Consensus is what you pay; the relationship to value determines what you get.

The foundation of “value investing” is built on a narrative that price and value are two distinguishable components. Benjamin Graham, also known as the father of value investing, is often credited as the first author of this narrative. The best evidence for this, if we exclude The Intelligent Investor and Security Analysis, is a quote from one of his famous disciples:

Additionally, the market value of the bonds and stocks that we continue to hold suffered a significant decline along with the general market. This does not bother Charlie and me. Indeed, we enjoy such price declines if we have funds available to increase our positions. Long ago, Ben Graham taught me that “Price is what you pay; value is what you get.” Whether we’re talking about socks or stocks, I like buying quality merchandise when it is marked down. – W. Buffett [2008 Berkshire Shareholder Letter]

The “Price is what you pay; value is what you get” phrase has become one of the most quoted expressions in value investing circles. It has also become one of the most misunderstood and misused quotes in investing. Still, I would argue that it is the most important quote in investing. This is what this post will be about.

We are all value investors, but…

One can make the argument that independent of our investment approach, fundamental analysis, technical analysis, indexing or pure speculation to buy low and sell high, no-one will buy something for more than what they think it is worth (i.e. the basic premise of what constitutes value investing). In other words, all investors have the intention to make money when they buy an asset. The opposite would be paradoxical and although I believe that we humans are not very rational I also believe we are not irrational. My point is, all market participants are inherently value investors.

But let us take a step back and consider this:

Not all successful investors call themselves value-investors and not all investors that call themselves value-investors are successful.

or if I haven’t convinced you with my “we are all value investors” argument:

Not all successful investors call themselves [insert investing philosophy]-investors and not all investors that call themselves [insert investing philosophy]-investors are successful.

First of all, I make the statement above to point out that there exists no need to put investing-labels on ourselves or to fight on Twitter with a purpose to defend our investment-style. Outside of Twitter, the same phenomena exist in books on investing, in blog posts and podcasts on investing etc. I have been there myself and I can honestly say that nothing fruitful come out of these discussions. That is not to say that this phenomenon of labeling ourselves and that we defend our investment-style with nails and claws is not interesting. To the contrary, this is extremely interesting!

What fascinates me is that it seems like we have an inherent urge and need to belong to a certain tribe of investors. An urge and need to subscribe to a certain investing philosophy with the simultaneous exclusion of other approaches although we might share some common ground. As you probably realize, the very same phenomena can be found in discussions about politics, sports, religion etc. In the case of investing though, I would argue that this urge and need makes us blind for the path towards the holy grail of investing. It makes us forget about the only question an investor needs to focus on. That is the question of:

What determines the success of an investor?

The holy grail of investing

I can assure you, answering the question above and you have attained the map to the holy grail of investing. Answering the question and you have almost figured it all out. The answer is “simple but not easy” as Mr. Munger has famously said about investing in general. But let me give you the answer:

The success of an investor is determined by the exploitation of price and value. More specifically, buying assets for less than they are worth

This conclusion goes back to my argument that we are all value investors. With the help of inversion we also realize that; if we buy something for more than it is worth we will be unsuccessful investors. However, this simple answer is not easy to implement successfully. Especially on a reoccurring basis. The reasons for that are multiple. On an overall level though I would argue that it has to do with a basic misunderstanding of the value/worth component as it relates to the price paid for an asset.

The quality-fallacy

The basic misunderstanding is this:

Buying good things ≠ Buying things good

or said differently:

Quality ≠ Value

What I mean with the two statements above is that the quality characteristics of an asset (i.e. good things) are not a substitute for buying assets for less than they are worth (i.e. buying things good). Investors fall for this quality-fallacy all the time. The reason for that is that it’s far easier emotionally to buy and own what is considered to be of quality (good asset) than what is considered non-quality (bad asset). Unfortunately though, in investing the quality of an asset is not a determinant for the value you will get. This is a mistake that people make all the time when investing. This is even true if one isn’t careful to think about what the quote that started this post “Price is what you pay; value is what you get.” really implies. Let me explain.

A simple misunderstanding

What people don’t understand or misinterpret about the quote is that the value component, “what you get”, is a residual. What you get is the difference between the price paid for an asset in relation to the value of that asset. That is the value you will “get” as an investor. Again, I would like to point out that “value” in this quote is not a synonym for the quality of that asset, as some people would like to believe. Making this mistake is not something to be ashamed of considering how the quote was framed by Buffett himself:

Long ago, Ben Graham taught me that “Price is what you pay; value is what you get.” Whether we’re talking about socks or stocks, I like buying quality merchandise when it is marked down. – W. Buffett [2008 Berkshire Shareholder Letter]

I know that buying “quality companies” has been key to Buffett and Munger (Berkshire’s) success. However, people forget that they have still bought those companies at a price below their worth (i.e. “when it is marked down”). Too often though I see their philosophy for what constitutes a good investment dwarfed into an argument that a good company equals a good investment (i.e. “I like buying quality merchandise”). Although their methods for determining value were different from those used by Graham they never deviated from the lesson of what determines the success of an investor. That is, buying assets for less than they are worth. Remember that.

Evolving the quote

In order to make what I consider the most important quote in investing a bit clearer and to summarise this post I thought I would wrap things up with an evolved quote. In order to fully understand this evolved quote, I would like to frame it with the help of two favorite quotes of mine. These quotes will help to explain the “price” component and the drivers behind what makes an investor not only successful but more successful than everybody else. Both quotes are from the famous investor H. Marks:

The price of a security at a given time reflects the consensus value. The big gains arise when the consensus turns out to have underestimated reality [value], or to have miss-estimated reality [value]. To be able to take advantage of such situations, you must be able to think in a way that’s away from the consensus. You must think different and you must think better. It’s clear that if you think the same as everybody else, you’ll act the same as everybody else, and have the same results as everybody else. – H. Marks

[value] has been added by me to the original quote.

Note that Mr. Marks is not saying “different and right” in the quote above, he is saying “different and better”Better in the sense that:

Superior performance does not come from being right, but from being more right than the consensus. You can be right about something and perform just average if everyone is right too. Or you can be wrong and outperform if everyone else is more wrong. – H. Marks

Based on what I have concluded in this post and what H. Marks has helped to explain in the two quotes above:

Price is what you pay; value is what you get.

evolves into:

The consensus expectations of value is what you pay today; the realization of those expectations in relation to the value at a future date is what you get.

or as I would like you to remember with the help of fewer words:

Consensus is what you pay; the relationship to value determines what you get.

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