How to find “conservative” investments? The ones with the greatest probability of preserving your purchasing power and with the least amount of risk.

Buffett resisted buying large and popular companies because he thought this category was valued irrationally by investors. But then, he was not in favour of buying small, unproven companies as well. As he wrote in his 2010 letter…

At Berkshire, we make no attempt to pick the few winners that will emerge from an ocean of unproven enterprises. We’re not smart enough to do that, and we know it.

Instead, we try to apply Aesop’s 2,600-year-old equation to opportunities in which we have reasonable confidence as to how many birds are in the bush and when they will emerge (a formulation that my grandsons would probably update to “A girl in a convertible is worth five in the phonebook.”).

Obviously, we can never precisely predict the timing of cash flows in and out of a business or their exact amount. We try, therefore, to keep our estimates conservative and to focus on industries where business surprises are unlikely to wreak havoc on owners.

Even so, we make many mistakes: I’m the fellow, remember, who thought he understood the future economics of trading stamps, textiles, shoes and second-tier department stores.

This reiterates Buffett’s key definition of conservatism over these years – conservatism depends on how you choose and not what you choose.

In other words, investing conservatively is not about simply identifying large well-known businesses, but going through a process that identifies why a particular company qualifies as a conservative investment.

As Buffett would want you to understand, there is one simple way to look at a conservative investment.

Conservative investment = Preservation of capital

A conservative investment is one that has the greatest probability of preserving your purchasing power and with the least amount of risk.

This probability can in turn arise from the process that you follow to identify such opportunities that will preserve your purchasing power in the future.

So, where most investors fail in attempting to invest “conservatively” is blindly assuming that by purchasing any security that qualifies as a conservative investment, they are in fact, conservative investors.

In other words, such investors are thinking conservatively, but not acting conservatively.

If you indulge in such things, it could prove to be a costly affair.

Here is what Buffett wrote in 1965…

Truly conservative actions arise from intelligent hypotheses, correct facts and sound reasoning. These qualities may lead to conventional acts, but there have been many times when they have led to unorthodoxy. In some corner of the world they are probably still holding regular meetings of the Flat Earth Society.

We derive no comfort because important people, vocal people, or great numbers of people agree with us. Nor do we derive comfort if they don’t. A public opinion poll is no substitute for thought. When we really sit back with a smile on our face is when we run into a situation we can understand, where the facts are ascertainable and clear, and the course of action obvious. In that case – whether other conventional or unconventional – whether others agree or disagree – we feel – we are progressing in a conservative manner.

The above may seem highly subjective. It is. You should prefer an objective approach to the question. I do. My suggestion as to one rational way to evaluate the conservativeness of past policies is to study performance in declining markets.

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Buffett (2000): IPOs usually result in transfer of wealth and that too on a massive scale from the ignorant shareholders to greedy promoters.

In Warren Buffett's letter for the year 2000, he talked about how investors, in their irrational exuberance, tend to gravitate more and more towards speculation rather than investment. Let us go further down the same letter and see what other investment wisdom he has to offer.

IPO – It’s Probably Overpriced

If it is out there in the corporate world, it has to be in the master's annual letters. Over the years, Mr. Buffett has done an excellent job of giving his own unique perspective of the happenings in the business world. Whatever be the flavour of the season, you can rest assured that it will be covered in the master's letters. Since the letter for the year 2000 was preceded by the famous 'dotcom bubble' and the flurry of IPOs associated with it, the master has spent a fair deal of time in trying to give his opinion on the same. And as with other gems from his larder of wisdom, strict adherence here too could do investors a world of good.

On IPOs, the master goes on to say that while he has no issues with the ones that create wealth for shareholders, unfortunately that was not the case with quite a few of them that hit the markets during the dotcom boom. Unlike trading in the stock markets, IPOs usually result in transfer of wealth and that too on a massive scale from the ignorant shareholders to greedy promoters. The master feels so because taking advantage of the good sentiments prevailing in the markets, a lot of owners put their company on the blocks not only at expensive valuations that leave little upside for shareholders but most of these companies end up destroying shareholder wealth.

Hence, while investing in IPOs, two things need to be closely tracked. 

• One, the issue is not priced at exorbitant valuation and 
• second, the company under consideration does have a good track record of creating shareholder wealth over a sustained period of time. 

Thus, if an IPO is only trying to sell you promises and nothing else, chances are that you are playing a small role in making the promoter, Mr. Money Bags.

Master's golden words

Let us hear in the master's own words his take on the issue. He says, "We readily acknowledge that there has been a huge amount of true value created in the past decade by new or young businesses, and that there is much more to come. But value is destroyed, not created, by any business that loses money over its lifetime, no matter how high its interim valuation may get."

He further adds, "What actually occurs in these cases is wealth transfer, often on a massive scale. By shamelessly merchandising birdless bushes, promoters have in recent years moved billions of dollars from the pockets of the public to their own purses (and to those of their friends and associates). The fact is that a bubble market has allowed the creation of bubble companies, entities designed more with an eye to making money off investors rather than for them. Too often, an IPO, not profits, was the primary goal of a company's promoters. At bottom, the ‘business model’ for these companies has been the old-fashioned chain letter, for which many fee-hungry investment bankers acted as eager postmen."

To conclude, the master says, "But a pin lies in wait for every bubble. And when the two eventually meet, a new wave of investors learns some very old lessons: 

• First, many in Wall Street - a community in which quality control is not prized - will sell investors anything they will buy. 
• Second, speculation is most dangerous when it looks easiest."

Buffett (2000): Discounted cash flow approach to valuations is the single most important tool in valuing assets of any kind. 'A bird in the hand is worth two in the bush.'

Warren Buffett described his reluctance to invest in tech stocks and the key reasons behind the same (in his 1999 letter to shareholders). Let us move further to the next year and see what the master has to offer in terms of investment wisdom at the turn of the millennium i.e., in his letter from the year 2000.

Buffett's acquisition spree

The year 2000 was the year that could easily go down in Berkshire's history as the ‘year of acquisitions’. Sensing favorable market conditions, the master completed two transactions that were initiated in 1999 and bought another six businesses during 2000, taking the total to eight. This steady stream of acquisitions is perhaps what inspired him to once again bring his theory of valuations out from the closet and present it before his shareholders. However, while the underlying principles of his theory remained the same, it came cloaked in a different analogy.

What Aesop taught Buffett?

This time, the master has turned to Aesop for help and likens the process of performing valuations to his famous saying - 'a bird in the hand is worth two in the bush'. Without getting too much into details, suffice to say that the master reaffirms his faith in the discounted cash flow approach to valuations and believes it to be the single most important tool in valuing assets of any kind, right from stocks to as exotic assets as royalties and lottery tickets.

Let us read the master's own words on his thoughts -

"The formula we use for evaluating stocks and businesses is identical. Indeed, the formula for valuing all assets that are purchased for financial gain has been unchanged since it was first laid out by a very smart man in about 600 B.C. (though he wasn't smart enough to know it was 600 B.C.)."

"The oracle was Aesop and his enduring, though somewhat incomplete, investment insight was ‘a bird in the hand is worth two in the bush’. To flesh out this principle, you must answer only three questions. 

• How certain are you that there are indeed birds in the bush? 
• When will they emerge and how many will there be? 
• What is the risk-free interest rate (which we consider to be the yield on long-term US bonds)? 

If you can answer these three questions, you will know the maximum value of the bush 3/4 and the maximum number of the birds you now possess that should be offered for it. And, of course, don't literally think birds. Think dollars."

"Aesop's investment axiom, thus expanded and converted into dollars, is immutable. It applies to outlays for farms, oil royalties, bonds, stocks, lottery tickets, and manufacturing plants. And neither the advent of the steam engine, the harnessing of electricity nor the creation of the automobile changed the formula one iota 3/4 nor will the Internet. Just insert the correct numbers, and you can rank the attractiveness of all possible uses of capital throughout the universe."