“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:

“I don’t think about the macro stuff. What you really want to do with investments, is think about what’s important and what’s knowable. Understanding Coke or Wrigley is knowable… but we have never bought a business or not bought a business because of any macro feeling of any kind… We don’t want to pass up the chance to do something intelligent because of some prediction about something that we’re no good at anyway.” – Warren Buffett, 1998 at the University of Florida

I just had a few thoughts this morning. There has been a tremendous amount of banter back and forth lately about the market, the Fed, the possibility of a bubble, etc… I’ve had numerous conversations with clients and some friends of mine (non-value investor friends) who believe that the Fed is propping up the market… that seems to be the consensus view.

In these conversations with non-investor friends, I occasionally voice my opinion on my investment philosophy (which is usually greeted by yawns). Value investing is boring. Who wants to read 10-K’s and analyze pages of numbers on financial statements? It’s much more fun to engage in the game theory aspect of Fed policy (i.e. which quarter of 2015 will Yellen decide to raise rates and when will stocks react?)

Debating Fed policy is fun… it’s like debating where LeBron James or Carmelo Anthony are going to end up. It gets great ratings… ESPN is setting records for ratings this July (partly because of the World Cup, but some of the highest rated Sports Centers ever in the month of July have been the shows that have been focused on the various pieces of the current NBA free agency puzzle.)

Here is ESPN’s home page this afternoon:

LeBron Carmelo and Bosh

So this NBA drama is getting great ratings. Similarly, whenever there is a big macro event, CNBC and the other cable news channels always get a boost in their ratings. 2008-09 was a great time to be in the business of news. I love reading the paper, and I enjoy the news probably more than the average person. I find the macroeconomic landscape intriguing, but I personally don’t think that this intrigue–or analyzing it and making decisions based on that analysis–is a productive way to manage capital. There are too many uncertainties in the world to handicap all of the various probabilities. Of course, there are countless possible outcomes with each investment—macro or not—but I try to reduce the amount of variables that I need to understand and consider.

The NBA free agency is great theatre. That’s how I think of the Fed policy and other macro things… great theatre, but it’s really difficult to predict. Wherever LeBron James ends up is important (that’s an understatement—he’s single-handedly probably worth 20 wins to Miami and 30 to Cleveland). So obviously, where he goes will have a huge impact on the various teams involved. It’s important… but, in advance, his decision isn’t knowable.

That’s how I feel about the Fed, commodity prices, the economy, the stock market, and many other aspects of the great web that is macroeconomics. It’s all fascinating, it’s all important, but it’s not knowable.

There are lots of opinions out there on many things that are important, but not knowable. Buffett’s wisdom always keeps things in perspective. I’ll wrap up these brief thoughts the same way I started them–with another Buffett quote, this one from his 1994 shareholder letter:

Buffett 1994 Shareholder Letter Quote

Have a great weekend.

(Hopefully for Chris Bosh’s sake, LeBron drops the curtain on this theatre and chooses a team… if you’re a Disney shareholder, hope that he waits until August to decide)… 

Here is the video I referenced above (it’s one of Buffett’s best in my opinion):

“The highest rates of return I’ve ever achieved were in the 1950’s. I killed the Dow. You ought to see the numbers. But I was investing peanuts then. It’s a huge structural advantage not to have a lot of money. I think I could make you 50% a year on $1 million. No, I know I could. I guarantee that.”Warren Buffett, 1999

Most Buffett fans have seen that quote. I recently had a few questions and comments that I’ve been meaning to address regarding Buffett’s early strategy. In fact, my own thoughts on how Buffett really generated those 50-60% annual returns in the 50’s have changed as I’ve really researched his past holdings. In my opinion, there are two things regarding Buffett’s early investment style that most people don’t fully weight:

  • Buffett understood the power of compounding at an early age, and cared about the quality of a business and its long term earning power, even in the early days
  • Buffett’s portfolio management strategy, and specifically the level of concentration he put on the compounders

There is a perception out there that Buffett made his huge returns in the early years by buying a bunch of cheap Graham style cigar butts and flipping them for profits. At the annual meeting a few years ago, he mentioned that the majority of his returns—even in the early years—were due to just a select few decisions. The rest were largely average results. I think he mentioned he owned over 400 securities during the time of his partnership (not at once—400 over the entire time period of 13 years).

It’s hard to say exactly how he made these 50% returns in his pre-partnership years, but we do know about a few of the investments he made. From studying his early letters and the two main biographies, I believe that he made his returns largely through the higher quality businesses that could compound value (in some cases good businesses with profitable histories that were also ridiculously cheap), and not the cigar butts that everyone talks about. In fact, you can piece together a few of his early investments from reading Snowball and a few other biographies.

Some Early Buffett Investments

Buffett made 75% in 1951, mostly because of a large position in GEICO, that proceeded to double in the first 18 months he owned it. He sold it too soon (it would rise 100x over the coming decades), but he replaced it with another insurer in 1953 that was a profitable business trading at around 1 time earnings and a fraction of book value. Most are familiar with a column Buffett wrote called “The Security I Like Best”, which was an excellent writeup on GEICO. Fewer people know about the next insurance stock he invested in called Western Insurance. Buffett referenced Western Insurance at a talk at Columbia in 1993, using it as an example of stocks he found by flipping through Moody’s manuals:

“I found Western Insurance in Fort Scott, Kansas. The price range in Moody’s financial manual was $12 to $20. Earnings were $16 per share.”

Buffett also wrote up a column on this stock, demonstrating how remarkably cheap the stock was. The interesting thing about looking at the old Moody’s manuals is that the company was profitable, and had a stable operating history with rising premium volume and consistent earnings. As a side note, this stock actually traded as a low as $1 in 1949, and appreciated up to $95 in 1955, a 95-bagger for those fortunate souls who bought the stock six years earlier!

Buffett was buying Western in 1952 and 1953, and although I’m not sure where he sold, it’s likely he at least doubled his money on this stock as well. He said he was buying between $12 and $20, and wrote his analysis write-up in early 1953 when the stock was at $40–later that year it traded to $65 and then to as high as $95 two years later.

We know how good of a company GEICO was, but Western Insurance–despite being incredibly cheap–was also a quality business. Of course, the attraction was not just that it was a good business, but it was cheap: When Buffett wrote the column, it was trading at $40, and had made $24 per share of earnings the previous year in 1952, a year Buffett called a poor year for auto insurers. Buffett felt the company had “normal earning power” of $30 per share, which gave this stock a P/E of around 1.3 at that price.

But back to the issue of the firm’s quality: it’s interesting to note how Buffett was thinking, even in the early days of the early 1950’s, when he was supposedly a Graham style cigar butt investor. Notice how Buffett ends his write-up on Western Insurance:

“Operating in a stable industry with an excellent record of growth and profitability, I believe Western Insurance common to be an outstanding vehicle for substantial capital appreciation at its present price of about 40″. 

Buffett seemed enthusiastic about the earnings power and the profitability, and of course the valuation. But the article doesn’t seem to emphasize valuation as much as you’d think (considering the stock had a 1 P/E)! He clearly is excited about the profitability, the growth, and the stable operating history. It’s also interesting to note that he is recommending a stock that has gone up 40 fold in the last 4 years!

Graham’s Influence on Buffett

Many people think he made 50% by buying a bunch of Graham and Dodd cheap stuff and constantly flipping them. It is certainly true that he bought a lot of cigar butts, but I think even at age 21, he was a much different investor than his mentor Ben Graham. Buffett understood that a quality business can be very valuable as it compounds for you. He was much more interested in GEICO than I think even Graham was (who was more interested in it because of the margin of safety–they could have liquidated it if it didn’t work out). Graham wouldn’t have likely bought GEICO as an outside minority common stockholder. He bought it as a partner and became chairman of the board. Buffett saw GEICO as a compounding machine and put 65% of his assets into it.

One thing I would agree with is that his turnover was much higher in the early years—partly because his conveyor belt of ideas was moving at a much faster speed and he was continually finding ideas that were much more undervalued than the ideas in his portfolio that appreciated, so there was a consistent cycling of ideas.

There are also examples of more of the classic Graham style investments that everyone thinks of… and looking back at some of his early investments, many of them were special situations (the Jay Pritzker cocoa bean investment skyrocketed about 5 fold or so very quickly–that’s one example of a special situation investment he made).

But if you look at his returns and past holdings, I think he was interested in the compounders at an early age… and although he bought net-nets and cigar butts like Cleveland Worsted Mills and Marshall Wells, most of the money he made–even early on–was due to a few big winners that were, for the most part, superior quality businesses. And later in his partnership days–much of the same. He owned a lot more stocks, but even he admits that the big money came from just a few ideas.

An Early Partnership Investment

Everyone knows about the hugely successful American Express and Disney investments in the partnerships, but even in the 50’s, one of his first investments was Commonwealth Bank. And if you read that early partnership letter, you’ll see that Buffett wasn’t interested in it only because it was cheap. He thought that the bank was a high quality bank that was growing intrinsic value over time. Here is how he summarized his thoughts on this particular stock in 1959, which he felt had a current intrinsic value of $125 per share:

“So here we had a very well-managed bank with substantial earning power selling at a large discount to intrinsic value… we had a combination of 1) Very strong defensive characteristics; 2) Good solid value building up at a satisfactory pace, and; 3) Evidence to the effect that eventually this value would be unlocked although it might be one year or ten years. If the latter were true, the value would presumably have been built up to a considerably larger figure, say, $250 per share.” 

He mentions management, earning power, and his estimation that the business will likely continue growing intrinsic value over time. I don’t think he was excited about net-nets that were not compounding intrinsic value as much as he liked the quality businesses. Everyone talks about Munger having this influence on him, and that’s true, but I think Buffett understood this early… even back to his gumball machine days in the barber shops: Cash flow is important. Better yet, cash flow from gumball machines that can be reinvested into more gumball machines is even better.

To Sum It Up

It’s interesting to study Buffett’s past results for obvious reasons. I think many investors are always trying to compartmentalize Buffett’s career and categorize the various phases of his career. There have certainly been phases and evolutions, but I think his ideas on investing in the early 1950’s were much more advanced than even Buffett himself lets on.

And one quick comment on Graham: I believe there are similar misinterpretations on his strategy as well. He is often labeled as a “net-net” investor, and he did employ that strategy in his early hedge fund, but it was one of five or six separate strategies he employed, and it only represented a small portion of his funds. In fact, in some of his writings Graham was much more interested in quality and earnings power than most people realize (see this post on a lesser known book by Graham).

So in terms of mentors, Buffett was most influenced by Graham–there is no question about it. But Buffett was an investing genius, and I think he took influences from Graham, Fisher, and Munger and molded them with his own investment thoughts.

Next week, I’ll finish up my discussion on the importance of Return on Invested Capital. At some point in the near future, I’ll post some comments on some small banks (an area that I have one investment in and will likely have a couple other investments in soon), and a brief summary of one of Buffett’s first bank investments.

Have a great week!

I received a couple questions/comments from readers lately regarding Buffett and some previous comments I made on strategy before and after the Berkshire annual meeting. I always enjoy interacting with readers. The vast majority of my days are spent researching new investment ideas, so I can’t always respond to everything, but please feel free to email me questions/comments to john@sabercapitalmgt.com. I read all my emails even if I don’t always have time to respond. When possible, I’ll respond individually, or when I receive numerous emails on the same topic, I’ll do a post.

As for the questions that I wanted to address on Buffett, a few have to do with his evolution from deep value to quality (an evolution that I think is very misunderstood, which I’ll comment on in the next post).

For this post, the question was on how I think about quantitative vs. qualitative analysis and specifically, what do I think about net-nets?

Here is a discussion that I’ll repost from a comment I made a number of months ago: 

I’m very much interested in the numbers… but I also work hard to try and understand the qualitative aspects of a business. But I generally agree with Buffett when he said the most “sure” money is made on the quantitative side, while the real big money is made when both qual and quant line up…

But to answer your question–very generally speaking–my ideal investment is a great operating business that produces consistent free cash flow and high returns on capital that for some reason trades at a low price relative to normal earnings. But those investments are relatively rare. So I’m always on the lookout for undervalued situations such as hidden or cheap assets or other special situations resulting from some corporate event like restructuring, or spinoffs, etc…

But very simply, I’m just trying to find large, low-risk gaps between price and value. I try to make everything very simple. I want obvious value…

Net-Nets: Almost Always Poor Long Term Investments

The headline above might aggravate some of my friends. So let me briefly explain: investing in net-nets can be a viable strategy, but net-nets are dubious long term investments on an individual basis. The topic of net-nets reminds me of Winston Churchill’s famous words about Moscow in 1939 that I paraphrased in the title of this post… individually, they are risky and unpredictable.

Ben Graham would agree, most net-nets are inferior businesses that by their very nature lead to inferior long term investment returns. However, the overall strategy of owning a basket of them can work. The key is owning a basket of them and selling them “on the blips”–it’s a strategy that I don’t feel comfortable with, for reasons that I’ll elaborate on below.

However, the general strategy seems to continue to work according to all of the tests, and I know investors who have done very well just mechanically buying these things (net-nets, negative EV stocks, etc…). Although I look at net-nets occasionally, I’m not very excited about them. I would prefer to own businesses that are growing intrinsic value (my experience is that most net-nets today have shrinking intrinsic values). This means that over time, your margin of safety will erode, meaning you need the investment to work out sooner rather than later. As soon as you get in, you’re looking for a way out.

So despite the empirical evidence that the strategy can work and my respect for the investors I know who implement such a strategy, I typically tend to pass on most investments in this area. I have a large amount of discomfort when I know that the fate of my investments depends not only on the price that some other investor is willing to pay me for my assets, but also the timeframe in which he or she must accommodate me. In other words, these backtests tend to work because most of the holding periods are quite short (usually just 1 year).

I have done a lot of research on these tests, and just anecdotally, I’ve noticed that many of the holdings in these mock portfolios do in fact jump up in price from time to time, allowing the investor to exit at a profit. But if you look at some of the old portfolios from say 3-5 years back, you’ll find that most of the holdings (even after some occasional significant rises) ended up either in bankruptcy or continue to wallow along at low prices.

One example I wrote about was Charlie479’s investment in NVR vs. his investment in WNMLA.

So as long term investments, they often tend to be quite mediocre. This means you have to have more of a trader’s mentality, or a liquidator’s mentality with these types of really cheap cigar butts. You need to get out of them as quickly as you can once you’re involved. That’s just not a relaxing situation to be in, and it just doesn’t suit my personality.

Net-Nets: A Different Ballgame in Graham’s Day

I think Graham and Schloss had a field day with net-nets in the 30’s-50’s because of the opportunities available. The significance of the discounts that were widely available in the shadows of the Depression cannot be overstated. Schloss often found companies that weren’t necessarily great (some might even be losing money temporarily), but they had “$35 worth of liquid assets with a stock price of $15 and a 6% dividend”. It’s hard to lose money with a basket filled of situations like that. Most of the net-nets today are burning cash at a rate that will erase the margin of safety you initially get in just a year or two. Some of those will work, but they have much higher risk than I think Schloss would have wanted to take on.

A&P: The Largest Retailer in America

Another example that Graham referenced: In the late 1930’s, a company called A&P was the largest retailer in America, if not the world, and in 1938 it traded so cheaply that it was a net-net. (Imagine if Walmart had a bad year or two and traded below liquidation value—that’s the kind of environment Graham was working in)

In the late 20’s A&P traded close to $500 per share. By 1938, it had sunk as low as $36, thanks to a bad year and general pessimism. To put this price in perspective, A&P had net current assets $38 per share, including $24 of cash. So basically, the market was pricing A&P at liquidation levels–assigning no value to their business. But the average earnings per share of the previous 5 years (1933-1937) were about $6 per share. So A&P had a P/E based on avg 5 year earnings of about 6, and it traded below net current assets (which were largely liquid).

These might be some of the more extreme examples, but there were many opportunities to invest in good stable operating businesses that might be experiencing a temporary bad year. These were logical, low risk investment ideas.

The net-nets today (at least in the US) are not of this caliber. Some investors are quite adept at finding cheap and safe stocks, and are achieving excellent results. But on balance, I think Graham and Schloss would have not been interested in the vast majority of net-nets and so-called cheap stocks that show up today in these typical screeners and backtests.

If they were investing today, my guess is that they would have looked at and found many undervalued ideas, and as Schloss did in each decade of his career, they would have adapted to the current set of opportunities, but I doubt they’d be buying most of the net-nets in the US today.

Buffett’s 1989 Shareholder Letter

The above thoughts are much more eloquently and succinctly summarized by Buffett in the ’89 letter:

“If you buy a stock at a sufficiently low price, there will usually be some hiccup in the fortunes of the business that gives you a chance to unload at a decent profit, even though the long-term performance of the business may be terrible. I call this the ‘cigar butt’ approach to investing. A cigar butt found on the street that has only one puff left in it may not offer much of a smoke, but the ‘bargain purchase’ will make that puff all profit.

Unless you are a liquidator, that kind of approach to buying businesses is foolish. First, the original ‘bargain’ price probably will not turn out to be such a steal after all. In a difficult business, no sooner is one problem solved than another surfaces – never is there just one cockroach in the kitchen. Second, any initial advantage you secure will be quickly eroded by the low return that the business earns. For example, if you buy a business for $8 million that can be sold or liquidated for $10 million and promptly take either course, you can realize a high return. But the investment will disappoint if the business is sold for $10 million in ten years and in the interim has annually earned and distributed only a few percent on cost. Time is the friend of the wonderful business, the enemy of the mediocre.

You might think this principle is obvious, but I had to learn it the hard way…”

To Sum It Up

So those are just some thoughts… remember to keep it simple, look for obvious value… and focus on investing in businesses that you can understand and can reasonably estimate intrinsic value. In the end, it doesn’t really pay to put yourself into a rigid style box. Just try to identify the value of things and then try to pay a lot less.

I have a few more comments on a similar topic that I’ll post next week on Buffett, and specifically on his famous “guarantee” that he could make 50% per year investing small sums—a result that he in fact achieved for a number of years by using an investment strategy that I think is mostly misunderstood by most investors.

Until next time…. Have a great week!

Some posts related to this topic:

I recently came across two videos with Mohnish Pabrai. Readers here know that Mohnish is one of my favorite investors to listen to. He is extremely generous with his time, and he has a genuinely interested attitude toward his audience. You can tell that he truly enjoys teaching others about his investment experiences.

Pabrai has given numerous lectures over the past year, and I wrote a summary of one that I thought was particularly interesting here.

In that post, I summarized Pabrai’s results, which I thought are good enough to repost here:

Pabrai Results:

  • 1995-1999: 43.4% annualized
  • 1999-2007: 37.2% annualized (he started Pabrai Funds in 1999 and this is before his fees)
  • 2007-2009: -41.7% annualized 
  • 2009-2013: 32.7% annualized

Basically, Pabrai is interested in playing a “30 year game” as he calls it, which he is now 18 or 19 years into. So far, so good: He’s averaged roughly 26% annually since he began his investment journey in the mid 90’s. Unsurprisingly, he was inspired by the results of Buffett up to that point:

Buffett Results:

  • 1950-1956: 43.0% annualized
  • 1957-1964: 27.7% annualized
  • 1965-1993: 29.1% annualized

After seeing Buffett’s results, he began thinking the same thing that countless of other investors have thought: “maybe I too can achieve such investment success”. This statement could be thought of as unrealistic as it is naive, but incredibly, after nearly two thirds of his “30-year game”, Pabrai has indeed achieved a very similar result in terms of compounded annual returns.

Pabrai runs a concentrated portfolio. He only owns 7 stocks currently, and the majority of his assets are in Horsehead Holdings, General Motors Warrants, Bank of America, Chesapeake Energy, and Citigroup. He has mentioned at recent annual meetings that he is also willing to hold sizable cash positions temporarily while waiting for the right investment opportunity.

Probably the most important thing I’ve ever taken away from Pabrai’s lectures is the following advice that he often gives… He says that in order to significantly beat the market, or to achieve significant results of 20-30% annual returns, you have to do two things:

  1. Don’t try to beat the market (go for absolute returns as opposed to focusing on what the indices are doing)
  2. Don’t buy any stock unless you feel it has the potential to be worth 2-3x in 2-3 years

I agree with both of these points, and I also think Buffett used similar type logic in his early partnership days and even before that, when he averaged 50% per year for a few years. I once posted a blog where I made the comment that Buffett wasn’t trying to beat the Dow in the 1950’s, he was trying to make money. That’s it. He was looking for really, just blatantly obvious undervalued stocks. He didn’t care about the Dow. He did begin using it as a yard stick in the partnership days, but I don’t think he even cared about it then either. I think he was simply out to locate really mispriced undervalued businesses with the objective of making money.

I think there are subtle differences in the way you think about this that can mean big variations in long term results.

The second point is also an excellent one. I sometimes alter the 2-3 years to an indefinite time period, as I’m willing to own stocks for longer periods, but the concept is the same. You need to find huge gaps between price and value. I read write-ups all the time on Seeking Alpha and elsewhere where there is 24% upside, or 35% upside, or even 60% upside. Furthermore, these same write-ups often say things like “plus it has a margin of safety”. To me, if a stock has 35% upside, it doesn’t have much of a margin of safety. I equate the gap between price and value with the margin of safety.  Of course, if that amount of upside is accurate, it’s not a bad result. But the problem is that if one thing goes wrong, then the upside disappears in a hurry, threatening your principal.

It’s hard to find 50 cent dollars, and that’s why Pabrai is extremely patient, waiting and waiting for the right opportunity. This unwillingness to invest in moderately undervalued ideas is one reason why he has been able to achieve such excellent long term results. His patience and his ability to wait for the right opportunity is likely one of the main competitive advantages he has as an investor.

Enjoy the videos…

This is part 2 of my follow up thoughts on compounders, cheap stocks, and the importance of returns on capital. Part 1 is here. Also, some previous posts before that are relevant to this post as well:

To recap last post, I basically wanted to convey that valuation and quality are not mutually exclusive. There seems to be two factions within the large value investing community. It sometimes feels like a presidential primary race. We’re all on the same team at the end of the day, but these two factions seem to always disagree on numerous points. The factions I’m referring to are the Graham deep value followers and the Buffett quality company followers, for lack of a better way to put it.

I espouse that there really isn’t as much of a difference between the two that everyone seems to think. The end game is that we are all trying to locate low risk 50 cent dollars.

In the last post, I made a comment about Fastenal, and that the stock has been one of the best performers in the US Stock market in the last 25 years, averaging better than 20% annual returns since the late 1980’s. Of course, many will say: “sure, it’s easy to use FAST as an example”. That’s true, it is…

And I agree that even though paying 50 times earnings would have worked very well for FAST shareholders in 1989, I’m not interested in going anywhere near that type of valuation, because I don’t want to rely on my dubious ability to predict the future that far in advance. However, this does not mean that I want to abandon my effort to study some of the most successful businesses of years past. Improving pattern recognition skills increases the probability of successfully identifying these types of quality firms going forward.

I want to find good businesses and I want to own them. I just am not willing to pay the prices they typically trade at. So I wait for opportunities for good operating businesses at cheap prices, occasionally investing in some special situations, hidden asset situations, or other undervalued safe ideas. Often enough, I’ll locate an idea where I can buy into a quality company at a very cheap price. In the last post, I referenced a very low risk, low cost bank that I own that has grown book value at 9.3% annually over the past 15 years without a single down year, has paid a sizable dividend every year since 1926, and yet could be purchased at 7 times earnings and 60% of book value. Those are the types of compounders that I like to own. If I’m wrong about the quality, I didn’t pay much for it. If I’m right about quality, my returns will be significantly better than a similarly valued lower quality stock.

As Pabrai says, “Heads I win, tails I don’t lose much”.

Return on Invested Capital is Most Important Over Time

The following is a collection of some comments that I made following one of the previous posts. I thought it would be interesting to demonstrate the importance of quality (return on capital) when it comes to long term ownership of equities. Again, this doesn’t mean that buying at 70% of book value and selling at 100% is a bad idea (on the contrary, it’s one that I will participate in under certain circumstances) it just means that over time, companies that can consistently produce returns of 15% on their capital are going to create far more wealth for their owners than companies that only produce 5% on their capital.

As I mentioned, I’ve done some rudimentary studies of this ROIC vs Value topic previously. A good way to demonstrate the importance of high returns on capital is to look at long term shareholder returns (over 15-20 years or more). For example, I just picked up my Value Line and flipped to the steel section, and industry that is known for their low returns on capital over time. Note: the steel industry is cyclical, which leads to very volatile results. The companies will produce periods of very high returns followed by periods of very low/negative returns. But over the full cycle, the economics of the steel business inevitably lead to very mediocre returns on capital of 4-6% in most cases.

We could do this exercise on a number of stocks, but take US Steel for example. This company has reorganized a couple times in the past few decades and so a glance at the chart doesn’t reflect the entire story, but it still provides a Keynes style “roughly right” look at the results a long term owner would have achieved. Pulling up a long term chart we see that the stock (X) traded around $30 per share in the early 1990’s.

X Long Term Chart

USX earned around $3 per share in the early 1990’s, followed by a few years of losses, and then a period of excellent profits in the early 2000’s, and then back to losses.

But just taking a snapshot in time in the early 1990’s, one could have bought the stock at $30 or so at around 10 times earnings. Today, the stock trades at $25, leaving long term shareholders with a loss of principal after 20 years or so.  Interestingly, even if we paid 3 times earnings for X in the early 1990’s—which would have been around $9 per share—our returns over the next couple decades would have only amounted to around 5% per year, which equates roughly to the company’s average return on capital.

Now, you might notice that we could have paid 3 times earnings and then sold out at a profit a few years later, reaping a nice IRR. But this relies on buying low and selling high in a shorter period of time–a feat that is much easier said than done. In retrospect, it seems like a cinch: just buy in 2003 and sell in 2007, right? Some can practice this type of investing, but I find that timing is the most difficult aspect of executing an investment approach, so I try to minimize the importance of getting the timing right.

But the point here is that paying low prices to earnings is more important if your holding period is a shorter period of time and you have confidence in your ability to know when to unload your shares at a higher price at some point in the future—a necessary skill when trying to buy and sell mediocre businesses that produce unexciting returns on capital.

Some Other Examples in Steel

Flipping through the steel section of Value Line, this example holds true with many other steel stocks—subpar ROICs over time leading to subpar investment returns over time. Gilbraltar (ROCK) traded at $7 in 1994 (20 years ago), and it trades at $15 now, an annualized return of just 3.5%.

ROCK Long Term Chart

ROCK paid dividends in some years, but they weren’t large dividends, and even if we add 2-3% to those returns, they are still mediocre.

One more example: Ampco-Pittsburgh Corp (AP) traded at $8 in 1994, and it trades at $21 today, a 4.9% annualized return before dividends, which again might add 2% or so to those returns.

AP Long Term Chart

An interesting note with AP, if we go back even further to 1984 (30 years ago), the stock traded at $22 per share. So 30 years later, our poor long term shareholder has roughly the same principal that he started with 3 decades ago, albeit at a much lower real value! It is likely that a buyer of AP stock in the mid 1980’s could have paid far less than 1 times earnings for AP, and still be left with very mediocre long term returns.

I’m not trying to pick on steel stocks. They are just an example of an industry that is burdened by miserable economic headwinds that has left most companies struggling to earn adequate returns over time. Of course, not every steel company produces low returns. The low cost producer might be able to sustainably create above average returns on capital over time. But in a business like steel or any other commodity business, it’s tough.

The exercise is really about any company that produces low ROIC vs any company that produces high ROIC over long periods of time.

High ROIC always wins in the end, given a long enough time horizon.

Compare Long Term Results from High ROIC Companies

One of the best performing stocks of the past quarter century is Fastenal (FAST). FAST sells nuts and bolts, sounds basic enough… but the returns are far from basic. The company averages around 20% returns on capital and produces very consistent results. 25 years ago, the stock traded for a split adjusted $0.32. Today it trades at $44, or 138 times the price in 1989. A $10,000 investment in FAST in 1989 would be worth just shy of $1.4 million today and it would be throwing of $30,000 per year in dividend income to boot—the annual income from the dividend alone is three times the total initial investment! The stock has averaged 21.8% annualized returns not including dividends. This outstanding long term investment result nearly matches the company’s average return on capital over that time.

FAST Long Term Chart

Fastenal earned roughly $3 million in 1988, and a buyer of FAST paid somewhere around 25 times earnings for FAST in 1989. But a buyer could have paid 50 times earnings for FAST in 1989 (or roughly $0.65 per share) and the compounded annual return would have only decreased from 21.8% to 18.4%…. a big difference over time, but certainly still a splendid result.

This is just one simple example, but a similar long term result could be observed with Walmart, McDonalds, Starbucks, The Gap, Wells Fargo, M&T Bank, Eaton Vance, and many other well-known examples of high ROIC companies that have correspondingly high stock CAGR’s over time.

Valuation and Quality: “Joined at the Hip”

The idea here is not to attempt to push long term compounders. And these comments above will agitate deep value guys. But, I certainly am NOT recommending paying 50x earnings—even for great businesses. Capitalism is too competitive and the future is too uncertain (at least for me) to be able to consistently pick out the next Fastenal.

But it does demonstrate that a business that can sustainably produce high returns on incremental investments over long periods of time (a good business) is far more important for long term shareholders than the price they initially pay for that business.

Again, I cannot emphasize enough that valuation is more important over shorter time periods, quality is more important over long time periods (10-15 years or longer). The longer you hold a stock, the more important the quality of that company is, as your long term returns will approximate the company’s business results–and their internal returns on capital over time.

In the shorter term (1-3 years), valuation is key. You can buy a steel company at 5 times earnings and will likely have the chance to sell it at 10 times earnings at some point. Same goes for low P/B stocks, net-nets, etc…

It seems that the two factions I referenced above always want to put their style into a box. I try to think about it more simply, more logically. If my goal is to locate and own a group of businesses, I want those businesses to be of high quality, conservatively financed, predictably stable, well managed, and cheap.

Forget about the metrics, the style boxes, the value leader you follow, etc… just try to think about what kind of business you want to own, and what kind of long term rate of return you demand, and then search out ideas that match those things. Look for the simple, the understandable, and the obvious—large gaps between price and value.

The objective is the same: figuring out what something is worth and paying a lot less for it.