More Calculation Leads to Victory, Less Calculation to Defeat : Stock Selection and Valuation Analysis
"More Calculation Leads to Victory, Less Calculation to Defeat"
(The Art of Invest : Laying Plans)
Sun Tzu, in his seminal work The Art of War, emphasizes the importance of strategic calculation and analysis before engaging in battle. The quote from the “Laying Plans” chapter encapsulates this philosophy:
"Now the general who wins a battle makes many calculations in his temple ere the battle is fought. The general who loses a battle makes but few calculations beforehand. Thus do many calculations lead to victory, and few calculations to defeat: how much more no calculation at all! It is by attention to this point that I can foresee who is likely to win or lose."
The Principle of Calculation in Sun Tzu's Strategy
Sun Tzu believed that before any engagement, one must evaluate all relevant factors and only proceed when the chances of victory are high. If the chances are low, it is wise to refrain from action. Engaging in battle without such an assessment is perilous.
The "calculation" Sun Tzu refers to is a thorough analysis, which he valued greatly. He stressed the importance of carefully analyzing both the strengths and weaknesses of one’s own forces as well as those of the opponent, along with the environmental conditions. Only after a comprehensive assessment should a plan of action be developed, one that maximizes the chances of success. The more detailed and precise the analysis, the higher the likelihood of victory; the more superficial the analysis, the lower the chances of success. Engaging without any analysis at all almost guarantees failure.
However, Sun Tzu’s concept of "calculation" is not about analyzing everything indiscriminately. It’s about focusing on key factors and making calculations where they matter most, thereby effectively increasing the probability of victory.
Buffett's Application of Strategic Calculation in Investing
Warren Buffett, a disciple of Benjamin Graham, embodies this strategic approach in his investment philosophy. Graham famously advised, "The first rule of investing is don’t lose money; the second rule is don’t forget the first rule." This principle profoundly influenced Buffett, who understands the critical importance of preserving capital. Therefore, like Sun Tzu, Buffett never makes investment decisions lightly. He always engages in thorough analysis and calculation before proceeding.
In stock investing, Buffett's calculations focus on two critical aspects: analyzing a company's business performance to identify high-quality businesses, and determining the intrinsic value of those businesses. He then waits patiently for the right opportunity to purchase the business at a reasonable price.
For Buffett, a prudent investor only needs to excel in two tasks:
1. Stock Selection: Seek out high-quality businesses with sustainable competitive advantages (economic moats).
2. Valuation: Calculate the intrinsic value of the business and then purchase it at a price below its intrinsic value.
The Connection: Sun Tzu's Strategy and Buffett's Investment Approach
Both Sun Tzu and Buffett emphasize the importance of careful calculation and analysis to ensure success. Sun Tzu’s "temple calculations" before battle and Buffett’s detailed financial analysis before investing are analogous processes. Both aim to evaluate the situation thoroughly to maximize the chances of success while minimizing risk. Just as Sun Tzu advocated for focusing on key factors that would determine the outcome of a battle, Buffett focuses on key business metrics and valuations to guide his investment decisions.
By integrating the strategic insights of Sun Tzu with the financial acumen of Buffett, investors can adopt a disciplined, thoughtful approach to investing that significantly improves their chances of achieving long-term success.
Stock Selection
For Warren Buffett, investing in stocks is synonymous with investing in businesses. His method of stock selection is therefore deeply rooted in a thorough analysis of the underlying company's fundamentals, business model, and financial health. Buffett assesses whether a company possesses a strong competitive advantage and the ability to generate consistent profits by understanding its core competencies.
Buffett's analysis doesn't stop at the company level; he also closely examines the financial information, strengths, and weaknesses of its competitors. This comparative analysis ensures that the company he invests in is a leader within its industry, offering a better chance of long-term success.
Focus on Business Fundamentals
Buffett believes that investors should concentrate on understanding a company's operational performance rather than attempting to predict future stock price movements based on past trends. He famously critiques analysts who rely heavily on technical analysis, comparing them to fortune-tellers who try to predict the future by interpreting patterns in charts. Such "calculations," according to Buffett, do not genuinely enhance the probability of profitable stock investments.
Key Aspects of Buffett's Stock Selection Process
1. Business Quality:
- Sustainable Competitive Advantage : Buffett looks for companies with a durable competitive advantage, or "economic moat," that protects them from competitors. This could be due to strong brand loyalty, unique products, or cost advantages.
- Stable and Understandable Business Model : He prefers businesses with stable, straightforward operations that he can easily understand. This reduces the risk of unexpected negative surprises.
2. Management Quality:
- Integrity and Competence : Buffett places significant importance on the quality of a company's management. He seeks leaders who are both competent and act with integrity, ensuring that they will make decisions in the best interest of shareholders.
3. Financial Health:
- Strong Balance Sheet : Companies with strong balance sheets, low levels of debt, and ample cash flow are preferred, as they are better equipped to withstand economic downturns.
- Consistent Earnings : Buffett values companies that have a history of consistent earnings growth, as this is often indicative of a well-run business with a stable demand for its products or services.
4. Industry Leadership:
- Competitive Positioning : By analyzing a company’s competitive positioning within its industry, Buffett ensures that the business is not only strong but also well-placed to dominate its market. This involves a careful study of competitors to confirm the chosen company’s superior standing.
Valuation
After identifying high-quality businesses, Warren Buffett's next crucial step is to estimate their intrinsic value. Knowing the intrinsic value of a company is essential because it helps determine the price at which one should buy its stock. The more accurate the valuation, the higher the likelihood of a successful investment.
How to Estimate Intrinsic Value?
Buffett has a simple yet effective method for estimating the intrinsic value of a stock: treat it like a bond.
Buffett’s Definition of Intrinsic Value: "It is the discounted value of the cash that can be taken out of a business during its remaining life."
Buffett’s formula for calculating value is straightforward: estimate the cash flows a company is expected to generate in the future and then discount them back to their present value using an appropriate discount rate. This method applies to both stocks and bonds. The only difference is that bonds have a fixed coupon and a maturity date, allowing investors to know the future cash flows with certainty. For stocks, however, the investor must estimate future "coupons," or earnings. Thus, to Buffett, stocks are essentially bonds with variable interest rates.
Buffett’s Valuation Formula
*Intrinsic Value = Sum of Discounted Future Cash Flows
This formula may be simple, but predicting a company's future profits is highly challenging. Even the most experienced analysts can make errors in estimating future cash flows, leading to mistakes in valuing a company's intrinsic worth. However, Buffett has a strategy to minimize these valuation errors.
Buffett’s Approach to Avoiding Valuation Errors
Buffett's method is both straightforward and effective: he avoids trying to value companies with unstable and unpredictable earnings. Instead, he focuses on companies with highly stable and predictable cash flows. These companies typically have simple and stable business models, strong and sustainable competitive advantages, and a unique economic moat. Buffett says, "Since these companies' earnings are as stable as bonds, we can value them using a similar approach."
The Secret Behind Buffett's Stock Selection and Valuation
This approach is the key to Buffett’s success in both stock selection and valuation. By focusing on companies with stable and predictable earnings, he can apply a bond-like valuation method, which is more reliable and less prone to error.
In the context of *The Art of War*’s principle of “Many calculations lead to victory, few calculations to defeat,” Buffett’s “calculations” involve evaluating the quality of a business and estimating its intrinsic value. By focusing on these critical aspects, he increases the probability of investment success.
In summary, Buffett’s valuation process is about estimating the intrinsic value of a company by discounting its future cash flows, much like valuing a bond. He simplifies the process by selecting companies with stable and predictable earnings, making the valuation more accurate and reducing the risk of errors. This disciplined approach to valuation, combined with careful stock selection, aligns perfectly with the strategic wisdom of Sun Tzu — ensuring that the "calculations" are focused where they matter most, thus enhancing the likelihood of long-term investment success.
