. In his book, he talks about it, he says, “You need to do a discount analysis, you need to figure out what the present value is today based on the expectation of the company to earn in the future.” But he doesn’t get into these equations. He doesn’t get into the math behind this. And that was one of my frustrations with this book because I wanted to get into that. I think for a lot of people out there they hear the discussion of okay, how do I do this?

Stig Brodersen  32:08

Yeah, you’re definitely the right, Preston, because we’re all looking for that one formula that can just tell us what intrinsic value is and let us compare that to the current market price. But unfortunately, it’s not that simple.

So we talked about the discount rates first. How I teach my students to look at this is I teach them about the opportunity cost, first of all. So the opportunity cost is important. That’s also why Warren Buffett uses the 10 year Treasury because that is an opportunity cost of a risk-free investment. Intuitively, that’s also why you would rather buy $1 today than in a year because you would have the chance to invest that dollar and get a return from that over that one year.

Another thing to include is inflation. If we have high inflation, everything else will demand a higher return on our capital. Also, I think is important to look at risk and compare that to the discount rate that you’re using. And the hard thing about this is that there is no finite number that we can just say this is the perfect measure of risk.

I think one of the best examples I come up with is that a lot of people have approached me and want to me help raise capital to their startup company. And whenever you’re in such a process, and you will usually issue shares to raise capital, you will have to consult with them about so what do they think their company’s worth. How do they come up with the valuation of the company? This all comes back to discount rates because they were showing me all these graphs and all these prospects of how much money they will make. And that might be all right, but it’s extremely risky and extremely uncertain.

And even the highest cash flows, when you discount that with the appropriate discount rate if it’s a risky company like a startup, you’ll just see that that is completely reflected in the intrinsic value. So if it helps people to understand to look at the discount rate and the earnings, or the cash flows that Preston was talking about before, as two sides of the same coin. You have *inaudible earnings, but they have to be discounted, given the risk, inflation, and opportunity cost.

Preston Pysh  34:13

So let me talk about where I kind of have a different opinion than Buffett, and not necessarily Graham, because Graham doesn’t necessarily say that it needs to be a 10 year Treasury use this discount rate. That’s much more Buffett that’s saying that. I disagree with Buffett on that I think that the discount rate should be the current yield of the S&P 500. That’s what I think should be used when you’re comparing an individual stock pick.

And the reason that I have that opinion is because of this. If I go and I take an individual company, and I use it for, in today’s example, the 10 year Treasury, is 1.7%. That’s going to give me a much higher intrinsic value of a stock using a 1.7% discount rate. Then using what we think is the current S&P 500 yield is which is 4%. So if I use 4% compared to an individual company, I’m going to get a lower intrinsic value on that business because I use the higher discount rate.

Now, the reason why I’m saying use the S&P 500 is that if you took an individual stock, and you compared it to the S&P 500, you made both of them have the same yield in this example,4% discount rate. I’m going to tell you every single day of the week that the S&P 500 is lower risk than an individual company. So why in the world would I use a discount rate of the 10 year Treasury when I could be using something that’s giving me a more matched, if you will, risk and more conservative price estimate by using the current yield of the S&P 500. I think that that’s a much more appropriate discount rate that’s giving you a much more conservative estimate. That’s an apples to apples kind of estimate because you’re using equities and because you’re getting a much safer, or much more appropriate risk appetite comparing a basket of 500 stocks to an individual stock. But that’s my opinion.

I’m curious to hear what Stig thinks about that idea.

Stig Brodersen  36:19

Well, the thing is it is a good point that you have Preston and I also thought about so if we do use the 10 year Treasury, does that mean that there is no risk in anything because it’s so low? I can see that the interest rate would work in some territories, but it doesn’t work today. And perhaps at the time, Warren Buffett was saying it, it might be taken out of context, and the interest rate might be a lot higher.

So I just think if we return to what you said, when you said 4%, for the S&P 500, 2% for the Treasury, it doesn’t mean it’s just twice as good. The best way for me to explain this is that you hear about if you eat this, you will have a 30% higher chance of this disease. That might be right, but you know, a 30% increase of nothing, it’s still nothing. I think that would be my take in terms of explaining what is the opportunity cost here because I’m looking at this as opportunity cost. And if you’re just picking an individual stock, obviously, that could be a management issue, or that could be like something catastrophic happen with this company. But if you own S&P 500, you own like, all the companies, and you don’t have to spend time on that. So I definitely see where you’re coming from, Preston.

Preston Pysh  37:29

Where this idea kind of originated with was I would get frustrated because people would go and use the intrinsic value on our Buffett’s Book site. And I get these emails and all these messages from people and they would do the analysis. They would calculate the value and they’d be using the 10 year Treasury and it was like yielding, you know, 1.7%. And they’re figuring out the intrinsic value of these companies using a 1.7% discount rate because that’s the way Buffett says, and they’d be getting these high market prices for different companies because this is the easiest way to understand it: the lower that that discount rate goes, the higher your intrinsic value number is going to be on the company.

So as these interest rates continue to be manipulated by the central banks and it gets pushed closer and closer to zero, the intrinsic value of all these stocks just get pushed to the moon. I mean, they just go through the roof. And so I’m looking at that, and a person would be saying, “Yeah, so company XYZ is worth $1,00  a share, discounted at a 1.7% discount rate.” And I’m thinking oh, man, yes it is. But you’re not accounting for the fact that with a treasury, you’re going to get your money, no matter what. The federal government is going to pay that back, you’re going to get the coupon. With the company, you have no, there’s tons of risk that the company might not be able to hit those earnings. And then you’re only discounting it at 1.7%, which is giving you this crazy price.

So that’s whenever I was like there has to be a better discount rate than the 10 year Treasury that’s representative of an equity to equity because this is I’m going to totally geek out on you. But when you’re talking about a bond, you’re talking about a finite financial instrument. It’s something that that will mature on a fixed date. When you’re talking about an equity, it’s something that goes into perpetuity. So you’re already comparing apples to oranges, as far as I’m concerned, because you’re comparing a finite instrument to an infinite instrument when you’re talking equities and fixed income.

39:23

So I wanted something that was different than that, that compared apples to apples equities to equities, if you will. And I also wanted something that had that compared a stock to stock but it was also taking into account the risk appetite. So for me when I look at the S&P 500 if you can’t match that price. In fact, if you can’t beat that price, why in the world are you taking in individual stock pick over the S&P 500 if you can’t beat it. And so that’s why I like using the current yield of the CAPE Shiller.

I know that the people listening to this might be frustrated. I think there are a few people out there that are listening to this or maybe enjoying the conversation because we are getting into the weeds on some hardcore finance and accounting type stuff. But this is important if you’re a person that’s calculating values of businesses and not just kind of selecting things on an emotional level, but you’re doing some math to figure things out. And to be honest with you, one of the first things that Graham talks about in this book is if you’re an investor, and you’re figuring out the value of something, there needs to be math associated with what you’re doing. And so that’s why we’re kind of going down this path and talking about the math behind determining the value of a company.

Stig Brodersen  40:40

Yeah, and just in continuation of that, I’m sure you experienced the same, but I get so many emails that talk about intrinsic value, and also how a lot of emails from people saying could you discuss that more in the show. So good news and bad news. We just did that. And you just saw how complicated it is. And also I want to say it has something to do with the podcast medium because we thought about this many times before. Should we talk more about intrinsic value? And you can just hear that when we’re talking about this, we’re talking about graphs, we’re talking about math, a podcast is just a hard medium to explain that.

And if I could just come with another example. So if you look specifically at “The Intelligent Investor,” then Benjamin Graham would say, you can use these rule of thumbs when you’re looking at earnings, you will look at those from the past seven to 10 years and then you would weigh them differently compared to how long has been since they have these earnings.

Now, I’m sure a lot of people would understand what I said here, but it’s not difficult to explain, but it’s difficult to illustrate and to simplify speaking on podcasts. So I guess that would be my disclaimer for not doing it before. So if you’re frustrated about this conversation, don’t worry as Preston said before, we have some videos that illustrate this. It’s not because we don’t want to talk about on the podcast, but it’s a hard medium to do so.

Preston Pysh  41:53

Yeah, definitely go to the show. If this stuff piques your interest and you want to learn more about it, go to our show notes. We have links to the Intrinsic Value Calculator, which has the videos on the same web page that teaches you where to find the data to plug into the calculator, how to think about some of this stuff. So we got all that on the website, just go to the show notes.

So we’re going to skip over a bunch of this stuff between those chapters and go right to chapter 20, which is an important discussion, one of the chapters that Warren Buffett said that we need to focus on in “The Intelligent Investor.” And that’s the discussion about margin of safety, and how important this is to investing.

So the best example that I think Buffett provided that people can easily conceptualize and think about is the idea of a truck crossing over a bridge. So Buffett says if you’re going to build a bridge that could support 10,000 pounds and drive across the bridge, how strong would you build the bridge? Would you build it so that it was 10,001 pounds that it would support? Or would you build the bridge so that it would be it could support 15,000 pounds? And it’s such an easy discussion for people to have, but it doesn’t necessarily have an answer.

It’s kind of I mean, if I was the person building the bridge, I’d say, “Okay, what confidence level do we have that the trucks going to weigh 10,000 pounds? What kind of weather are we going to have? And what kind of environmental situations do we have in this area where the bridge is going to be built?” There are all these different considerations but at the end of the day, you’re going to kind of make a swag, if you will, as to what margin of safety you’re comfortable building the bridge yet. So you know, off the top of my head, I’d say yeah, we’ll build it for 15,000 pounds if the heaviest vehicle going over should be 10,000. That way, you have your margin of safety.

43:43

So when it comes to investing, it’s the exact same thing. If you’re wanting to buy a company, and you can get a 2% return on it on a 10 year Treasury and a company is priced at a 2% yield, it’s a no brainer. You buy the 10 year Treasury because the yields are the same. And this is assuming that inflation is nothing, just for ease. So that’s an easy decision because the bond is a lot lower risk than the equity or the stock. And that’s where he’s getting into this margin of safety.

So how much above that 10 year Treasury price or above the yield you’d expect to get out of the S&P 500? How much above that do you need to make a selection on an individual stock pick? So if you’re out there, and you’re calculating the intrinsic value of General Electric, and I don’t know what the intrinsic value of General Electric is, but let’s just say that you determine it is 5% or 6%. Is that margin than 1% or 2%? Is that extra 1 %or 2% above the S&P 500 giving you a 4% return worth your risk? I can’t answer that. I don’t know. That’s completely up to you to determine what that margin of safety needs to be in order for you to make that selection.

But that’s what Buffett’s getting into here, where you’re jumping from one risk scale to the next, where S&P 500 is lower risk than the individual stock pick and the 10 years Treasury is less risk than the S&P 500. You have to make that determination of where you’re satisfied, assuming more risk for the yield that you’re potentially going to get. And that’s a keyword: potentially going to get. And it’s kind of up to you to determine but I think that discussion, and for a lot of people just thinking of things in that context is an important thing. So, Stig, I’m curious to hear your thoughts on this margin of safety stuff.

Stig Brodersen  45:37

Well, I think I agree with you, Preston. Actually, if you saw I was eagerly forcing something. It wasn’t so much about the margin safety. It’s one of those things that either you get it or you don’t. I think the vast majority of people out there that are saying, “Hmm, bridge, 10,000 pounds, 15,000 pounds, it makes a lot of sense.” And then you have other people in there who might not listen to this podcast saying, “Oh, so I saw that the stock was down 4% yesterday, so it’s probably going to bounce today.” I mean, it’s just different ways of looking at stocks. And if you accept the whole notion that price and value are two completely different things, I think the margin of safety concept is extremely powerful.

But also I think it is so simple that if you have the right mindset, you could probably have figured the whole thing out fast, and that we could explain it because it’s just so obvious. But if I should talk about “The Intelligent Investors,” in general, and what I was missing, because I would like a discussion about competitive advantage, and for anyone who knows about Benjamin Graham and is now saying, “Stig, that does make any sense that you say that because Benjamin Graham, he is very conservative. He’s not saying this company would do well because they have valuable intangible assets or he would not be saying this company would do well because they have a strong brand. That’s not his type of investing.”

I just want to throw that out to you guys out there, if you’re looking for the one book, and you heard about everyone saying you should be “The Intelligent Investor” because that’s where you can shape your investment philosophy, then I’ll say yes, the latter is true. This book is a vital feature shifting investment philosophy just as it did with Warren Buffett, but still, if you want to do active investing, and if you want to do active investing like Warren Buffett is doing, then you also need to have the qualitative part included. And I think that was something I was missing from this book.

47:31

So guys, that kind of wraps up our summary of “The Intelligent Investor.” One of the things that I want to throw out there to our audience, Stig and I are kind of working on creating more value for our audience, building new things into our website and things like that. So one of the things that we talked about a few times on our show, is when we look at our own personal business, we kind of break it into two different segments. You’ve got the operational side where you’re creating assets, kind of like this podcast, this is an asset for us. That’s creating a cash flow for our, you know, our personal business. You might have a business of your own, you might have a brick and mortar store, you might have a digital online store, whatever it is, that’s creating a cash flow for yourself. Once you create that cash flow, you then have to be able to invest the retained earnings of that cash flow. And that’s what we’re typically talking about on our show is that second part, where what do you do with this money once you have it, whether it’s your salary, whether it’s your own business, and like today, when we’re talking about investing in stocks. We’re talking about how do you take that cash flow and purchase another asset that somebody else has created to own a proportional piece of equity in that business?

What we’re trying to do is talk to people and maybe teach people how to do that first part where you’re creating online assets or you’re creating equity in some type of business or you’re doing something that’s creating a cash flow stream for yourself. And so to do that, what we’ve done is, is we’ve bought a domain, that’s going to point you back into The Investor’s Podcast website. But we’re trying to create videos and tutorials to teach people how to create income, specifically passive income, because that’s what a lot of our assets are, for yourself. And so we purchased the domain Create Passive Income. If you type that into your web browser, Create Passive Income, it’s going to take you to a page where we’re creating tutorials and video courses for people to learn passive income investing, stock, investing all sorts of things.

But if you go there to create a passive income, you’re going to be able to see some of the products that Stig and I are building. So one of the products that Stig just recently built is a chapter by chapter video course of “The Intelligent Investor.” So let’s just say you go out and you buy this book that we just got done discussing and you’re going through it and it’s difficult for you to understand… Stig created a chapter by chapter course video-based course, where he teaches literally every chapter of this book. So if that’s something you’d be interested in, go to createpassiveincome.com. And you can see the course that Stig built. We’re creating other courses.

50:16

I’m in the process, I’m a little bit slow, not as quick as Stig. But I’m in the process of building a course, on how to stand up and create your own podcast. So if you’d like to do maybe your specialization in hunting or whatever it is, I don’t know. And maybe you want to create your own podcast and talk about this kind of stuff. I’m trying to create a tutorial video that shows you all the equipment we use kind of how we do our show, all that kind of stuff. But that’s something that we’re trying to build out for our community so that you can start creating different online assets, digital assets for yourself if that’s something you want to do. If not, no sweat, you can just completely ignore all that. But I want to throw that out there for people so that they know that it exists.

So that concludes our episode for this week on “The Intelligent Investor.” Hopefully, you guys enjoyed our conversation. We apologize if we got a little too technical over the audio format. But if we did, and you want to see more stuff on video, we got the Buffett’s Books tutorials which are completely free, all the calculators, all that stuff is free. And we’ll have links in the show notes for that. So thanks for joining us this week, and we’ll see you guys next week.

Outro  51:28

Thanks for listening to The Investor’s Podcast. To listen to more shows or access to the tools discussed on the show, be sure to visit www.theinvestorspodcast.com. Submit your questions or request a guest’s appearance to The Investor’s Podcast by going to www.asktheinvestors.com. If your question is answered during the show, you will receive a free autographed copy of The Warren Buffett Accounting Book. This podcast is for entertainment purposes only. This material is copyrighted by the TIP Network and must have written approval before commercial application.