Category Archives: Act Like an Owner

Knowing a Business Leads to Investing Success

Great investing may be simple, but it is not easy. It requires that you master not only a number of analytical skills, but also your own emotions.

One of the mistakes that investors make is spending too much time studying investment philosophy and process, and not enough time studying businesses. Investment philosophy and methodology will never be a substitute for knowing a business inside out.

When you come across a “millionaire next door”, he or she probably made their money by mastering a small corner of the business world, not spending endless hours studying management theory or entrepreneurship.

Think Rose Blumpkin. She had an advantage over her competitors because of her relentless focus on the furniture business.

There’s a show on the History channel called American Pickers about two guys who travel around Iowa looking for antiques and collectables that they can then restore and resell. The reason they can make a business out of it is that they have an informational advantage. Through years of focus and experience, they know what will sell and what won’t and, most importantly, what things are worth.

Investing is very similar. You must be able to 1) value a business and 2) wait for the right price.

I believe you should spend at least as much time reading annual reports as you do studying books on value investing. I’m not saying you don’t need to master the great books and writings on investing. On the contrary, this is essential and part of the reason this blog exists. Nevertheless, as you master the framework and develop your own investing process, more and more of your time and energy should shift to studying businesses.

Think how much sense it would make for an aspiring golfer to spend all his time reading books and magazines on golf, but only infrequently play golf.

The foundational skill of a great investor is being able to confidently value a business. Only then will you have the confidence to make a meaningful investment when everyone else is afraid or focused on the wrong things.

What annual reports and 10-K’s are queued up for your reading this week?

Patience Plus a Great Franchise Can Make You Wealthy

The 2nd tenet of my investing blueprint is Act Like an Owner. The 8th tenet is Practice Patience. A great business generates wealth over time. Owners of privately held great businesses know they have something special that is worth holding on to and passing on. They are likely to be naturally patient in holding on to their businesses. I recently came across an example that powerfully reinforces this lesson and shows that the rewards of private business ownership are also available in the stock market.

I saw a comment on an investing forum where a contributor noted that Berkshire Hathaway now enjoys a 27% dividend yield on its original purchase of Coca-Cola. The stock currently pays a dividend of $1.76 on an annualized basis and Berkshire’s cost in the stock is $6.50 per share on a split-adjusted basis ($1.76 / $6.50 = 27%).

It’s amazing to think that you could have put $1,000,000 in Coka-Cola stock in 1988 and today, on top of your unrealized capital gains, you would be receiving annual checks totaling $270,000. Moreover, the $270,000 would be likely to grow at 5-7% as far as the eye can see.

Buffett’s purchase of Coca-Cola is highly celebrated and studied. Buffett invested $1,299 million and it is now worth $11,176 million based on the August 31, 2010 closing price. That is an average annual return of 10.3%, assuming a holding period of 22 years. Buffett purchased shares of Coca-Cola during 1988 and 1989.

What’s interesting to me is not only Buffett’s Coca-Cola purchase and its results, but also how well you would have done if you had purchased shares in other leading franchises at the end of 1988.

Johnson & Johnson

  • Price 12/31/1988 – $3.45
  • Price 8/31/2010 – $57.02
  • Average annual return – 13.8%
  • Current dividend – $2.16
  • Dividend yield on cost – 63%

McDonald’s

  • Price 12/31/1988 – $4.42
  • Price 8/31/2010 – $73.06
  • Average annual return – 13.8%
  • Current dividend – $2.20
  • Dividend yield on cost – 50%

Exxon Mobile

  • Price 12/31/1988 – $5.48
  • Price 8/31/2010 – $59.11
  • Average annual return – 11.6%
  • Current dividend – $1.76
  • Dividend yield on cost – 32%

Pepsico

  • Price 12/31/1988 – $4.18
  • Price 8/31/2010 – $64.18
  • Average annual return – 13.42%
  • Current dividend – $1.92
  • Dividend yield on cost – 46%

Total returns would be considerably higher if the calculations included the reinvestment of dividends.

It is worth noting that these companies were very well established and widely followed in the late eighties. Their strong economics and competitive advantages were on display for any investor willing to take a look. In short, they were hiding in plain sight. Moreover, I could have found many other examples of companies with similar performance.

Most investors missed them because they were not “hot” or “exciting”.

Also, it is important to understand why these businesses were able to produce such impressive results. These types of businesses earn high returns on equity, typically 18-20% or higher. After paying dividends and repurchasing shares, they are able to increase their equity by 10-15% per year. This reinvested capital, in turn, earns a high rate of return owing to the businesses’ durable competitive advantages. The mathematics are the same as those in play if you kept adding money to a savings account; the unusually high rate of return is a function of the moats these businesses enjoy.

Finally, don’t forget that if you invest outside of a retirement account, the tax benefits to this type of investing are huge. Buffett points out that the deferred capital gains tax amounts to an interest-free loan from the government.

Today, many world-class global franchises are available at very reasonable prices. Smart investors have taken notice and are buying large numbers of shares. Take a look at the holdings of leading investors at gurufocus.com.

Remember, as we have learned from Buffett, sins of omission can be every bit as costly as sins of commission.

Buffett’s Investment Process: Simple, but Not Easy – Part 2

Buffett’s investing process is grounded in common sense and uncommon wisdom.

Buffett argues that the approach you should take to investing in public companies through fractional ownership via the stock market is precisely the process you would use if you were looking to purchase a private business in a small town, for example, a gas station or a lawn care business.  You would first examine the business and its competitive position to reach a judgment about how stable the business was, whether it could be expected to prosper and grow or decline under the weight of increased competition, changing demographics, or whatever other factors would impact the business’s prospects.  This is the certainty factor.

You would then try to estimate how much cash the business would generate over its lifetime, taking fully into account the capital expenditures you would need to make to maintain and grow the business.  You would then estimate the timing of the free cash and discount it back by the risk free rate of return to arrive at an estimate of (maximum) value of  the business – what Buffett’s call intrinsic value.  The final step would be to compare this value to the asking price and make a decision.

Most investors would intuitively do these steps if buying a private business, yet, when many of these same investors consider buying a stock, they spend their time looking a host of factors that having little or nothing to do with the value of the business.  They forget that a stock is not a piece of paper but fractional ownership in a business.  Over time, the economic success – or failure – of the business will govern the results they achieve.

Finally, unlike many valuation practitioners, Buffett does not use a higher interest rate to compensate for uncertainty in a prospective investment.  To him, the thought process is binary: either an investment has the required level of certainty of it does not. This assessment starts with a judgment of whether the business is within your circle of competence and if you can make a reasonably sure assessment of the business’s future prospects after consideration of the facts.  Buffett does not think it makes sense to compensate for uncertainty by raising the discount rate in your calculation of intrinsic value.

Buffett’s investing framework can be used to value all assets including the general stock market.  The long term driver of the stock market’s total return is corporate profits.  Certainly there are other factors at play such as investor sentiment and interest rates, but in the long-term it is the underlying performance of the businesses that make up the stock market that will determine the long-term performance of the stock market.  In the long-run, you cannot expect the stock market to return in aggregate results that are greater than those of these underlying businesses.

Buffett’s approach to beating the market is a combination of buying stocks that are cheaper than the general market and that are growing intrinsic value faster the general market.  In both cases, Buffett looks to get more value for his investments than he could get by investing those same dollars in an index fund.  Wash, rinse, repeat.  Buffett has been using this same playbook to consistently trounce the market for over fifty years.

Doug Kass and Market Noise

Doug Kass, a frequent guest on CNBC and general partner at Seabreeze Partners Management, has made a call that the market has made a low for the year. He may be right.

The Internet and cable networks are full on a daily basis of these types of market calls. In order to be correct, a market prognosticator needs to be correct not only about short and medium-term economic fundamentals but also about market participants’ mass psychology. Can anybody do this on a consistent basis?

The world pays attention because the majority of market participants are speculators not investors. What’s the difference? If you’re a speculator you’re focused on trying to figure out what the price of a given security is going to do in the short term.

If you’re an investor, you’re focused on doing deep fundamental research and finding a situation where the value you receive in making the investment is greater than the cash you invest. Moreover, the payoff more than compensates you for the risk that you are taking. An investor generally has no idea when the market will recognize the under-appreciated value in his investment. He doesn’t overly fret about this because the timing – absent a clear catalyst – is generally not known.

The majority of the world gravitates to speculation because its generally viewed as the path to fast money. If your money manager is in this school, he appears to have super insight into the future – one that is worth a lot of money. Who wants some old-school money manager who just picks a group of boring stocks and sits on them for five to ten years?

The problem with this thinking is that the evidence shows that the real wealth has been generated by true investors.

So why bring up Doug Kass? I have no beef with Mr. Kass – he seems like a very sharp person. The reason I bring this market call up is that as investors you have to be vigilant not to come under the influence of all the noise that is out there. If you’re an investor, it’s not your game. You need to approach it like you would if you had a chance to buy a great business in your city in a private transaction.

What types of things would you be thinking about? I don’t believe it would be whether the markets had made a low for the year.