Many people look at business and investing as two completely different activities: one requires organizing employees, materials, and other inputs in a way that can generate profit over time; the other requires watching prices on a screen and getting ahead of whatever trade comes next.
But at Bluestone, we view business and investing as two sides of the same coin. The same philosophy and approach can be applied to both, it’s simply that in business the owner is the operator. Whereas in investing, the owner hires a manager or management team to run the operation. We love owner-operators and that’s who we focus on with our advisory services.
So how does a thoughtful private investor assess an opportunity, whether as a business to be run or an investment to be made? In their 3rd quarter 2019 commentary(1), investment manager Horizon Kinetics (HK) put it this way:
“Here are two investment choices; it’s a test. You can buy only one. Remember, there are no wrong answers.
The first is a simply terrific, large-cap, name-brand, debt-free company growing at 20% per year.
The second is a newly bankrupt corporate bond with a 5% coupon.
Which do you choose?
If you’ve already made a choice or were about to, I’m sorry, but you fail the exam.”(1)
How can that be? Isn’t it obvious that the fast growing large-cap company is the better investment?!
Pump the brakes. Making a choice means you fail because you do not know the most important piece of information – the price.
HK goes on to point out that if the large-cap growth company trades at 35x earnings, it’s highly unlikely you’ll get a satisfactory long-term return. Yes, there are exceptions, but the probabilities are decidedly not in your favor. Now let’s say the bond trades at 50c on the dollar and is expected to emerge from bankruptcy in 18-24 months and has good standing relative to other liabilities and total assets such that it will very likely be paid off at 100c. The two-year return is 41% annualized. Even if repaid at 75c in three years, the annualized return is 14%. Not bad for a security with contractual protection that mitigates downside risk.
These different securities – the growth company and the bond – are neither good nor bad in isolation. It is price that makes them so. And price is just a reflection of what other investors think of those securities.
HK also notes that storied investors, like Buffett, Icahn, and Zell, understand this dynamic extremely well:
“They buy securities that have been priced by OTHER PEOPLE to their satisfaction, companies that other investors have fled or simply abandoned. They bide their time. They don’t try to earn steady returns most of the time with only short periods of volatile interruptions; they keep their capital safe most of the time, awaiting those volatile interruptions. It’s a wholly different understanding of how the market works.”(1)