Housing Goes from Graham to Munger

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Dear fellow investors,

Ben Graham is ascribed as being the father of value investing. The intellectual framework he brought to investors was using the available accounting to measure value of a business. His way of measuring was book value, the total assets minus all liabilities. By figuring out this number, he could then divide this metric by the total shares outstanding to understand how much book value per share (what some may call net worth) a company had versus what the price the shares were trading for in the stock market.

This is where we get the famous axiom, “Price is what you pay. Value is what you get.” Graham specifically preferred book value that was predominantly cash or marketable securities. Liquid assets made the book value easier to understand. In this lens, an investor would have little regard for the amount of income that a business can generate over time as he primarily focused on the balance sheet.

Warren Buffett was hugely influenced by his teacher’s concepts early in his career. In later years, after being introduced to Charlie Munger and witnessing what they saw with their investment in See’s Candy, he began to think much more about the future of a business than the current balance sheet.

Charlie Munger is widely quoted for saying: “Over the long term, it's hard for a stock to earn a much better return than the business which underlies it earns. If the business earns 6% on capital over 40 years and you hold it for that 40 years, you're not going to make much different than a 6% return—even if you originally buy it at a huge discount. Conversely, if a business earns 18% on capital over 20 or 30 years, even if you pay an expensive looking price, you'll end up with a fine result.” What Munger is pointing to is not the current book value, but instead how the book value could grow. Return on equity (ROE) is nothing more than book value growth.

Munger’s principle is true no matter how you run the numbers. A company running 18% ROE doubles their book value every four years. A company running 6% doubles book value every twelve years. This would lead an investor to pay a multiple relative to the amount of time needed to grow book value. If we are talking about twelve years, you’d pay three times as much for the current book value of the investment doubling book in four years, though this is not perfect as you can’t know the future of either investment.

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