Plenty of people admire Warren Buffett, the billionaire "oracle of Omaha," for his prowess as an investor, but there is one thing he can be criticized for: making investing look too easy. Other famous investors have done the same kind of thing, including legendary fund manager Peter Lynch, who turned the tiny Magellan Fund into a $13-billion (U.S.) behemoth and outperformed the S&P 500 by a huge margin for 10 years in a row.
Whatever dreams of glory they may have, every weekend warrior who plays in a shinny league doesn't think he can play hockey as well as Wayne Gretzky did, nor does every duffer on the course believe that he is as good a golfer as Tiger Woods but investors large and small are convinced that they can produce the same kind of returns that Warren Buffett does, or Peter Lynch did. Buy low and sell high; how hard could that be?
Well, guess what it's hard. Some might think that it has gotten a whole lot harder over the past year or so, with companies imploding right and left as a result of accounting scandals or restructuring themselves due to their staggering debt levels, and debate raging about whether the Dow and the Nasdaq are still wildly overvalued or an unparalleled buying opportunity. But in reality, things are just starting to get back to normal now on the investing front, and the fact is that even normal investing is hard work.
This may seem rather obvious. And yet, over the past few years at least, the conventional wisdom seemed to be that investing wasn't really that difficult at all. You could buy shares of just about anything particularly on the Nasdaq Stock Market, but even stodgy old members of the Dow Jones industrial average and see them increase in value at a fairly rapid rate, in some cases by 10 or even 100 times. The fact that '10 baggers' are normally as rare as a hole in one in golf didn't bother most people.
If you followed any of the coverage of the Enron accounting scandal, don't feel bad if you got hopelessly confused about the methods the energy firm used to disguise the true state of its business the off-balance-sheet entities, the multitude of interrelated subsidiaries, the fluid nature of the company's 'mark-to-market' method of valuing its assets, and so on. How could even an accountant understand any of that, let alone an investor trying to assign a real-world value to the company's stock?
The cruel truth, however, is that this is precisely what investors have to do, if they want to take any kind of responsibility for their own investments as opposed to handing some money over to a mutual fund manager and forgetting about it, that is. Obviously, it's impossible for the average investor to root out actual fraud or duplicity but much of what Enron did, irresponsible or not, was laid out in its financial statements. The same goes for WorldCom, and Global Crossing, and dozens of others.
WorldCom's alleged transgression was easier to understand than Enron's, but it still points out an inherent difficulty with investing, which is that there is an awful lot of interpretation involved more than profiles of Mr. Buffett tend to let on. In a nutshell, the company took money that it paid other telecom companies for access to their network and booked it as an investment rather than as an immediate cost. The sum involved was massive $4-billion or so but the process was relatively mundane.
Various experts have said this was clearly wrong, but others disagree. They say WorldCom may have erred, but that the debate about whether to book spending as an investment or an up-front cost is far from black and white just as the debate over whether to record stock options as an expense has experts on either side. And now that more firms have started to expense options, the debate is over how to value them (current value, future value using some form of discount rate, the Black-Scholes equation, etc.).
The painful reality is that all companies make judgments when they report their financial results. Some including plenty of blue-chip companies take advantage of grey areas in the rules to move revenue from here to there, or stockpile profits for a rainy day, or count things that aren't profits, or try to distract investors from real costs. More rules won't help, and could even make matters worse. Trying to understand inside and out how a company operates, how it makes money, is the only defence.
But Warren Buffett doesn't have to worry about evaluating how a company works, or making judgments about their financial reporting, does he? He just invests in firms like Dairy Queen and Coca-Cola and then hangs onto them until he's even richer than he already was. A nice story, but not true. Mr. Buffett goes through a fairly exhaustive analysis of a company's balance sheet, and along the way he makes all sorts of judgments. After all, his approach is to value a company based on "the discounted value of the cash that can be taken out of a business during its remaining life."
How is that cash produced? Discounted by what method? Over what period? Using what kinds of assumptions? How do you determine a company's "remaining life"? Those aren't easy questions and Mr. Buffett would probably be the first to admit it. Guess what? Investing is hard.
E-mail Mathew Ingram at mingram@globeandmail.ca
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