There’s a mathematical property called, Transitive Equality. A transitive equality property states that if A = B, and B = C, then A = C. With the abundance of daily financial news, data, and information clawing for your limited attention, it’s very easy to forget and overlook the following very simple idea: a stock is nothing more than a small sliver of equity in a business. In other words, stocks are businesses, just divided into millions of shares. Now to use our transitive equality property. If stocks are businesses, and a good business makes for a good stock, then the world’s best stocks should also be the world’s best businesses, right?

Let’s explore this idea further. The father of Value Investing, Benjamin Graham was aware of the above idea. But, Graham tended to shy away from the world’s best businesses in favor of what he called, “cigar butt business”. The companies Graham preferred to invest in might not have the world’s largest market capitalization, or the highest profit margins, but Graham was able to see beyond those initial metrics. Graham evaluated his picks based on their relative performance, and made his valuations accordingly. In other words, part of what made Graham such a great investor was that he wasn’t swinging for the fences all the time, he focused his energy on getting on base, again and again and again.

Enter Warren Buffett and Charlie Munger. When Buffett moved to New York to work for his mentor, Benjamin Graham at the Graham-Newman Corp. he learned and practiced Graham’s style of cigar-butt investing. But when he later began his own partnership with Charlie Munger, the two felt like there was room for improvement on Graham’s ideas. As Buffett acknowledges, buying a fair business at a wonderful price is good, but “It’s far better to buy a wonderful business at a fair price.” To elaborate, Graham was more of an intellectual and quantitative-thinking man, and he found his legendary margin of safety within the balance sheet. Buffett and Munger on the other hand are business guys, through and through, and they’re able to spot a margin of safety in the qualitative aspects of the business. Thus, this new approach of looking for wonderful businesses at fair prices, opened up a whole new world for Buffett, who previously was only hunting for bargain basement deals.

Value investors today are continuing to improve upon Graham, Buffett, and Munger’s ideas. Take for example Larry Sarbit of Sarbit Advisory Services. At SAS, Larry has adopted the concept of business-first investing into four distinct and solid pillars. In our interview with Larry, here’s what he had to say about business investing:

I derived a lot of these from Warren Buffett, of course. But he thinks business. He is very much a rational business investor. He’s not a stock market guy, he’s a business owner – that’s how he perceives himself. And when I look at how successful businesspeople have achieved their wealth, all I’m trying to do is copy what they have done. Just duplicate as much as possible how a very successful business owner and manager have behaved in the past. What they have, the first pillar we would say is buy a wonderful business. A terrific business is a business that has terrific characteristics. It has a sustainable competitive advantage. I don’t know if you want me to go into these in any amount of detail, but first and foremost you have a business that has terrific characteristics that mean that it’s odds of success are going way up.

Perhaps this is another way to think about the Graham quote: “In the short run, the market is a voting machine, and in the long run, it’s a weighing machine.” Short term performance of a stock in a market is detached from the actual performance of the business. Yet, in the long run, the two are correlated. Those who speculate seek to make their money in the market, while those who invest seek to make their money in the business. Here’s Larry’s thoughts regarding timing:

It takes time to build a business. You don’t get instant returns. Building a business, if you own and run a business, it’s a multi-year, multi-decade, perhaps generational process of growth. People in the stock market seem to think that they should be given returns on a regular and short term basis. If you think in that fashion, if you approach it as a rational business owner and keep this top of mind, and start with those principles, you have a far greater probability of creating wealth.

One of the biggest and most obvious advantages of seeing stocks as businesses, is that it demystifies the whole investing process. If you have any inkling or acumen as a businessperson, you don’t need an MBA or a fluent understanding of derivatives to see that a company who can sustainably sell a product with a 50% profit margin is a good idea. Similarly, it should be obvious that a company with massive amounts of debt and a product that loses money on the dollar is not a wise decision. It doesn’t require emotion, just common sense. All accountants know the following equation like the back of their hand: AssetsLiabilities = Shareholders’ or Owners’ Equity. Which means if you have a business with increasing assets and liabilities that are remaining constant, guess what.. owners equity is going to increase too. And, that’s what business investors want to see.

Again, that’s just rational. That’s what businesspeople do all the time. They care about price or what they pay for it, but first and foremost it has to be a terrific business. They don’t mind paying a bit more for something that is truly, truly great.

(Watch the full conversation in The Manual of Ideas Members Area.)

As a business-thinking investor, another part of your job is to avoid getting ripped off. Just because you’ve identified the world’s best business doesn’t make it the world’s best purchase. If a company, no matter how great, is trading on the market well above what it’s actually worth, then it might not be what Graham would see as a relatively good investment. Just as a savvy shopper compares name vs. generic brands, and looks for quality, the savvy investor should do and think in very much the same way. Good deals don’t always have to come from the discount store, you just have to keep your eyes open.

Summary

Thinking about stocks with the same acuity of business rationality is what Warren Buffett did to the world of value investing. He and Charlie Munger ignored the hoopla of Wall St. and just focused on the actual value of the companies being traded. Buffett and Munger still make their decisions based on Benjamin Graham’s ideas of value, but they’ve gone beyond picking up only cigar butts. An investment is a commitment to the business in the long run, and part of finding wonderful businesses means, you don’t have to keep second guessing your original decision to invest. The wonderful thing about a wonderful business is that it provides a peace of mind to the investor, whose life shouldn’t be dictated by the volatile moods of Mr. Market. This is how Larry Sarbit looks at companies. This is how Warren Buffett looks at companies. Let mathematics, logic, and common sense be your friend, and leave those whose primary occupation it is to skim profits off the fluctuations of the market to live and die by their irrational speculation. At the end of the day, the market itself isn’t a business, it’s a market. The stocks in the market are the real assets, selling real products, to real customers, for real profits. Keep that in mind and sit back, and let the weighing machine do its job.