I’ve been spending the vast majority of my time working on a number of new investment ideas, but I do find time to catch up on reading the paper. Earlier this week I came across a post on one of the Wall Street Journal blogs that posted a copy of an old letter that Warren Buffett sent to George Young at National Indemnity (a Berkshire owned insurance subsidiary) regarding his thoughts on GEICO.

I’ve written a few posts on Buffett and GEICO, and his history with the company goes back to 1951 when he put 65% of his net worth (at the time around $13,000) into GEICO stock. At that time, a 21 year old Buffett saw the enormous growth potential GEICO had because of the large market it operated in and the fact that GEICO could provide car insurance at a lower cost than any of its competitors.

The two most important factors:

  1. Low cost provider of a product that competes mainly on price
  2. Huge addressable market

These two things—combined with good management—contributed to GEICO’s fabulous growth in earning power in the subsequent decades, and its stock price went up over 100 times.

As I’ve stated before, despite the frequent comparisons between Buffett and Graham in his early years, Buffett was in fact much different than Graham. Although Graham bought a controlling stake in GEICO, he rarely made investment decisions based on the factors that Buffett used to put a majority of his capital into GEICO—factors such as management, market share, cost structure, and future growth prospects. As Buffett wrote about in his 1951 writeup of the stock, these qualitative considerations were much more significant to Buffett than price (which although not a Graham asset based bargain, was still attractive at around 8 times earnings).

So the fact that he bought it at 8 times earnings certainly contributed to Buffett doubling his money in the stock in the next year and a half, but the qualitative factors Buffett pointed out were the reasons that the stock was a 100 bagger over the coming decades.

Regarding his early 1950’s purchase, Buffett wrote that he was able to “develop a depth of conviction which I have felt few times since about any security”.

“At the time I felt that GEICO possessed an extraordinary business advantage in a very large industry that was going to continue to grow. Since that time they never have lost that advantage—the ability to give the policyholder back in losses a greater percentage of the premium dollar than any other auto insurance company in the country, while still providing a profit to the company.”

But fast forward a couple decades—despite its core low cost advantage still intact—the company was struggling because of factors that often ail many insurance operations—focusing on growth more than prudent underwriting. GEICO’s management had been doing a poor job of pricing its product and they were accepting inadequately priced risk.

Buffett often talks about the dubious prospects of investing in turnarounds, but GEICO was one that he thought could in fact turn. Buffett felt that GEICO was the rare exception to his rule because it had a low cost advantage that was still intact, it was just being mitigated because of poor management.

Buffett felt that this could be corrected, and with the right manager—Jack Byrne—this proved to be true. Buffett bought a significant amount of stock in the 70’s, and then bought the rest of the company entirely in the mid 90’s.

Here is one clip from the letter I thought was worth highlighting, as it is a key advantage to consider with other businesses and investment opportunities:

“I have always been attracted to the low cost operator in any business and, when you can find a combination of i) an extremely large business, (ii) a more or less homogenous product, and (iii) a very large gap in operating costs between the low cost operator and all of the other companies in the industry, you have a really attractive investment situation. That situation prevailed twenty five years ago when I first became interested in the company, and it still prevails.”

Here is the link to the entire letter that Buffett sent to National Indemnity concerning his thoughts on GEICO.

There seems to be a strange dichotomy in the value investing universe: those who buy so-called compounders, and those who buy so-called cheap stocks. I want to own businesses that are building value, but that doesn’t mean I don’t care about valuation. I pass on probably 99% of the ideas I look at, many of which are great businesses, simply because the current price won’t allow my investment in the stock to compound at the rate of return that I’m looking for over time.

However, I think there is far too much “compartmentalization” going on in the value investing world. I should say—I too tend to compartmentalize on occasion. And Buffett compartmentalized when he ran his partnership. (By this, I mean that investors tend to put stocks into categories such as compounders, cheap assets, net-nets, arbitrage, special situations, etc…)

I don’t think there is necessarily anything wrong with putting investments into these buckets, and when it comes to selling stocks, I think it might be useful.

However, I think when you rigidly define what type of stocks you invest in, you run the risk of pigeonholing yourself into a strategy that might negatively impact your investment results.

In other words, knowing what type of an investment you’re in is helpful, but limiting yourself to only a certain bucket of investments is not.

Focus on Things You Understand

This is not to say that you should go outside your area of competence… just the opposite. You should limit your investments to only those that you truly understand. Looking for businesses and investment situations that you can easily understand and can value is much more important than trying to fit all of your investments into a style box, just because that’s “what kind of investor you are”…

After all, to paraphrase what Alice Schroeder once said about Buffett: if you offered him a $1 bill for 50 cents, he would gladly accept it, despite the $1 bill having no competitive advantages over other dollar bills.

The reason this compartmentalization is counterproductive is because it can cause investors to make mistakes of omission (or failing to invest in a situation that is understandable and well within one’s circle of competence). Examples such as “I can’t pay 15 times earnings for this, I’m a value investor!” Or, “I wouldn’t buy that stock at any price because there is no moat!”

Instead, I think it’s helpful to understand that each investment is its own unique situation with unique risk/reward dynamics. I think portfolio management is an art form. There are no black and white rules that tell you when an undervalued stock should be sold, or how long a great compounding business should be held.

So although it’s helpful to understand what type of investment you’re in after you’re in it, I don’t think it’s a great idea to say “I’m looking only for net-nets”, or “only low P/B stocks, or “only great compounders with moats”, etc…

Just look for undervalued merchandise.

I prefer quality businesses, so I look for good businesses cheaply priced most of the time. But I too will happily accept a dollar from you if you are offering it at 50 cents.

To simplify everything, one of my favorite quotes is “Value investing is figuring out what something is worth and paying a lot less for it”. That’s the name of this game.

Buffett’s Disney Investment in 1966

These thoughts on investment tactics began percolating again this weekend, as I was visiting family and picked up my father’s copy of “Tap Dancing to Work”, a collection of Warren Buffett articles compiled by Carol Loomis.

I just happened to see the book on his end table, and opened it up randomly. The article that I opened to discussed Buffett’s investment in Disney. It was an article written in 1996, and describes how Buffett decided to accept stock in Disney (as opposed to cash) when Disney was buying Cap Cities/ABC.

The article got me thinking about how Buffett has often lamented the fact that he bought Disney at a bargain in 1966, only to sell it a year later in 1967 for a 50% gain. Not a bad gain in one year, but Buffett likes to point out that he bought the stock for $0.31 in 1966, sold for $0.48 in 1967, then watched it rise to $65 per share 30 years later in 1996.

He implies that selling Disney was a big mistake in 1967. However, I crunched some quick math yesterday. At the price Buffett sold at in 1967 (48 cents per share) until 1996 (when the article was written and Disney was trading at its then price of $65 per share), the stock compounded at 18.4% per year.

A fabulous compounder to be sure… but what’s interesting is that Buffett was able to compound that 48 cents per share much faster than Walt Disney. Buffett compounded Berkshire’s equity at around 24% in that 29 year period (and estimates show that his stock portfolio compounded at a rate even better than that).

So Buffett was able to compound the 48 cents that he received from selling Disney much faster in other investments over the 29 years between 1967 and 1996, suggesting that it was in fact a great decision to sell Disney (one of the all time great compounders) after a 50% gain.

The opportunity costs of owning Disney for that period instead of selling it were huge (Disney grew 135x during those three decades while Berkshire’s equity grew over 500x)!

So despite his appetite for buying and owning great businesses “forever”, Buffett outperformed one of the great compounders of the 20th century by occasionally trading fairly valued merchandise for undervalued merchandise.

The Point Please?

So these thoughts were mostly ruminations (a euphemism for ramblings) regarding some topics that have been on my mind lately. Maybe this post doesn’t have a hard conclusion, but one thing that comes to mind is “Invert, Always Invert”.

Buffett often talks about moats and great businesses, but he also was a great handicapper. He could do a decision tree in a few minutes and estimate the probabilities for various outcomes for many different investment situations. This led him to make investment decisions that don’t always match his general advice on holding great businesses. It’s not because Buffett is being cagey, I think it’s just because it’s impossible for him to explain to us mere mortals—in simple terms—all of the decisions he’s made (some of which might contradict one another).

So inverting the situation, I think you might be able to deduce that Buffett dealt with each situation differently, and he was very good at picking out a few simple things that mattered in each investment. Furthermore, he invested in things that he understood and knew how to value. And yes, they were primarily long term investments in quality businesses that were building value, even in the partnership days.

So I think the key is to focus on businesses that you understand and stocks that you can value. Worry less about trying to fit stocks into a specific subcategory.

I think understanding the business and the situation go a long way in investing.

“Experience, however, indicates that the best business returns are usually achieved by companies that are doing something quite similar today to what they were doing five or ten years ago… a business that constantly encounters major change also encounters many chances for major error. Furthermore, economic terrain that is forever shifting violently is ground on which it is difficult to build a fortress-like business franchise. Such a franchise is usually the key to sustained high returns.”  

-Warren Buffett, 1992 Shareholder Letter

In the last post, I compared two hypothetical companies using some basic math regarding returns on capital.

It helps to keep this general formula in mind, which is a rough estimate for how fast a business will compound intrinsic value over time… A business will compound value at a rate that approximates the following product: ROIC x Reinvestment Rate.

To look at a real life simple example, let’s look at a company I’ve discussed before: Wells Fargo. Just for fun, I decided to check out the price in 1972, since I like looking at historical annual reports and I wanted to use a year where the stock market was in a bubble (and about to crash 50%). 42 years ago, the stock market was at the end of what is now known as the “Nifty-Fifty” bubble. It was a stock market where many large cap stocks were being bought at 40-50 times earnings or more by newly created mutual funds that were gathering assets at a feverish pace and were putting this inflow of cash to work at ever rising stock prices regardless of valuations. We know how this ended: by 1974 stocks had lost half their value, mutual funds went from uber-bullish at the top of the market to uber-bearish at the bottom, and valuations became much more reasonable.

I wanted to use a year where stock prices were generally expensive to ensure that I wasn’t using data from a market bottom, and to also show that even in a bubble year, a business that subsequently continues to produce high returns on capital will create shareholder value.

High Returns on Incremental Investments Leads to Compounding Value

In 1972, Wells Fargo was trading at $0.59 per share (obviously, adjusted for splits). Today the stock trades around $52 per share, roughly 88 times the price it was in the 1972 market top. In other words, WFC has compounded its stock price at 11.4% annually, not including dividends. If we include dividends, shareholders have seen around 14% total annual returns over the past four+ decades.

How did this happen? There are many reasons, but let’s just look at the math (i.e. the results of management’s execution, we’ll leave the “why” for another time).

So to review this math, I pulled up an old annual report showing financial data from the early 70’s. The 1974 WFC annual report is the first one to provide market prices for the stock, as well as book value data. So I got 1972’s numbers from the ‘74 report.

Here are some key numbers to look at from 1972 (again, I adjusted these for splits):

  • 1972 WFC Book Value: $0.40
  • 1972 WFC Stock Price: $0.59
  • 1972 WFC ROE: 10.9%
  • 1972 WFC P/B Ratio: 1.5

Let’s compare that to the numbers from halfway through 2014:

  • 2014 WFC Book Value: $31.18
  • 2014 WFC Stock Price: ~$52
  • 2014 WFC ROE: 13.5%
  • 2014 WFC P/B Ratio: 1.6

So in the past 41 and a half years, Wells Fargo has:

  • Compounded Book Value at 11.1%
  • Compounded Stock Price (not including dividends) at 11.4%
  • Earning power has compounded at 11.7% (earnings have grown from around $0.04 to over $4.00 per share)
  • P/B Ratio is roughly the same as it was 42 years ago

As you can see, the intrinsic value of the enterprise (as evidenced by the compounding net worth and earning power) has compounded very nicely over a long period of time, which has led to similar returns for shareholders. If we include dividends, shareholders have seen around 14% annual returns, even if they invested toward the top of the 1972 bubble.

This year I spent a lot of time paging through many old Wells Fargo annual reports. If you look back over time, you’ll find that Wells Fargo produced mid-teen returns on its equity capital over the past four decades:

Wells Fargo Historical ROE

Some interesting things to note about the last 42 years:

  • Wells Fargo was profitable every single year (42 for 42)
  • Earnings increased from the previous year 35 out of 42 years
  • ROE averaged about 15%

And this isn’t in the table above, but worth repeating:

  • WFC book value compounded at 11.1% since 1972
  • WFC stock price compounded at 11.4% since 1972 (not including dividends)
  • WFC earnings power compounded at 11.7% since 1972

You’ll also notice that in most years, it retained 2/3rd of its earnings and paid out the other 1/3rd in dividends. So I’m using some back of the envelope thinking here and simply saying that the reinvestment rate is the level of earnings Wells Fargo has to allocate after paying dividends (note: some of these earnings could be used for buybacks, acquisitions, etc…). 

Remember the back of the envelope math:

  • A business will compound at the product of two factors:
    • The percentage of earnings it can retain and reinvest
    • The rate of return it can achieve on that incremental investment

So it’s just the ROIC times the percentage of earnings it can reinvest (aka the reinvestment rate). In the example of Wells Fargo, I used equity capital (and thus, ROE), and the growth of book value as a proxy for the growth of intrinsic value.

By the way, you could also look at ROA, which might be a better way to compare core earning power of the bank. However, I wanted to look at ROE in this case since we are buying the equity when we buy the stock and we accept the given amount of leverage (ROE = ROA x Leverage).

Also, ROE  averages over a long period of time (less dividends) is a good back of the envelope way to eyeball the growth in book value. And for a company like Wells Fargo, this long term compounding of net worth will approximately move in lock step with intrinsic value growth—and also stock price compounding… again, over a long period of time.

As an interesting side note, Wells Fargo carries less than half the leverage in 2014 than it did in 1972. In any event, we’ll compare the returns on equity capital to see how shareholder capital compounded over time.

So as you can see: 15% ROE and 66% Reinvestment Rate = 10% Intrinsic Value (Book Value) CAGR. 

You’ll notice it’s not exact, as book value compounded at 11%, and this back of the envelope math suggests book value will compound at 10%. The difference has to do with the aggregate effects of things like share buybacks/issuances, dividends, acquisitions, etc… but the basic idea should demonstrate that a business like Wells Fargo that can produce 15% returns on equity capital will grow the value of its net worth and earning power by 10% or so if it can reinvest 2/3rds of its earnings at that rate of return.

Note: I went back to 1972 just for fun. You don’t need to wait 42 years. I also looked at the 1974, the 1984, and the 1994 numbers, which would have provided very similar results, thanks to the incredibly consistent returns on equity.

Now, every time I post about a company with a long history of success, I get emails or comments about cherry picking, or the more sophisticated academic term: “confirmation bias” or “survivorship bias” (or something like that).

The point here is not to say that WFC is a good investment now or a good company now just because it has done well in the past.

The point is to simply look at the math…

High Returns on Incremental Investments Leads to Compounding Value

And the math tells you that if you can locate a company that is producing attractive returns on its incremental capital, and your analysis of the business tells you that it has enough reinvestment opportunities that it will continue to be able to produce those returns going forward, then you will likely have a company that will compound at an above average rate.

Wells Fargo was able to compound value for shareholders over decades because they were able to consistently reinvest sizable portions of retained earnings at attractive returns on equity.

Of course, this is just the math. The real work is handicapping each situation and being able to analyze and evaluate businesses. But the concept is important, and despite all that has been written about it, I think many people miss the concept, which puts them immediately behind in the count.

A Clue in Determining if a Business Can Continue Producing High Returns

You might ask: How does one determine if attractive returns in the past will lead to attractive returns in the future? One reason I inserted the Buffett quote from the 1987 shareholder report is that he provides a very valuable clue: It helps to locate a business that will likely be doing the same thing in 5-10 years that it’s doing now.

In 2009, Blackberry was producing incredibly high returns on invested capital–around 40%. But the problem is that in 2014, Blackberry is a completely different business with different products than it was in 2009. And in 2009, it would have been very hard to predict what 2014 would look like for Blackberry. Similarly, Apple is producing incredible returns in 2014, and they have a great business. But I don’t know what products Apple will be selling 10 years from now. My guess is that they will still have cool products and they will still be a great company, but it’s hard to value a business when you don’t know what they will be selling in 10 years.

But it would have been fairly easy to predict in 2004 that Wells Fargo would likely be taking in low cost deposits and lending them out in 2014. They were doing this 5, 10, 20, 50, and 100 years ago. You wouldn’t have needed to know about the crash, the credit bubble, or the massive economic recession… just that the business you’re evaluating is durable and has survived various “real life stress tests” before, and that in 10 years, you’ll be able to close your eyes and picture what kind of business the company will be doing. Once you can reasonable predict what the company will be doing, then you can determine price, valuation, how much to pay, etc…

We can discuss more on this in future posts… the point here is that it’s important to understand that a business that produces attractive returns on the capital it employs will produce value over time.

Disclosure: John Huber owns warrants to buy Wells Fargo common stock for his own account and accounts he manages for clients. This is not a recommendation. Please conduct your own research. 

I thought I’d circle back to discuss the topic of compounders and return on capital. I wrote a few posts about earlier this year, and there have been numerous comments and questions.

In this post, I want to discuss the actual math behind the compounders, to try and show why return on capital is so important to long term business owners (which is what we are as stockholders).

To recap what I mentioned earlier, I usually put investments in two broad categories, but ideally, I’m looking for:

  • A business that can produce high returns on capital
  • A business that can reinvest a large portion of earnings at similar high rates
  • A business run by good management, who will allocate the excess cash in a value creating way (preferably management owns a large stake in the business themselves, aligning interests)

These three factors combine to create the rate that the business compounds intrinsic value over time.

The Math Behind Compounding Intrinsic Value

The math is simple.

To briefly review, I find it helpful to use a back of the envelope formula as a way to think about the rate at which a business is compounding its intrinsic value. Basically, a business will grow its intrinsic value at a rate that equals the product of two factors: the incremental return on invested capital (ROIC) and the reinvestment rate.

A simple example: a business that can reinvest 50% of its earnings back into the business at a 12% return on investment will compound the intrinsic value of the enterprise at 6% annually (50% x 12%). See this post for more discussion on this.

Let’s look at a hypothetical example of 2 businesses (Company A and Company B):

  • Company A produces 20% ROIC and can reinvest 100% of its earnings
  • Company B produces 20% ROIC and can reinvest 50% of its earnings

In both examples, we’ll assume the investment is a long term investment over 15 years. Many investments don’t last this long, but in this exercise we are imagining ourselves as a long term partner in the business, and this is how I happen to think about stocks anyhow. And business owners don’t trade in and out of businesses every year or two. We’ll look at various starting and ending valuations, and we’ll see how both the valuation (the P/E ratios) as well as the quality (ROIC) impact our investment returns over the 15 years.

Example 1—Company A

In this example, we’ll assume earnings are cash earnings to make things simple. Let’s assume the business produces $1.00 of earnings per share, and let’s say Company A has a stock price of $25.00 (a P/E of 25). Let’s assume the business is a growing enterprise and it can reinvest 100% of its earnings back into the business at a rate of 20% after tax (20% Return on Capital). The business sells a niche product to a growing market of customers that rely on Company A exclusively, thus the business has a nice competitive advantage over potential competitors. This “moat” allows them to achieve 20% returns on capital for the next 15 years.

Let’s take a look at the value of the business in 15 years:

  • Year 1 EPS = $1.00
  • Year 15 EPS = $15.40

Pretty simple… if the business has an ROIC of 20% and can reinvest 100% of their earnings, then earnings will grow at 20% over time, and the growth of the intrinsic value of the business will also approximate this 20% annual growth rate.

Now, let’s say we paid 25 times earnings for this business 15 years ago ($25 per share). Let’s take a look at what the value of our stock (and the 15 year CAGR) will be at various P/E multiples (remember we paid $25 per share 15 years ago for Company A):

  • 10 P/E: $154.00 per share (12.9% CAGR)
  • 15 P/E: $231.00 per share (16.0% CAGR)
  • 20 P/E: $308.00 per share (18.2% CAGR)

So for this wonderful business, even paying 25 times earnings worked out to a stellar return for shareholders of around 13% annually for 15 years even as the P/E multiple contracted from 25 all the way down to 10, which would be a very low multiple for a great business like this.

Example 2—Company B

Let’s assume that this business–Company B–reinvests half of its earnings at a rate of return (ROIC) of 20% and pays out the other 50% as a dividend. In this case, the intrinsic value of the enterprise will compound at 10% annually (20% ROIC times the 50% reinvestment rate equals a 10% growth rate). Let’s assume we paid the same price as the first business (25 times earnings). Let’s assume the same $1 starting EPS.

In 15 years, EPS will equal $4.17 per share (assuming a constant 20% return on incremental capital and a 50% reinvestment rate). Let’s also assume a constant 2% dividend yield, since Company B can pay out a portion of earnings as dividends, unlike Company A which reinvested all of its earnings.

  • 10 P/E: $41.77 (5.5% CAGR)
  • 15 P/E: $62.66 (8.3% CAGR)
  • 20 P/E: $83.54 (10.4% CAGR)

So both of the above businesses produce 20% returns on invested capital, but Company A is clearly the superior investment if both are priced around the same level. This is simply because company A has twice the level of investment opportunity, as it can reinvest all of its earnings at 20%, whereas company B can only invest half of its earnings at 20%.

Logically, this makes perfect sense. If two businesses (Company A and Company B) have opportunities to make 20% returns on incremental investments, but Company A can invest twice as much as Company B at that 20% rate of return, then company A will create much more value over time for its owners than Company B.

Both companies above will show up in screeners as businesses that produce 20% ROIC, but one is clearly superior to the other because it can retain and reinvest a higher portion of its earnings, and thus will compound intrinsic value much faster.

Picking the “Right Business” is More Important than Picking the “Right Multiple”

In Part 3 of this series, I mentioned that ROIC is far and away the most important factor to consider, as the math (the back of the envelope formula) shows. A business that produces 6% ROIC will not compound intrinsic value regardless of how much they can invest back into the business (in fact, a business that produces low returns would be better off not reinvesting, as owners could likely reallocate those earnings at higher rates elsewhere).

So a business that can produce above average returns on capital is crucial when it comes to compounding value.

But I also wanted to demonstrate that picking the right business (i.e. the one that can invest large amounts of capital at attractive rates of return) is far more important than paying the lowest multiple to current earnings.

Notice in the simple example above, I assumed that we paid a P/E multiple of 25 for both businesses. Obviously, at the same price to earnings ratio, the business that can compound intrinsic value faster will create better returns for shareholders. But let’s compare investment results if we pay a lot less for Company B (the inferior compounder).

Company A vs. Company B at Various Valuations

Note: As a couple readers correctly pointed out, I made an error in my earlier tables by not reinvesting the dividends in Company B (I accounted for dividends, but the proper comparison would be to reinvest those dividends). Not a good thing to make a “math” error when the title of my post is “The Math of Compounding”! I happened to notice this error shortly after I published it, and since the previous comparisons were haphazard and probably difficult to read, I thought I’d create a few tables. I’m not sure if these tables make it any easier to read, but here they are…

The tables compare purchase price P/E’s for Co A and B (the top row) and compares that to various sale P/E’s 15 years later (the left hand column). As you can see, at a certain valuation, Company B is a better investment, but I noticed that you could roughly pay twice the valuation for Company A and still come out ahead over time. And I used 15 years, but the longer you own Company A, the wider the gap gets between Company A’s and Company B’s investment result.

Comp Math 1

So at a certain gap between the valuation levels, Company B becomes a better investment. But you’d have to pay 2.5 times the valuation of Company B in order to get an inferior result from Company A.

Below, you can see that at twice the valuation (P/E of 20 vs. P/E of 10), it is roughly even. But if you have to pay 15 times earnings for Company B, Company A is a vastly superior investment.

Comp Math 2

If the ending P/E is the same for both companies (unlikely given the better quality of Company A), Company A still outperforms Company B as an investment, even if Company A’s multiple contracts and Company B’s multiple expands and even though we paid 20 P/E for Company A and just 10 P/E for Company B.

Keep in mind, Company B is still a good company (it’s compounding value at 10%), it’s just not nearly as good as Company A, which will be the superior investment all the way up to twice the price relative to earnings.

If you’re right about the business, you’ll make a lot of money.” – Warren Buffett, University of Georgia, 2001

Some of you might be rolling your eyes at the simplicity (obviously, high ROIC and the corresponding growth will lead to good investment returns). Other readers are thinking—yeah, owning a great business is great, but the problem is predicting which businesses will be able to sustainably produce these high returns on capital.

I agree… it’s difficult. But the purpose here is to show the actual math behind the ROIC and the ability of a business to reinvest large portions of earnings and why those two factors are so important to long term owner returns.

This is why Buffett is always talking about great businesses. It’s not just because he wants to sound like a simple, wise, grandfatherly figure--it’s because of the math. If you pick the right business, the multiple you pay for the business is far less significant on your returns than the quality and sustainability of the returns on capital.

Now, I am not recommending paying 25 times earnings for quality businesses. As the skeptics pointed out earlier, it’s far too difficult to predict what the next 15 years will look like.

But that doesn’t mean I want to abandon the effort to locate great businesses. It’s just that ideally, we want to find them cheap enough to secure a large margin of safety in case we are wrong in our assessment of the quality of the business, as this gives us two things:

  • A margin of safety if we were wrong about the quality or sustainability of the business’ return on capital
  • The benefit of much higher returns if we were in fact right about the business

This is part art, part science, but over time, sticking to businesses that create high returns on the capital it invests will significantly improve the probability of achieving above average investment returns.

In other words, as some investors like to say—and a phrase I often repeat—Heads, we win. Tails, we don’t lose much…

In the next post, we’ll take a look at a real life example (one among many examples), to show that a business that produces consistent returns on capital over time does in fact create real value for its owners.

I just came across an article I just read that I thought was interesting, and thought certain readers might enjoy. Although the article has nothing directly to do with investing, I think there are some takeaways for those of us in the investment world. Certainly the article has relevance to anyone whose chosen endeavor requires the occasional deep thinking.

The article is called “Why Walking Helps Us Think”. The article—as you probably guessed from the self-explanatory title—describes the benefit of going for a walk. I’m not sure about all of the studies that it references, but I can say for sure that it is an activity that I believe helps my investment process.

Walking and Productive Thinking

I enjoyed reading the article because I walk just about every day, sometimes for a couple hours at a time. This activity is something that I’ve begun doing more in recent years. My personal exercise routine has evolved since my days as a competitive runner. I still run occasionally, but I find it’s more enjoyable, and—at a more relevant level to this discussion—easier to get what I would call “quality thinking” accomplished. So I do occasionally exercise vigorously, but I think of walking more as an investing activity than I do an exercise activity.

After hours of reading annual reports, making calculations, and spending time thinking in my office, I sometimes find that walking helps me crystallize the work and the thinking that I put in earlier.

Basically, I’ve always felt that investing is a discipline that is most successfully implemented in a quiet environment that promotes thoughts, ruminations, and observations much more than it promotes hustle and activity. I’m a big fan of hard work, and a big fan of those that hustle. But investment is a field where one must diligently work, think, and act, and must resolve oneself that results come later—often years after—that groundwork has been laid.

Buffett, Munger, and Archimedes

Investment results—the fruits of one’s labor—cannot always be pinpointed to a specific episode of work. In other words, a successful investment cannot be credited to one specific activity that you completed earlier. I think it’s much easier for most people to say: “If I do X, then I’ll get Y as a result”. To succeed as an investor takes lots of hard work, yes… but it also takes equal parts patience, discipline, and more specifically, the willingness to work hard now with the expectation that eventually you’ll reap a reward down the road—sometimes years down the road.

Buffett and Munger talk about this frequently. Buffett read the annual report for IBM for 50 years until one day while sitting (and thinking) in his office, he gained an insight on IBM that he hadn’t had previously—and this insight subsequently led to an $11 billion investment by Berkshire in IBM stock. Buffett also said that he came up with the idea to invest in Bank of America using the preferred stock and warrants while sitting in his bathtub.

(Interesting side note: Archimedes didn’t figure out which Greek banks were undervalued while in the tub, but it was the bathtub where he first realized that the volume of his body that was submerged underwater while getting into the bathtub displaced exactly the same volume of water.)

Back to Buffett… Again, Buffett read annual reports for Bank of America and its predecessors for 50 years before finally being able to reap what he sowed all those decades. The work has to get done without a tangible handle on where the reward eventually comes from. And the foundation of that work is often solidified by spending significant amounts of time thinking.

Although I’m not sure if Buffett, Munger, or Archimedes ever spent significant time walking, I think they spent significant time just sitting quietly and thinking—either in the bathtub or elsewhere.

The Importance of Quiet Thinking

Thinking in a quiet atmosphere is virtually unheard of in this day and age. The problem that we have as investors is that this type of behavior is not the typical behavior that’s required for success in virtually every other field. In most fields, urgency, hustle, and activity is often rewarded—and usually rewarded very quickly. Not so in investing. Hard work is absolutely necessary, make no mistake. But you have to be willing to work hard and also accept that the specific result of that work will come at an unknown time and in an unexpected form. That can be too difficult for most people to handle, and I suspect it’s why so many perform poorly in an activity that at its core, is quite simple.

As I’ve said before, I think there are numerous advantages for individuals and smaller investment managers to do very well—much better than the average—if they capitalize on the structural advantages that they have over the larger funds and the majority of the other stock market participants.

Of course, there are the principles of value investing that matter most. And there are certain other requirements such as hard work, skill, and to a much lesser extent, a certain intelligence level—but I think that just as important as hard work (and more important than intelligence) is the ability to do two things: 1) maintain a long term time horizon along with maintaining the discipline and patience required for long term success, and 2) have the ability to slow things down… to spend time thinking.

Have a great weekend. Hopefully you can find time for a walk.

“The way to win is to work, work, work, work and hope to have a few insights.” – Charlie Munger

I came across a post on one of my favorite sites (Farnam Street) about Buffett on some fundamental keys to successful investing. I’ve always thought the most important aspect of investing is waiting for the proverbial “fat pitch”. As readers know, I’m a baseball fan (I love the game, and I love the numbers that are part of the fabric of the game).

Ted Williams was famous for “waiting for the fat pitch”. He would only look to swing at pitches in the part of the strike zone where he knew he had a higher probability of getting a hit. There were parts of his strike zone where he batted .230 and there were other parts of the strike zone where he batted .400. He knew that if he waited for a pitch over the heart of the plate and didn’t swing at pitches in the .230 part of the strike zone—even though they were strikes—he would improve his odds of getting a hit and increase his overall batting average.

Ted Williams Strike Zone

Similarly, Buffett waits for the .400 pitches. And as he’s pointed out, the beautiful thing about the stock market is there are no called strikes. You can never get behind in the count while passing on the .230 pitches and waiting for the .400 pitches.

The concept of “waiting for the fat pitch” is one that is often talked about in investing. Despite the well-known baseball metaphor, it’s still one of the most valuable concepts in investing. “There are no called strikes on Wall Street” is something that is often stated, but rarely practiced. Investment managers are paranoid about falling behind in the count. Part of this behavior is what leads to the various inefficiencies that occur in the market.

Here’s a clip that Farnam Street referenced from a 2011 interview with Buffett talking about this topic:

Warren: If you look at the typical stock on the New York Stock Exchange, its high will be, perhaps, for the last 12 months will be 150 percent of its low so they’re bobbing all over the place. All you have to do is sit there and wait until something is really attractive that you understand.

And you can forget about everything else. That is a wonderful game to play in. There’s almost nothing where the game is stacked in your favor like the stock market.

What happens is people start listening to everybody talk on television or whatever it may be or read the paper, and they take what is a fundamental advantage and turn it into a disadvantage. There’s no easier game than stocks. You have to be sure you don’t play it too often.

This concept is obvious to many value investors, but I always find it useful to keep in mind. The philosophy was also brilliantly articulated by Charlie Munger in a well-known talk he gave in 1994, called The Art of Stock Picking.

Munger describes the stock market as a pari-mutuel system—a system that is largely efficient, but not completely efficient. It can be beat, but the key is waiting for the “mispriced bet”. And the first step is investing in businesses that you can understand.

Pick Your Spots

Munger illustrates the circle of competence concept by describing the edge that can be carved out by a hard working individual who desires to become the best plumbing contractor in Bemidji (a small town in Minnesota of around 13,000 people):

 “Again, that is a very, very powerful idea. Every person is going to have a circle of competence. And it’s going to be very hard to advance that circle. If I had to make my living as a musician, I can’t even think of a level low enough to describe where I would be sorted out to if music were the measuring standard of civilization.

“So you have to figure out what your own aptitudes are. If you play games where other people have the aptitudes and you don’t, you’re going to lose. And that’s as close to certain as any prediction that you can make. You have to figure out where you’ve got an edge. And you’ve got to play within your own circle of competence.

“If you want to be the best tennis player in the world, you may start out trying and soon find that it’s hopeless—that other people blow right by you. However, if you want to become the best plumbing contractor in Bemidji, that is probably doable by two-thirds of you. It takes a will. It takes intelligence. But after a while, you’d gradually know all about the plumbing business in Bemidji and master the art. That is an attainable objective, given enough discipline. And people who could never win a chess tournament or stand in center court in a respectable tennis tournament can rise quite high in life by slowly developing a circle of competence—which results partly from what they were born with and partly from what they slowly develop through work.

“So some edges can be acquired. And the game of life to some extent for most of us is trying to be something like a good plumbing contractor in Bemidji. Very few of us are chosen to win the world’s chess tournaments.”

The good news is that the stock market is filled with opportunities (10,000 opportunities in the US alone), and most people—if they have the will and the work ethic—can carve out an advantage in some small corner of the market not unlike the one that the best plumbing contractor in that small Minnesota town has.

Opportunities Abound (As Evidenced By 52 Week High/Low Gaps)

I got to thinking about Buffett’s comment about 52 week high prices being 50% higher than 52 week low prices.

This argument against market efficiency has always been one of the most compelling ones to me. There is just no logical way to explain why large, mature businesses can fluctuate in value by 50% on average in any given year. It makes no sense that the intrinsic values of large mature businesses can change by tens of billions of dollars in a matter of months—and this dramatic price fluctuation occurs on a regular basis—in fact, every year.

For instance, let’s just start by taking American business at large, using the S&P 500 as a proxy:

  • The S&P 500 index is 21% higher than its level just one year ago. This begs the question: Are the 500 largest American businesses really 21% more valuable (or nearly $4 trillion more valuable collectively) than they were just 1 year ago? Unlikely…
  • To look at it from another timeframe: the S&P index 3 years ago today (9/8) closed at 1186. It is now 69% higher 3 years later. Are American businesses really worth 169% of what they were just 36 months ago?

These might be obvious statements to fellow value investors, but I’m always interested in displaying these numbers on 52 week highs and lows, as I think it’s the most compelling argument against the efficient market hypothesis.

Here is a list of the 52 week highs and lows of 10 stocks selected from the S&P 500. I simply looked up a alphabetical list of the S&P 500 constituents and picked the first 10 stocks on the list.

S&P 500 Random Sample of 10 stocks (first 10 in alphabet):

SP 500 High Low

So even for 10 of the largest companies in the US, the average high was 135% of the average low, not far from Buffett’s 150% statement, which applied to a much larger universe with more opportunities (the NYSE). It’s remarkable to me that a sample list of stocks with an average market cap of $50 billion can have market valuations that fluctuate by as much as 35% on average—or to put it in dollar terms, around a $17 billion yearly fluctuation.

And this is in a year where the volatility has been well below normal (the VIX is currently at 12). These 12 month ranges would be much wider in a year like 2011.

Since $50 billion market capitalizations represent some of the largest, most mature companies, let’s take a look at a list of smaller companies, whose values are often assumed to fluctuate much more. And remember, greater volatility brings greater opportunity for investors as the more a stock fluctuates around its true value, the larger the potential gaps are between price and intrinsic value.

Here is a random sample of ten Russell 2000 stocks (again, this is the first 10 in the alphabet):

Russell 2000 High Low

As expected, this list has a much greater range between the average 52 week high and 52 week low. The average high is 215% of the average low for these 10 stocks (in other words, the average high was 115% higher than the average low)!

Some might notice the outlier of 631%. Taking this outlier out of the list, we still have a 58% gap between the average high and low of the other 9 stocks.

Obviously this list tells us nothing about the intrinsic value of these stocks—only that the prices fluctuate widely. But it should be fairly obvious that prices are fluctuating much more than intrinsic values—which provides us with opportunity.

Clearly, there are a lot of opportunities in the pari-mutuel system known as the stock market. The key is to remember the plumbing contractor in Bemidji that slowly carved out his niche and gained an edge over all the other plumbers in that town. Keep carving out your niche. Spend hours and hours reading about things that interest you. Work hard. And patiently wait for opportunities that are easily identifiable and obviously mispriced.

You may not find yourself in a chess match against Bobby Fischer, but you might be able to conquer the plumbing business in a small town in northwestern Minnesota.

“Google has a huge new moat. In fact, I’ve probably never seen such a wide moat.”Charlie Munger, 2009

Google celebrated the 10 year anniversary of its IPO last week. Google is a company that I’ve never owned (unfortunately), but really admire. There are a few businesses I almost root for, like a fan of a football team. Costco, Fastenal, and Walmart among others are on the list. These are really high quality businesses that have made their shareholders wealthy over time.

Google is also on that list. I read an article in the Wall Street Journal that referenced Google’s initial prospectus (the filing that every company files with the SEC prior to listing its shares publicly). The prospectus is generally a great document to read, even for companies that have been around for a while. There are usually interesting nuggets of information, and many things you won’t find in the standard K and Q docs.

Anyhow, I read through the prospectus from 2004, and thought it would be interesting to take a look at a few numbers from Google’s first decade as a public company.

Let’s look at the results first. Take a look at the chart from the last 10 years:

Google Long Term Chart

The stock price appreciated from a split adjusted IPO price of $43 to $597 (that’s a 30.2% compound annual return for those shareholders smart enough to have held onto their stock through thick and thin over the past decade). And even more interesting, this 30% annual return came from a stock that sported a P/E ratio of around 60 when it began trading in 2004!

And this result has occurred even as Google’s multiple has shrunk by more than half (we hear about “multiple expansion” in investment theses all the time–this is “multiple contraction”. The P/E ratio was cut in half over 10 years even as the stock appreciated 11 fold).

I wrote a post last week about not caring about what the market does. If you own quality businesses that produce ever growing free cash flows and high returns on the capital they invest, then you shouldn’t worry about whether the S&P is expensive at 18 times earnings. And to be even more counterintuitive, sometimes stocks such as Fastenal, Walmart, and Google can turn out to be fabulous bargains even though they have seemingly expensive looking prices relative to earnings.

A Bargain Relative to Earning Power

As Ben Graham said in The Interpretation of Financial Statements:

“…the attractiveness or success of an investment will be found to depend on the earning power behind it. The term “Earning Power” should be used to mean the earnings that may reasonably be expected over a period of time in the future.”

After all, bargains are simply things priced for less than what they are worth. And the worth of a business—its intrinsic value—is measured against its future earning power, not the level of earnings it happened to achieve in the last twelve months. Google didn’t have a lot of the latter (when measured against its 2004 price), but it had plenty of the former.

In fact, you could have bought Google at a valuation of around $30 billion in 2004. To see what a bargain Google turned out to be (even with a high P/E), compare the $30 billion valuation in 2004 to the Google of 2014—one that made around $12 billion in after tax free cash flow last year and has $59 billion in net cash in the bank!

Indeed, Google was an undervalued stock in 2004.

A Look Back at the Decade of Google

However, my point of the post is not to lament the fact that most value investors missed out on Google. It may not have been prudent to invest in Google in 2004. It certainly wouldn’t have been for me. Very few investors had the foresight and the competence required to have taken advantage of a company such as Google in 2004—one that operated in a rapidly changing and newly developing search industry. But often times omitted investments (successful investments that made someone else rich) can be great learning exercises.

The point is to study a business that has been wildly successful, to try and uncover a few clues about why Charlie Munger thinks Google has one of the widest moats he’s ever seen.

This post is not this type of comprehensive study. But I thought it would be fun to take a look at some numbers from the past decade along with a few clips from the 2004 prospectus document.

First, take a look at Google’s numbers from its birth in 1999 to the year before going public in 2004:

Google 1999-2003 Financials

It’s incredible to think that Google was once a company that had $220,000 in revenue for a whole year. It’s now a company that grosses that much every 90 seconds.

Also notice that—unlike many tech companies—Google was very profitable at the time of its IPO with a 23% operating margin.

The Importance of Management and Time Horizon

We would request that our shareholders take the long term view.” –Google Original Letter to Shareholders, 2004

A deeper analysis would be needed to try to answer the questions about why Google has become so successful. But one thing to study is the management team and the founders.

Like Jeff Bezos at Amazon, the founders write a letter to shareholders. Interestingly, Brin and Page also reference Warren Buffett’s essays, letters, and Berkshire’s “owner’s manual” as inspiration for their letters and communication with Google shareholders. Here is the original intro to the first letter that you can find on page 27 of the registration document from 2004:

Google Letter Intro

Also like Bezos at Amazon, the founders at Google had very large aspirational goals, and they think for the long term:

Google Long Term View

Brin and Page knew from the beginning that a business should be focused on increasing earning power and shareholder value, not on meeting analysts’ expectations and quarterly numbers:

Google Long Term View 2

To Sum It Up

To summarize the post, here is a look at some of the numbers from Google’s 2004 results compared to the current numbers from 2014:

Google 10 Year Numbers

It’s hard to predict the next business that will compound at around 30% for a decade, but it helps to look for clues from the successful ones of the past. Great management teams are usually essential, and the qualitative factor of “thinking for the long term” should not be underappreciated.

I’ll leave the comprehensive analysis of Google for another time or for someone else, but I enjoyed paging through the old filing from 2004 and reading the letter to shareholders.

Have a great weekend!

I spend virtually zero energy thinking about the overall stock market. I’m always aware of what the indices are doing, but I really don’t pay attention to where I think they are headed or where they’ve been recently. As Munger has said, sometimes the tide will be with us and sometimes it will be against us, but the best thing to do is to just continue to focus on swimming forward.

I think this has been going on for well over a year now, but lately I’ve been hearing about many people who are worried about the stock market. This is a natural enough concern after a 5 year period from 2009-2013 that saw the S&P 500 advance 15.4% per year before factoring in dividends. I would agree that it is a virtual certainty that the next 5 years will not equal or exceed the returns we’ve seen in the last 5 years from the S&P. But it’s interesting to note the level of fear that exists in the market, even as the S&P continues to reach new highs. Many talk about the next “crash” as if another 2008 is right around the corner (maybe it is, maybe it isn’t–I don’t participate in that game, but as I’ll demonstrate below, the odds are against that type of a market event in the near future).

Read About Businesses, not Stock Market Predictions

In any event, this type of observation on the general state of the stock market doesn’t affect the way I conduct my work. It means nothing to me. I’m trying to find good operating businesses at cheap prices, and my energy is firmly focused on evaluating those situations, one at a time. If I find a business that I determine will compound intrinsic value at 10-12% per year and I can buy that business at a material discount to its current intrinsic value, why would I care what the S&P 500 does in 2014, not to mention trying to anticipate the Fed’s next moves, where interest rates are headed, European problems, etc… The macro things are important, as Buffett says, but not knowable (or predictable). So I like focusing on good solid “block and tackle” style investing. Find good businesses at cheap prices. Spend time reading and evaluating these things. Read more 10-K’s and fewer Section A’s of the Wall Street Journal, etc…

Stock Prices Over the Past 200 Years

Having stated the above disclaimer, I will proceed forward with some interesting general market data to share. I’m a glutton for historical numbers, especially pertaining to stocks. A while back I came across a post that had a histogram of the overall stock market returns since 1825. More on the numbers shortly…

Prior to reading that post, I was already aware that from the end of 1814 to the end of 1925, the US stock market experienced compound annual growth of about 5.8% per year. This is based on data put together by Robert Shiller, and this measure used a price weighted index, which has many flaws, but is the way that most of the indices are measured today.

To use a different time period and a different yardstick, Buffett once mentioned that the Dow went from 66 to 11,219 during the 100 year period during the 20th century, which is a 5.3% CAGR. Add dividends to that figure, and shareholders might have realized 7-8% annually or so.

To use a third historical time period, I noticed in Buffett’s annual shareholder letter that the S&P 500 has averaged 9.8% annually over the last 49 years (since he took over at Berkshire).

I think the last 200 years provides pretty good evidence that over the very long term, I feel comfortable expecting the market to average somewhere between 6% and 9% annually including dividends (if I had to guess, I’d be closer to 6 than 9).

As we all know, these averages tend to hold up over time, but any individual year can result a widely varying result–the type of year that is hugely positive or terribly negative, right? Yes, this is certainly true. But I think that the probabilities of these outlier years are much lower (especially the negative outlier years) than many people might realize.

Take a look at the last 189 years of general stock prices:

Market Histogram

Some anecdotes I find interesting by observing the results 189 years between 1825 and 2013:

  • The market had 134 positive years and 55 negative years (the market was up 71% of the time)
  • 44% of the time the market finished the year between 0% and +20%
  • 60% of the time the market finished the year between -10% and +20%
  • Only 14% of the time (26 out of 189 years) did the market finish worse than -10%
  • Only a mere 4.8% of the time (fewer than 1 in 20 years) did the market finish worse than -20%

So to put it another way (using the 189 years between 1825 and 2013 as our sample space), there is an 86% chance that the market finishes the year better than -10%. There is a 95% chance the market ends higher than -20%. And as I mentioned above, there is a 71% chance that the market ends any given year in positive territory.

One last observation: the market was 5 times more likely to be up 20% or more in a year (50 out of 189) than down 20% or more in a year (9 out of 189)!

Now, lest my readers suspect me of predicting further gains… let me make it clear that I’m not trying to make a case that I think the market won’t or can’t go down, or even go down a lot. On the contrary, after 5 years in a row of not just positive years, but exceedingly above average gains, we are certainly “due” for a down year. After all, the market finished the year down 29% of the time over the past 189 years, or about once every 3 or 4 years.

I just think that it’s difficult to predict when the down year–and certainly when the next big crash will come. Make no mistake, the market will crash from time to time. The economy will suffer another banking crisis. It’s just difficult to know when. The stock market certainly will go through another 10% correction in the near future. It will likely go through a 20% correction in the near future. There have been 12 of those corrections since the mid-50’s when the S&P 500 index was instituted, or about one every 5 years. We haven’t had one since early 2009, so we’re due for one of those as well.

Some Businesses Create Value During General Stock Price Declines

But I think it’s important to remember that it’s incredibly difficult to precisely predict the timing of such a correction. And even when such a correction occurs, the business you own might actually be more valuable intrinsically after the correction than it was before it. It doesn’t mean the price will be higher, but often times quality businesses create value during these types of market events. Think about all of the enormous value Berkshire Hathaway created for shareholders during the last crisis in 2008-2009.

There are many businesses that can use their resources to actually take advantage of stock price corrections/crashes, either in the form of buying back their own stock at low prices, making acquisitions, or sometimes just gaining market share as competitors struggle. A study of Henry Singleton at Teledyne is very worthwhile when considering the value that can be created for shareholders during bear markets.

So to me, it is not worth the risk trying to sell a quality asset that is compounding intrinsic value just to try and outsmart other speculators in the near term. It’s a much more achievable task to locate a group of well selected quality businesses that happen to be undervalued relative to their true earning power, and patiently let them compound value for you through low and high tides.

Crashes Are Rare

Although certain to happen again, crashes are rare. The 2008 type scenarios, are extremely rare. Only 3 times since 1825 did the market finish a calendar year down 30% or worse. That’s about once every 63 years. People tend to overestimate the probability of a market crash when one recently occurred. The storm clouds of 2008 are in the rear view mirror, but they are still visible, and the effects of the storm still evident. This phenomenon works in the opposite direction also, as Buffett pointed out in his 2001 letter to shareholders:

“Last year, we commented on the exuberance — and, yes, it was irrational — that prevailed, noting that investor expectations had grown to be several multiples of probable returns. One piece of evidence came from a Paine Webber-Gallup survey of investors conducted in December 1999, in which the participants were asked their opinion about the annual returns investors could expect to realize over the decade ahead. Their answers averaged 19 percent.”

19% for the next decade?! That prediction turned out to be about 20% per year too high. But remember, in December 1999 the market was about to put a ribbon on 5 consecutive years of 20% or greater gains, a feat that never had happened before and likely will not happen again. Irrational exuberance to be sure.

As an aside however, I think it’s interesting to look at how various value investors did during the 2000 to 2002 market crash. Joel Greenblatt once told his students at Columbia that he had two of his worst years of his career in 1998 and 1999, only to gain over 100% in 2000. The 2008 credit crisis was obviously a much different, much more serious, and much more systemic crash, and there was virtually no place to hide. But even those types of events, as rare as they are (roughly once every couple generations) can’t permanently destroy an investor who owns quality assets at prices well below their aggregate intrinsic values. There is one thing I once heard from the great investor Glenn Greenberg that had a profound impact on the way I think about my investments. Greenberg basically said that he wanted to construct his portfolio in such a way that a 1987 type crash (down 25% in one day) would not worry him because the quality of the companies in his portfolio gave him confidence that despite their lower quotational values, their intrinsic values would increase over time, thus providing him with a margin of safety (time was his friend).

Value Investing Requires Patience and Logic, Not Crystal Balls

It doesn’t mean that value investors are immune to market corrections/crashes. On the contrary, the immense discipline and patience that is required of value investors is one reason that the strategy continues to work despite its well known formula, obvious logic, and proven merit. Sometimes the hardest thing to do is the right thing, and human behavior ensures that value investors will always be able to eat.

They key thing to remember is that when you own a stock, you own a piece of a business. Graham’s logic is as simple as it is timeless. It really helps to remember that you don’t own numbers that bounce around on a screen, you own a business that has assets, cash flows, employees, products, customers, etc… Just like the owner of a stable, cash producing duplex located in a quality part of town isn’t frantically checking economic numbers or general stock index prices on a daily or weekly basis, nor should the owner of a durable business that produces predictable cash flow–purchased at an attractive price–be concerned about the day to day fluctuations in the quoted price of his share of the company.

But as Munger said, sometimes the tide will be with us and sometimes the tide will be against us, but the best thing to do is to just continue to swim as competently as we can. Although ocean tides are much easier to predict than the direction of the stock market, I still think it’s best to focus on swimming as opposed to anticipating the changes in the tides.

“You don’t have to know a man’s exact weight to know that he’s fat.” - Ben Graham

I was reading through some notes from the 2008 Berkshire Hathaway Annual Meeting and one of the questions grabbed my attention. The question was pertaining to Warren Buffett’s decision to purchase stock in PetroChina back in 2002. Basically, the questioner was surprised that Buffett made such a sizable investment after a seemingly small amount of due diligence saying “all you did was read the annual report… Wouldn’t you want to do more research?”

Here is the question along with Buffett’s response:

Buffett PTR Response 1

I think think this displays one of the keys to Buffett’s success in the public equity markets that he has used throughout his career… namely, waiting to notice a huge gap between the value of a business and the price that you can buy the stock for.

Also, I think it’s interesting to note how he simply read the report, came up with a value, and only then checked the price. This is something that removes a lot of bias that comes when you know the price of the stock before trying to value it. Most investors will subconsciously anchor everything toward the current stock price. It would be hard to value PetroChina at $100 billion if you knew going in that the market was valuing it at $35 billion.

(Note: this is one of the reasons I enjoy valuing every spinoff situation. Normally, you don’t know the market valuation until the spinoff begins to trade, which allows you to come up with an intrinsic value ahead of time without any reference to the stock price. It can be a useful exercise.)

This appears to be what Buffett did with PetroChina. He loves reading reports, and you get the impression that he picked up the report one day in the spring of 2002, read through it, came up with a rough value of the business, then noticed that he could buy the stock for roughly a third of his estimated value of the business.

Of course, he was able to make this simple, seemingly quick decision to buy PetroChina stock because of his enormous foundation that came from the countless hours of reading and accumulating a bank of knowledge. This informational bank allows him to quickly compute the probabilities of various outcomes for each investment. But the takeaway is that the decision should be based on a few simple variables, and it should be a relatively easy decision. It’s easy to know that a $100 billion company that is currently priced at $35 billion is a bargain.

Indeed, a bargain it was back in 2002:

PTR Chart

Buffett purchased a stake in PTR between 2002 and 2003 at a cost of $488 million. He sold this stake in 2007 for $4 billion, netting Berkshire a gain of 8 times its initial investment. The capital Buffett put to work in PetroChina compounded at about 55% annually between 2002 and 2007.

The quote that I referenced at the top of this post from Graham is one that I always enjoy keeping in mind when valuing businesses. The idea is not to obsess over the details, but to understand the big picture.

Buffett finished his answer to the question with another example:

Buffett PTR Response 2

It’s interesting to hear him say “I never made an investment that would have been avoided due to conventional due diligence.”

To Sum It Up

I recall Joel Greenblatt saying something similar when asked about diving deep into footnotes in annual reports. He basically said that he reads the footnotes also, but he likes to keep the big picture in mind. Things like how good is the business (what returns on capital does it generate?) and how cheap is it (what is the earnings yield?).

Each investor has different ways of analyzing and evaluating investment opportunities, but I definitely think that keeping things simple, and keeping the big picture in mind is crucial to maintaining a margin of safety and establishing superior results over time.

Perhaps the best way to sum up this post is to quote the 18th century German poet Christoph Martin Wieland who once said:

“Too much light often blinds gentlemen of this sort. They cannot see the forest for the trees.”

I’m not sure if Wieland was referring to investment managers, but his words are certainly applicable to our chosen trade.

“We prefer businesses that drown in cash. An example of a different business is construction equipment. You work hard all year and there is your profit sitting in the yard. We avoid businesses like that. We prefer those that can write us a check at the end of the year.”

-Charlie Munger, 2008 Berkshire Hathaway Annual Meeting

I’m patiently looking for bargains everywhere. That’s the name of this game: “figuring out what something is worth and paying a lot less for it,” as Joel Greenblatt says. But everyone wants to be more specific… Ideally, what I like to invest in are compounders. What are compounders? Very simply, they are high quality businesses that can grow their intrinsic value at high rates of return over long periods of time. A business that can grow intrinsic value at say 12-15% over an extended period of time will create enormous wealth for its owners over time, regardless of what the economy does, or what the stock market does, or what earnings multiples do , etc…

I like a business that produces high returns on capital and consistent free cash flow. Like Charlie Munger says, we want to find businesses that can write us a check at the end of the year. I love this simple explanation, and it’s one that I always keep in mind, and it’s a good starting point—a conservatively financed business that can write you a check every year (i.e. produce more cash from operations than it needs to maintain its current competitive position) is unlikely to get you into trouble. That’s why I like keeping a list of businesses that have produced 10 consecutive years of free cash flow.

Cash Flow is Nice, Reinvestment Opportunities Are Better

I love the business Munger talks about that cuts me a check every year from its consistent and stable cash flow. But ideally, I’m looking for businesses that will forego sending me a check because of the attractive reinvestment opportunities that it has within the business itself. In other words, I would prefer a business that not only produces high returns on invested capital, but can also reinvest a large portion of its earnings at similar high returns. This is where a business achieves the true compounding power. Typically, these compounders enjoy a niche or some kind of competitive advantage that allows them to achieve consistent high returns on capital.

So it’s really nothing different from what most other investors and business owners want: quality businesses that will produce high returns on invested capital with attractive opportunities to reinvest earnings, which leads to value creation (higher earnings over time).

This gets discussed often, and the variables involved with businesses achieving this type of compounding power are sometimes difficult to ascertain and even harder to predict going forward. But the math is quite simple: A business’ compounding power can be calculated by three simple factors:

  • The percentage of earnings that a business can reinvest back into the business
  • The return that the business can achieve on this investment
  • What the business does with excess cash flow (if the reinvestment rate is less than 100%)

So ideally, we want a business that produces high returns on capital and can retain large portions of its earnings to reinvest at similar high rates of return. If there is excess cash flow that can’t be reinvested, I’m looking for logical capital allocation that might result in dividends, buybacks, or value accretive acquisitions (which are rare).

The Math of Intrinsic Value Compounding

I recently read something that used some examples to illustrate this compounding formula. Basically, the compounding effect is the product of the first two factors: return on capital and the reinvestment rate. If a business can achieve 20% incremental returns on capital and it can reinvest 50% of its earnings each year, the intrinsic value of the business will compound by 10% annually (20% x 50%).

Similarly, a business that can reinvest 100% of its earnings at 10% returns will see the value of its enterprise also compound at 10% annually (100% x 10%). Note: the first business is better because the higher ROIC and lower reinvestment rate means that 50% of the earnings can be used for either buybacks or dividends (or value creating investments).

ROIC is the Most Important Factor

But it’s crucial to understand the math… the math suggests that return on capital is the most important factor. A business that produces 6% returns on capital is simply not going to compound its owners’ value at attractive rates, regardless of how much or how little it can reinvest. But a business that produces 30% returns on capital will likely see the intrinsic value of its enterprise increase at high rates of return (even if it can only reinvest half of its earnings, the enterprise itself will grow at 15% annually, and the company will be able to create additional value by buying back shares or issuing dividends with the other half of the earnings).

So this hopefully illustrates why return on capital is such an important concept and why Buffett, Greenblatt, and even Graham often discussed it.

The key question is what to pay for a business like this. We haven’t discussed valuation. Ideally, I’m looking to be opportunistic with my investments, meaning that even with what I consider to be great businesses, I want to buy them cheaply because it dramatically increases the margin of safety in the event that you made an error in your analysis.

In other words, we want to locate quality businesses with high returns on capital, but we want to pay low price relative to the earning power of these businesses, as this gives us two things:

  • A margin of safety if we were wrong about the quality or sustainability of the business’ return on capital
  • The benefit of much higher returns if we were in fact right about the business

Heads, we win. Tails, we don’t lose much…

Some investors say that they don’t care about quality, only valuation. This has been shown to be true in various backtests, although most of the tests are short term in nature (usually 1-2 years). I think there are serious flaws in the logic of abandoning quality—and serious risks as a result. After all, quality, like growth, is a part of valuation. Too many investors get caught up in the simple metrics and assume that quality in mutually exclusive from valuation. It’s very much inclusive…

But that aside, it’s fairly logical that we would prefer—as business owners—to own quality businesses over mediocre businesses—valuations being equal.

How Much To Pay?

The question is what price to pay, and my general answer is that it depends on the business and the specific investment. I try to imagine what the business and its normal earning power would be worth to a private owner. I really look at each investment on its own–not as part of a larger portfolio. Each investment has to stand on its own.

When it comes to valuation, I’ve heard some people say that for quality businesses, they don’t want to pay more than an average valuation of around say a 6-7% normal cash earnings yield (the so called “good business at a fair price”). I don’t really use this type of thinking, but I think a 10% pretax earnings yield (something Buffett uses as a rule of thumb) is a fair guidepost for a quality business that is growing. This isn’t cheap, I know. It’s why I think of each investment differently. Graham had earnings multiple rules of thumb, Buffett has his rules of thumb, and I think they might be helpful in ensuring that you don’t overpay for what looks like a great business. But keep in mind those are rules of thumb. Some businesses are worth more. Most are worth less.

Think About Durability of Earning Power

As I’ll show in another post, the math behind choosing the “right business” is very compelling—it’s far more important to invest in the right business than it is to worry about whether to pay 10x or 12x or 14x earnings. It’s just that paying a low price protects us from our errors. The problem most investors have is that they are good at paying low prices, but bad at determining whether this low price corresponds to a large gap between price and value. There are lots of mediocre businesses available at 10x earnings, which will lead to mediocre results over time for long term owners.

The quality, the durability, and the earning power of a business are very important factors in assessing the margin of safety of the investment. Every bit as important as determining the normal earnings yield.

Compounders vs. “Special Situations”

Quality businesses will create more value for owners than mediocre businesses (groundbreaking news, I know…). So as a long term owner, I’d much prefer the former over the latter, almost regardless of how cheap the latter gets. A business that is shrinking its intrinsic value means that time is your enemy–you must sell as soon as you can because the longer you hold it, the lower the intrinsic value becomes.

But, flipping stocks might be a different story… it’s possible to buy a bad business at 8x earnings and sell it at 12x, yielding a nice 50% return. However, I find it much more comfortable and suitable to my personality to be able to garner investment results that correspond to the internal results of the business, as this eliminates the need to be right about timing, and it eliminates the need to constantly be producing good investment ideas—which is a difficult task to begin with.

In short, I like having my stocks do the work for me.

Of course, this is ideal, and not everything is ideal, and it leads me to a secondary category of investments, which I’ll group together as “Special Situations”… a category that includes these cheap stocks that can be sold at a profit to a private owner. This subset of investments also includes sum of the parts ideas, cheap/hidden assets, corporate situations such as spinoffs, rights offerings, recapitalizations, tender offers, etc…

The difference between these two categories can be summarized using an analogy of the dairy farmer (who raises dairy cattle to produce consistent milk over time) vs. a cattle rancher (who raises beef cattle which are used for meat production). The dairy cow provides consistent milk over and over for long periods of time. The beef cow doesn’t produce cash flow, but provides a payoff when the beef gets sold.

The compounders are the investments that continually grow intrinsic value over long periods of time with corresponding shareholder results over time. The investor buys compounding machines to partner in a business as a part owner, reaping his or her rewards over time as the business compounds in value. There is not an exit strategy in mind at the time of purchase with these types of businesses. It doesn’t mean they get held forever, but the idea is to compound your investment over long periods of time through the business’s results. The special situations are investments which are bought to be sold to someone else at a higher price.

But even in these “special situation” investments, I tend to keep in mind the same general business principles discussed above. Each investment is unique, but the principles are generally the same.

To Sum It Up

I look at a lot of undervalued situations and various opportunities, but I prefer investing for the long term—partnering with good management who are owner operators of high quality businesses with high returns on capital and attractive reinvestment opportunities.

The math is simple, and it exemplifies the importance of owning a business that can reinvest earnings at high rates of return—a situation that will create a compounding intrinsic value over time.

Some Other Posts in This ROIC Series: