The ability to buy shares has never been easier than it is today but assessing what makes a good or bad investment remains complex.
With thousands of companies to choose from and an almost infinite amount of information at your fingertips we feel it is more important than ever to know what you are looking for before you start investing. Joel Greenblatt, a US investor we admire greatly, achieved incredible annual returns of more than 30% for 20 years. This was his motto:
"Choosing individual stocks without any idea of what you're looking for is like running through a dynamite factory with a burning match. You may live, but you're still an idiot.”
The law of compound interest has been described as the 8th Wonder of the World. In the Lifetime of Learning section of this site we illustrate this with a chart showing its results. Simply put, an investor who compounds his portfolio at 15% pa for 20 years will end up with 6x as much as someone who compounds at only 5% pa. In order to achieve the highest possible value for investment monies over the long term, investors need to try to compound at the fastest rate possible. Many seek to do this by taking on too much risk only to find the actual outcome achieved is a lower growth rate for their portfolio. A better way to achieve higher compound returns, well proven by the greatest investors, is to own the shares in a business that can grow its own intrinsic value at a faster, but sustainable rate. So, are we saying we want to buy 'growth' stocks? No. We want to find great companies that are run by great managers available at great prices - we call these 'franchises'.
A sustainable business franchise is one that is able to grow its intrinsic value consistently over time while retaining strong defences against the constant threats that emerge from innovation and new competition. Three main forces determine the speed of growth in a company’s value:
A company that is labelled 'growth' will often look good on some of these measures but a company we consider a 'franchise' will excel in all three, plus a few more. Only by detailed analysis and by observing real-life examples of the interplay of these three factors can an investor start to see why some companies can grow their intrinsic value at 13% pa, some at 7% and some not at all.
For example, A company that makes a high return on capital, that is able to grow its revenues at a sustainable rate of c.5% p.a. and then allocates excess capital well can grow its intrinsic value at c.12-14% p.a. Buying such a company’s shares at a favourable price can increase the investment return even further.
While our investment process is complex, we can put it simply - we look for businesses that can compound at an attractive growth rate by being:
Think: Operate, Generate, Allocate
The most important driver, by far, is the ‘operate’ function. Without success or resilience in a company’s chosen field, its returns on capital and cash generated may fall. Assessing and concluding that a company excels in its field is not an easy task. Areas such as economies of scale, differentiation of products, distribution channels or brands all need to be considered. We feel conventional analysis often falls down in two areas – first, when assessing the ‘Operate’ function, many are keen to both tell and believe the ‘story’ of the company’s future. We take on board future changes to business models, but we are also very interested in the company’s past. We feel past achievements and actions should clearly demonstrate the traits and resilience we seek. Second, companies must also excel in ‘generate’ and ‘allocate’ functions if intrinsic value is to grow at an attractive compound rate. We cannot find anywhere in history a great company that did not make a good or great return on its capital and the really exceptional ones allocated it very well too.
“Price is what you pay – value is what you get” Warren Buffett
One of the greatest shortcomings we observe of many investors is their inability to value a company without any reference to its current or past quoted valuations. To us, this is a crucial trait required in ‘value’ and ‘franchise’ investing.
Ben Graham taught us to invest with a 'margin of safety' but this can only be assessed by an independent estimate of an absolute fair valuation. All of the investments we favour are assessed on their likely absolute return over the medium term (3 years) and long term, not on their relative attractions vs other stocks or markets.
As Messrs Buffett and Munger have been so successful investing in high-quality 'franchise' companies, others have looked to copy their approach. However, 'quality' companies are often valued accordingly (i.e. highly) and therefore most portfolios constructed with 50 such companies might do moderately well but they are unlikely to excel due to the high starting prices of such holdings.
With our approach, we only buy into high-quality companies when we feel they are significantly mispriced. As a result, our research ideas and portfolios can have an actionable list of a very small number of companies or, at times, a strong sector concentration. Here is an example:
A well-respected global company that many investors would accept as a franchise today makes a return on its tangible capital of 15%. The intrinsic value of this company is likely to rise, we assess, by c.11% many years into the future, therefore it is an interesting company. What we believe makes it a compelling investment today, however, is its starting price of 10x current earnings (PE). We think it is wrong that an investment which can compound at c.11% for many years can be purchased for 10% earnings yield and therefore, in time, its mispricing will be corrected by markets. So, a move to a justifiable PE of say 13x in 3 years' time, added to an 11% compound annual return, results in an investor IRR of c.21% over the next three years. However, the exact same company shares purchased at, say, a PE of 20x earnings that then falls to a multiple of 15x 3 years would make an annual return to the investor of less than 1%.
Such a thought process can only be applied if: a) our analysis makes us pretty certain of the quality of the company and its likely growth rate; and b) we are confident enough to value the company independent of the current market assessment that suggests there is something wrong with it. Clearly in the above example, we think we have found a good company priced like a bad one.
Over very long periods of time the return from owning a share will closely match the company’s achieved intrinsic value growth rate. That is why we seek those with the best growth rates, at the best price. The reason why our favoured list of stocks is often short is that in mostly efficient markets only a few quality franchises at any point in time may be mispriced. This is the logic to why all the best investors run concentrated portfolios. It is also why Buffett observed "when it is raining gold reach for a bucket not a thimble". In short, price matters. Only by buying great quality companies at cheap prices will we work our way up the compound interest chart and have a margin of safety.
- Warren Buffett
Price is what you pay -
value is what you get
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