Avocado & Wasabi

In our line of work, continuing to learn is essential. There are many ways to learn new things. You can set about the task directly, or you can take a more passive approach and see what you can glean from other people’s experience. In my case, valuable lessons have been learned erratically, sometimes from unexpected sources, and often by surprise. Here’s a funny (now) example.

Many years ago, I set out to learn what sushi was all about by eating it. In all my excitement, I mistook wasabi for avocado. When I popped a large green mass in my mouth to cleanse my palate, I learned something quite profound and unexpected. Wasabi and avocado may look similar, but the experience of eating them is profoundly different. Lessons like that are hard to forget, even at my age.   

Which brings me to an investment lesson I once learned with equal shock and awe: the distinction between investment merit (think avocado) and speculative merit (think wasabi). A strong business with a defensible moat, pricing power, and a history of delivering consistent and growing cash flows has intrinsic value. The business is worth all the future cash flows it will deliver to its owners. Since investors are fickle human beings, prices will fluctuate above and below the underlying intrinsic value of the business. Investment merit focuses on the relationship between price and intrinsic value. It is the backbone of Warren Buffett’s approach to investing.  

Speculative merit, by contrast, relies on the belief that someone else will pay a higher price tomorrow, regardless of the underlying value of the asset. Speculative merit is more colorfully known as “The Greater Fool Theory”. When the speculative thesis is compelling, the price you pay for a speculative asset is irrelevant, so long as a “greater fool” will pay a higher price later.  

There is nothing inherently wrong with speculative merit. Momentum is a powerful force. There is often money to be made from chasing hot trends, especially when “greater fools” are present in abundance.   

The real danger lies in mistaking speculative merit (wasabi) for investment merit (avocado). When the fickle attention of the markets turns back to valuing returns to cash flows, pricing power, and other fundamental drivers of intrinsic value, the supply of “greater fools” can evaporate quite suddenly. Prices not only react quickly, but they often overreact, falling below intrinsic value. I speak from personal experience when I say it is extremely uncomfortable to find out you are among the last of the “greater fools.” When the technology bubble burst in early 2000, I was overweight names like 3Com, Cisco Systems, Compaq, Oracle, and WorldCom. What I thought was investment merit turned out (in many cases) to have been speculative merit.  

Markets are forever humbling. Let us all remember: wasabi is best consumed in moderation and with proper intent.

Mike Masters