What is a No-Brainer investment?

By Joe Ponzio on February 29, 2008  |  18 comments

A few weeks back, I sent an e-mail to our advisers talking about the "no-brainer" type investments we are looking for. I wrote a nice, long e-mail (in true Joe fashion) about discounted cash flow and valuing businesses, about speculation versus investing - it was practically a novel in and of itself. Then, I deleted the whole thing, and started from scratch.

The way I figured it, you shouldn't have to be a rocket scientist to understand "no-brainer" investing. Here's a recap of what I wrote:

What is an investment? As I've told you in the past, I'm a big fan of putting money in when an opportunity jumps out at me. Let's look at (and use) the definition Ben Graham laid out in 1934:

An investment operation is one which, upon thorough analysis, promises safety of principal and a satisfactory return. Operations not meeting these requirements are speculative.

I have a $100 bill for sale, but it comes with a catch: You have to pay me today and I'll deliver the bill in five years. Right now, thousands of people are bidding on this bill. I've got offers as high as $86 and as low as $50. What's it worth to you? To truly understand the opportunity being offered, we apply Graham's 3-point definition - the foundation of all investing.

Safety of Principal

For this example, we'll simply assume that you will know where to find me in five years, and that I'll have at least $100 to my name. Safety of principal is a non-issue here.

Thorough Analysis

When analyzing companies, you must thoroughly analyze the prospects of the company, the management, the financials, and the future outlook - not just for tomorrow, but for five and ten years from now. In workouts, you must thoroughly analyze the terms of the deal, the price offered, the timeline, and the risks involved.

Thorough Analysis means an in-depth analysis of the opportunity, not just the price. (That's why some horrible companies can present attractive investment opportunities from time to time.)

For my $100 bill offer, you must thoroughly analyze the opportunity - what will this $100 bill be worth in five years? (We assume you know what a $100 bill is and that the US Government is guaranteeing that it will remain as legal tender.) Right now, inflation is running about 3% a year. (I can't remember the last time I saw just a 3% increase in anything. A discussion for another time.) Five years from now, my $100 bill will be worth $85.87 in today's dollars. If inflation is higher - say, 6% - the bill will be worth just $73.39 in today's dollars. Your thorough analysis leads you to believe that inflation will be about 5% over the next five years, and that this $100 bill will be worth $77.38 in today's dollars.

We now know (a) your principal is safe because I'm personally guaranteeing the $100 bill and that guarantee is good, and (b) after careful consideration and analysis of the US economy and inflation, I'm offering you $77.38 in today's value.

Satisfactory Return

Now, a little math. I'm going to present the actual math so that you can see the numbers; then, I'm going to show you the "no-brainer" way to buy $100 bills. Not a math person? Don't be scared, just follow along for the explanation.

You want to earn at least 10% on your money each year, net of inflation. You have an opportunity to buy $77.38 of value, net of inflation. If you offer me $77.38, you can expect to break dead-even. Offer me more, and you will lose money to inflation, even if you make $20 or so in real dollars.

So, what's the price you can pay?

Excel tells me that the present value of this $100 bill is $48.05, assuming 5% inflation and a 10% after-inflation return. Said another way, you can offer me $48.05 today and expect to earn 15% a year for five years (10% a year after 5% annual inflation) and to end up with $77.38 in today's dollars.

Returning to Safety of Principal

We now turn back to Safety of Principal We initially assumed that (a) you knew where to find me, (b) I'd have $100 to my name, and (c) the United States would still be honoring today's $100 bills as legal tender. In reality, you don't know exactly where I'll be and you can't follow me around all day. (Just like in stocks. We have officers and directors to "follow the company around all day" because we can't. And that's a risk.)

Enter the Margin of Safety. At $48.05, everything would have to play out as planned for you to earn 10%, net of inflation. If I'm not around, you lose money. To protect yourself from this risk, you decide to split your money up. Rather than buying one $100 bill from me for $48.05, you choose to buy two $100 bills - one from me, one from another guy in another town also offering $100 bills. With $48.05 to spend, you offer each of us $24.02, and refuse to pay any more than that. You demand a 50% Margin of Safety.

Doing so, you have cut your risk in half. If both of us are around in five years, you'll earn much more than 10% because you'll have bought $77.38 of value for just $24.02 - and did it twice - for an average annual return of 26%. If one of us can't cough up the $100, you'll still be paid on the other. You'll lose 100% on one investment, but earn 26% on the other, netting you 10% after inflation. You would have still invested a total of $48.05 and ended up with one $100 bill.

(Diversify? You can't put all your eggs in one basket, nor should you put each egg in a separate basket.)

The Full Package

To truly understand this opportunity, you must have an understanding of inflation, the direction of the economy over the next five years, discounted cash flow, and more. To identify a "no-brainer" investment, you must be able to fully understand the offer.

In common stocks, you must understand the business and its future; in workouts, you must know the terms and the risks. "No-brainers" only appear easy if you have put some thought into the opportunity.

So, how will I know when I see a no-brainer?

If I offered you the above $100 bill deal, you know exactly what price to pay because we just went through all the math, we analyzed the risks, and we attacked the problem from all sides. And now that you have a somewhat intimate knowledge of how to buy $100 bills, use it to find opportunities.

For sale: $50 bills, payable in five years. $6.74, or best offer.

Want one?

Also Filed Under "How to Think About Investing"

• Pabrai's Law of Large Numbers
• Investing Made Simple by Warren Buffett
• Predicting The Future of a Troubled Business
• The Dangers Of Overdiversification