Better To Be Approximately Right Than Precisely Wrong

To illustrate a concept of true investing:

Fast forward to the year 2050. Imagine there are 2 companies with equal book value of $1 billion. (book value refers to the amount of cash that the company can raise by selling everything in the business). Both have 100 million common shares held by shareholders.

SNS and FNF (acronym for slow and steady; fast and furious) are the names of these 2 businesses.

SNS is a simple business that does distribution of mineral drinking water obtained from mountain streams owned by SNS and purified at their facilities. Net worth derived mainly from the value of the mountain and SNS’s purification facilities.

FNF is a technological development and research facility that has successfully invented the very first Interstellar Spacepod. Its net worth is derived from its R&D facilities, factories, and inventories.

There is steady demand for purified mineral water as Earth is becoming more polluted by heavy industrialisation and healthy living increases in awareness for more people. Sales have been consistent and net profit from sale of mineral water amounted to $500 million. The fair value of SNS shares is $100 per share, but the market price is only $50 per share due to uninteresting prospect of the business and rumours that government is recalling land for building nature reserves.

On the other hand, due to FNF's previous success from the development of their Interstellar Spacepod, investors were hyped when FNF announced their Teleportation Device Development Project (TDDP). To fund the project, FNF decided to issue a $50 billion zero-coupon bond that promises return of 8% per year with a 10 year maturity date. (A zero-coupon bond is a bond bought at a price lower than its face value, with the face value repaid at the time of maturity) FNF will raise $23.2 billion through this issue and will redeem the bonds for $50 billion 10 years later. The bonds sold like hot pies.

Net profit from the sale of the Interstellar Spacepod in previous financial year amounted to only $50 million as it is only affordable by the minority rich and development cost was extremely high. However, due to the prospective potential of FNF, share price before the announcement of the TDDP was $1000 per share. After the announcement, in a single day, FNF shares closed at $10,000 per share.

Needless to say, many so called investors felt mighty rich after buying FNF shares, many became unsolicited promoters of FNF shares, recommending it to everyone they met on the streets.

If we make a comparison between SNS and FNF, we can conclude that SNS is under valued and FNF is highly speculative. The so called investors of FNF shares must be justly labeled as speculators and buyers of SNS shares can be referred to bargain hunters.

To present this in numbers, assume that both company are funded purely by equity (before FNF issued its zero-coupon bond) which they raised with an IPO of $10 per share, translated into the book value mention at the beginning. SNS's return on equity (ROE) is 50% and FNF's is 5%. While SNS earns 10 times more than FNF, its share price is only 5% of FNF's. It is either FNF being overvalued or SNS is undervalued, but in this instance, it is both.

Paying too much for a mediocre business because the share price is rising is a phenomenon known as the greater fool theory. It is like paying double the price for the last concert ticket, thinking that someone else will pay you a higher price for it.

Buying a business because it has high projected earnings is speculating because the projected earnings are not support by past records. The increased debt burden from the issue of zero-coupon not only virtually destroyed all profits of FNF, it puts the balance sheet in negative. For a company earning only $50 million a year to incur a debt of $26.8 billion($50 billion - $23.2 billion), it is suicide. Even if the project is a success and Teleportation devices are a hit, net profit needs to be at $5 billion a year in the first year and be consistent throughout for the next 10 years in order for FNF to cover the redemption of the bond. This is in a case where zero profit is retained or distributed to existing common shareholders.

To make matters worst, the soaring share price diminished the little value that was the worth of FNF share. In numbers, if FNF was to sell everything it owns at face value, even without depreciation charges, compensation will only amount to $241 per share. Compared to the purchase price of $10,000, speculators would make a minimum lost of $9759 for every share they own.

In contrast, while SNS does not seem to offer much explosive growth in net income, its steady profit and low costs offered dependable returns to shareholders. A demand for supply that is shrinking allows SNS to command higher price without fear of losing revenue. Net profit can be increased without increase in capital employed. Therefore, SNS is unlikely to become unprofitable suddenly.

As for concerns regarding rumours of government recalling land, in the event that SNS has to be put out of business, fair compensation can be expected to be made to SNS for the sale of its mountain by the Government. Every shareholder will then receive the proper compensation, perhaps with additional benefits like exemption from taxation of capital gains. In any case, the shareholder can stand to gain more than intrinsic value of the investment from the liquidation. The fear that drove the price down due to uninformed panic selling presents an opportunity for bargain hunter to capitalise on.

True investing is the allocation of capital in investments that offers safety of principle and expects reasonable rate of return. Though the above example is the extreme, its purpose is to serve as a guideline for investors to evaluate a company. Too many people fell to the allure of high returns over short period of time and end up with nothing.

As Warren Buffett says: It is better to be approximately right than precisely wrong.

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