Price on Value
September, 2000

Dedicated to Warren Buffett, the Sherlock Holmes of the stock market, on his 70th birthday

What has Sherlock Holmes got to do with investing? Most people, including myself up to a few years ago, would probably answer nothing. But something happened in 1997 that made me change my mind.

At the time I was mulling over a talk I was to give at a conference on the mathematics of options. My mind went from thinking of the pricing of options as paradoxical to thinking of them as mysterious. From there I went to Sherlock Holmes who was created by Sir Arthur Conan Doyle as the world's greatest detective, the pre-eminent person to solve any mysteries.

This led to two outcomes. The first was that I prepared a talk entitled the "The Case of the Missing Ten Pounds." It described the arcana of the theory of pricing futures and options in the setting of a Sherlock Holmes mystery. This talk became an article that you can read on my website.

The second outcome was that I reread all the Sherlock Holmes books and articles on the lookout for quotations that could be interpreted as sound advice for long-term strategies for the stock market. All right, we all do weird things from time to time. The important thing is that I came across a lot of pithy comments that can be directly applied to the stock market.

As this is the occasion of the second anniversary of writing the Price on Value articles, I thought that I would give you some of the quotes. Most of the quotes are from conversations that Holmes has with his friend and biographer, Dr. John Watson. Just let your imagination go and think of Holmes as expounding on principles of long-term investing in quality companies.

Methods

You know my methods in such cases, Watson: I put myself in the man's place, and having first gauged the man's intelligence, I try to imagine how I should myself have proceeded under the same circumstances. (The Musgrave Ritual)

You'll get results, Inspector, by always putting yourself in the other fellow's place, and thinking what you would do yourself. It takes some imagination, but it pays. (The Adventures of the Retired Colourman)

These quotes reminds me of Warren Buffett's many comments stating that he tries to think as an owner of any company that he might invest in. "I always picture myself as owning the whole place," he once said.

Ask your self questions such as, "What could go wrong?" and "Who are the competitors?"

Relevance

It is of the highest importance in the art of detection to be able to recognize out of a number of facts which are incidental and which are vital. Otherwise your energy and attention must be dissipated instead of being concentrated. (The Reigate Squires.)

We approached the case, you remember, with an absolutely blank mind, which is always an advantage. We had formed no theories. We were simply there to observe and to draw inferences from our observations. (The Cardboard Box.)

The difficulty is to detach the framework of fact-of absolute, undeniable fact-from the embellishments of theorists and reporters. (Silver Blaze.)

It has long been an axiom of mine that the little things are infinitely the most important. (A Case of Identity.)

When analyzing a company, focus on what is important and don't get stuck in side issues. Buffett started his career in New York but moved back to Omaha, Nebraska, where he found it "much easier to think." On Wall Street everyone has an opinion, a hot tip, but ultimate success depends on separating the facts from, as Holmes said, "the embellishments of theorists and reporters." Here we might add, "and stock analysts."

Secrecy

You know a conjurer gets no credit when once he has explained his trick; and if I show you too much of my method of working, you will come to the conclusion that I am a very ordinary individual after all. (A Study in Scarlet)

One of Sherlock Holmes' defects-if, indeed, one may call it a defect-was that he was exceedingly loath to communicate his full plans to any person until the instant of their fulfillment. Partly it came, no doubt from his own masterful nature, which loved to dominate and surprise those who were around him. Partly also from his professional caution, which urged him never to take any chances. (The Hound of the Baskervilles.)

We know just how secretive Buffett is regarding his investment decisions. He once said that he is lucky to have one good idea each year. "Good investment ideas are rare, valuable and subject to competitive appropriation just as good product or business acquisition ideas are," he wrote in the Berkshire Hathaway Owner's Manual. By keeping ideas a secret and at the same time acting on them with sizeable investments, Buffett ensures that Berkshire Hathaway profit the most every time his mental light bulb lights up.

Present Value

To determine its exact meaning I have been obliged to work out the present prices of the investments with which it is concerned. (The Adventure of the Speckled Band.)

Here we have it. Perhaps the first statement anywhere that the important calculation when valuing an investment is to determine the present or discounted value of its financial rewards. As Buffett has said, intrinsic value is "the discounted value of the cash that can be taken out of a business during its remaining life."

Putting it together

When Watson said that he thought that Holmes had seen more in the rooms than was visible to him, Holmes replied, "No, but I fancy that I may have deduced a little more. I imagine that you saw all that I did."(The Adventure of the Speckled Band.)

A similar idea is expressed in "A Case of Identity" in which Watson remarked that Holmes had seen things that were invisible to him to which Holmes replied, "Not invisible, but unnoticed, Watson."

Another time Watson complains that he cannot see anything unusual about what Holmes was showing him. Holmes responds, "On the contrary, Watson, you can see everything. You fail, however, to reason from what you see. You are too timid in drawing your inferences." (The Adventure of the Blue Carbuncle.)

I see no more than you, but I have trained myself to notice what I see. (The Adventure of the Blanched Soldier.)

Isn't this the secret core of investing? The ability to see what everyone else sees, the company reports, the products, the competitors, and so on, but to see it in a new way so that you can tell whether it is a superior investment or just another ho-hum stock. Buffett, for example, said that when he made his major purchase of Coca Cola stock that he only used the same information and material that was available to everyone else. The difference was that he deduced more than everyone else to arrive at the conclusion in 1988 that this was an excellent investment. He was right; the stock quadrupled in value over the next four years.

Stay with the facts

It is a capital mistake to theorize in advance of the facts. (The Adventure of the Second Stain.)

No, no: I never guess. It is a shocking habit¾destructive to the logical faculty. What seems strange to you is only so because you do not follow my rain of thought or observe the small facts upon which large inferences may depend. (The Sign of Four)

The temptation to form premature theories upon insufficient data is the bane of our profession. (The Valley of Fear)

In 1934, Benjamin Graham wrote in Security Analysis that the intrinsic value of a stock is that value which is justified by the facts, e.g., the assets, earnings, dividends, definite prospects, as distinct, let us say, from market quotations established by artificial manipulation or distorted by psychological excesses."

Doyle/Holmes in 1890 and Graham in 1934 could have been referring to the wild speculations that are put out by market commentators and analysts regarding dot com companies and that are dressed up as reasoned reports.

Knowledge and experience

He possesses two out of the three qualities necessary for the ideal detective. He has the power of observation and that of deduction. He is only wanting in knowledge, and that may come in time. (The Sign of Four)

It is better to learn wisdom late, than never to learn it at all. (The Man with the Twisted Lip.)

Learn from your mistakes

If it should ever strike you that I am getting a little over-confident in my powers, or giving less pains to a case than it deserves, kindly whisper 'Norbury' in my ear, and I shall be infinitely obliged to you. (The Yellow Face.)

Norbury was one of the rare cases when Holmes was not at his best. He asked Watson to use this as a reminder to make sure that he did not become over-confident in the future.

This reminds me of Buffett after his investment in USAir in 1989. Within a few years the airline was in such difficulty that Buffett wrote down the investment by 75 percent while trying to sell the shares at 50 cents on the dollar. Fortunately for stockholders in Berkshire Hathaway, Buffett was unsuccessful in finding a buyer for within a year or two USAir returned to profitability. In the end, Buffett's action brought a healthy profit to Berkshire Hathaway.

On a personal level, Buffett admitted that the purchase was a result of sloppy analysis that may have been caused by hubris. To guard against a similar lapse in the future, he once joked, "So now I have this 800 number, and if I ever have the urge to buy an airline stock, I dial this number and I say my name is Warren Buffett and I'm an airoholic. Then this guy talks me down on the other end."

There were no 800 numbers in the late nineteenth century so Holmes had to rely on Watson to "talk him down."

Check and double check

I have forged and tested every link of my chain, Professor Coram, and I am sure that it is sound. (The Adventure of the Golden Pince-Nez.)

These are just a small sampling of quotes from Sherlock Holmes that have an investing flavor. In fact, some of them seem to have been written as if their main purpose was to provide sound principles of investment, rather than as methods of criminal investigation. But perhaps we should not be surprised at this. After all, patience, tenacity, clarity of mind, a willingness to sift though the facts, resistance to unnecessary or premature speculation are surely traits of the best detectives as they are of the best investors.

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I sent a copy of this article to Warren Buffett and he replied:

Dear John:
      I enjoyed the Sherlock Holmes piece. Thanks for the dedication; I'm flattered.
                    Sincerely
                     (signed) Warren E. Buffett
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