Smart Money vs. Dumb Money

Everyone knows the Wall Street concept of smart money. It’s a myth really since even great investors do stupid things every now and then, but assume it’s a viable concept for the purpose of this post. Here’s how smart money talks about investing capital in a business compared to how dumb money talks about investing in a business.

Smart Money

Warren Buffets six criteria of buying a business

We are eager to hear from principals or their representatives about businesses that meet all of the following criteria:

(1) Large purchases (at least $75 million of pre-tax earnings unless the business will fit into one of our existing units)

(2) Demonstrated consistent earning power (future projections are of no interest to us, nor are “turnaround” situations)

(3) Businesses earning good returns on equity while employing little or no debt

(4) Management in place (we can’t supply it)

(5) Simple businesses (if there’s lots of technology, we won’t understand it)

(6) An offering price (we don’t want to waste our time or that of the seller by talking, even preliminarily, about a transaction when price is unknown).

Ian Cumming of Leucadia National Corporation (LUK)

We tend to be buyers of assets and companies that are troubled or out of favor and as a result are selling substantially below the values which we believe are there. From time to time, we sell parts of these operations when prices available in the market reach what we believe to be advantageous levels. While we are not perfect in executing this strategy, we are proud of our long-term track record. We are not income statement driven and do not run your company with an undue emphasis on either quarterly or annual earnings. We believe we are conservative in our accounting practices and policies and that our balance sheet is conservatively stated.

LUK also has its "Rules of the Road

1. Don’t overpay, no matter what the madding crowd is up to.

2. Buy companies that make products and services that people need and want and provide them as cheaply as possible with consistently high quality. Lower cost and higher quality is a relentless and never-ending task.

3. Earnings sheltered by NOLs are more valuable than earnings that are taxed!

4. Compensate employees for performance and expect hard work and honesty in return.

5. Don’t overpay!

William Thomas of Capital Southwest Corporation (CSWC)

Capital Southwest emphasizes the following elements in evaluating potential investments:

Management – Believing that the most important factor in any venture is the quality and integrity of the people who lead the company, we invest in financially committed management teams who share a vision of the future and have the ability and determination to achieve their goals. We prefer managers who have significant operating experience as well as an in-depth knowledge of their industries.

Markets – We search for companies serving markets which are large or expanding rapidly and have the potential to reach revenues of $100 million or more. In more mature markets, we invest in growth companies that have a clear competitive advantage or a strong market position.

Products – We invest in companies whose products or services are well positioned versus their competitors, offer significant value to customers, and are continually improved and upgraded. Proprietary products and services are attractive if supported by continuing development programs.

Dumb Money

Excite@Home buys Blue Mountain Card for $780 million in cash and stock – Dec 1999

"Excite@Home plans to leverage the Bluemountain.com audience reach and page views almost immediately to create more Excite@Home registered users, broadband subscribers and, ultimately, revenue," the company said.

"For Excite@Home, this acquisition promises to be a significant platform for future growth in both narrow and broadband content to generate increases in registered users, @Home broadband subscribers and revenue,"

Excite@Home sells Blue Mountain Card for $35 million in cash – Sept 2001

Google buys YouTube for $1.65 Billion

"The YouTube team has built an exciting and powerful media platform that complements Google's mission to organize the world's information and make it universally accessible and useful. This is just the beginning of an Internet video revolution."

"So by joining forces with Google, we’ll be able to sharpen our focus on this vision to create a new media platform for consumers and partners to distribute their media worldwide. This will allow us to, you know, with Google’s success in building a revolutionary new ad platform, this has inspired us to create a new model, a new platform for video content on the web. With this new relationship, we’ll combine Google’s experience and have the resources to continue on our mission to offer the most entertaining online video experience."

“There is a new class of sites that have developed very quickly and are very successful and delivering a lot of value.”

The smart money talks mainly about the numbers that are involved with the purchase. Is the business profitable? Are we paying a reasonable price for the asset? Does it have a sustainable competitive advantage?

The dumb money talks about conceptual information regarding the business that was bought. It will allow us to do this and it will allow us to do that, and it will provide a platform for moving into the next era, etc. They are short on details on the financial side because there is no financial side.

Why is the Internet industry like this? What makes successful and smart people suspend the normal laws of physics? Is it because they are using stock and not cash? When an individual wants to buy a small business, the first question to ask is – does the business make money? Would you pay 50 times sales to buy a corner grocery store or a t-shirt shop? I sure as hell hope not. Yet it happens all the time in Internet related businesses. Is it because of growth? Who cares about growth if profits don’t follow?

And yet investors love these stocks and crowd around them like a pack of teenaged groupies girls waiting backstage at a rock concert for the band to leave. "Oh, pick me! Pick me, please," they scream.

We will not give in to this madness.

Quotations from the Google/YouTube Conference call courtesy of Seeking Alpha