Saturday, January 21, 2012

Snowmen and Shovels: Investing Lessons?

I live near New York and woke up this morning to our first snowstorm of the winter (we had a freak one in the fall but no snow in November and December). As I looked out of my window, I heard two sounds. The first was of small children squealing in delight, as they tromped through the snow and started building snowmen and throwing snowballs. The second was the grating sound of snow shovels being used by their (mostly morose) parents to clear the snow from their driveways. Three things came to mind. The first was the oddity of the same phenomenon (a snow storm) evoking such different reactions from two different groups. The other was the irony  that the parents were one day (long ago in the past) happy to see the snow and today's  happy children will one day grow up and be wielding their own snow shovels. The third is that a week from now when it warms up, the snowmen will melt away, and the unshoveled driveways will look just as good as the shoveled ones.

I am sure that there are some deep life lessons in this phenomenon but I am not a philosopher. I do see some investing and valuation lessons in snowmen and shovels. After all, you can divide the world of active investors into two broad camps: growth investors and value investors. Consider the extremes in each camp. Extreme growth investors (you know the ones.. they go for momentum, love IPOs and are dazzled by high growth) remind me of the happy children, looking at snow and seeing snowmen, whereas extreme value investors (and you also know these ones.. they love net net investing and read Ben Graham's Security Analysis for inspiration)  more closely resemble the snow-shoveling parents. Each group views the other with disdain. Extreme value investors consider growth investors to be dilettantes, unserious and unwilling to grow up, who see the world through rose-colored lens. Extreme growth investors view value investors as boring, stuck-in-the-mud pessimists, who see only the dark side of things.

So, which side is right? I think both sides are right and both are wrong. While each side sees a portion of reality, each side is also missing a piece of the real world. While the value investing group is right in its view that most growth companies will not make it through the challenges of the real world, the growth investing group is also right in its view that some of these growth companies will be the big winners of the future. By staying dogmatic, both groups open themselves to significant investing/valuation mistakes. A growth investor who closes his eyes to the very real likelihood that a growth company will not survive will over value that company. By the same token, a value investor who insists on incorporating only the worst case scenarios, estimates cash flows “conservatively” and then applies a huge “margin of safety” before investing will never find growth companies to be bargains.

The key to investing, as in so much in life, is to maintain balance, recognizing that dreams sometimes come true, while keeping your feet grounded in reality. Put in valuation terms, the key to valuing a company well is to estimate what will happen (to earnings and cash flows) not only in good scenarios (let’s call these the snowman scenarios) but also in bad ones (the shovel scenarios).  It is a challenge I face whenever I do valuation. As I value a company, I have to constantly stop and look at the assumptions I am making and whether I am tilting too much to one side (snowman or shovel). If I find myself tipping too much into the “snowman” camp, I have to bring in some of my “shovel” side to play to get back to synch. If, on the other hand, I am letting my pessimistic shovel side dominate, I have to consciously force my fun snowman side come into play. 

So, here is how I am going to start today’s path back to balance. I shoveled this morning, just before I came in and wrote this post. My kids are too “old” to enjoy building snowmen, but I am not. I am going to go out and build a snowman, make a snow angel and perhaps throw some snowballs. Why should those kids have all the fun?

17 comments:

andres leon said...

Very true, thank you! I'm passionate about this subjects and this balance is worth remembering. Have fun!

Anonymous said...

..... and then there are those who build ice hotels for people to come and stay in

Vignesh Rajan said...

Awesome post Ash

Eric Burkholder said...

If 100 years of data shows active managers rarely beat the market after fees (or after the effort spent shoveling/building snowman), why not purchase a small share of all the snow shovelers and snowmen in the neighborhood and gain access to growth and value factors at a much lesser cost and 96% of return?

Barry said...

I think perhaps you are more of a philosopher than you realize.Thanks for the thought provoking ideas I am going sledding with my kids!

Urquiagga HL said...

I think the cold made ​​the philosophical side prevail today.
I can draw a parallel between the children playing in the first rains of the year and their parents worried about the flooding in the streets that they may find on the way to work tomorrow ...

Vinicius Caldas said...

I´ve never thought that snowmen and shovels could teach us something about investing until reading this post. A great metaphor, Professor. That proves all in the world is (or almost is) finance.

Anonymous said...

As a child growing up in the 80s, there was a commercial for Honeycomb cereal which had an enormous impact on me. It portrayed a kid, sans any safety gear, racing through the woods on his bmx bicycle, taking jumps and generally looking awesome.

I took inspiration from that and built a ramp out of cinder blocks and plywood so that I could emulate and enjoy the awesome success of the kid in the commercial.

On my first run the thing collapsed and I obtained a scar across my chest which I still have today.

Now that I am a shoveler, I would never attempt such a feat. Reason being, that my snowman builder of the past was far more able to sustain and recover from injury than my old shoveling self today.

Thanks for the post, I found it very inspirational.

Immortal said...

Great observation and your passion for picking out valuation lessons such easily is remarkable :)

Ashwini Chube said...

What a wonderful observation and it is remarkably fantastic to apply the snowfall facts to Valuation.Fantastic Article!!

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Anonymous said...

" Why should those kids have all the fun?"

AWESOME. you are a great writer and true value investor. Driving a valuable lesson for life out a snowstorm for FREE.(isn't this the theme of value investing)

Akhil Parekh said...

Nice post Prof. There is so much to learn from your blogs and website. Hats off to you ! I believe if there is desire to learn new everyday, there will always be good people like you spreading knowledge. Once again thanks for the valuable information you keep on sharing !!

Geraldine said...

A very apt analogy. I read this blog today for the first time, but I'm sure I will do that in the future many times.

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