My Golden Rule of Investing

My Golden Rule of Investing: 
Companies that grow revenues and earnings will see share prices grow over time.

• Over the long term, when companies perform well, their shares will do so too.  
• When a company's business suffers, the stock will also suffer.

For examples:

Starbucks has had phenomenal success at turning coffee - a simple product that used to be practically given away - into a premium product that people are willing to pay up for.  Starbucks has enjoyed handsome growth in number of stores, profits and share price.  Starbucks also has a respectable return on capital of near 11% today.

Meanwhile, Sears has languished.  It has had a difficult time competing with discount stores and strip malls, and it has not enjoyed any meaningful profit growth in years.  Plus, its return on capital rarely tops 5%.  As a result, it stock has bounced around without really going anywhere in decades.




Over the long term

Over the long term, when a company does well, your interest in that company will also do well.

Stocks are ownership interests in companies.  Being a stockholder is being a partial owner of a company.

Over the long term, a company's business performance and its share price will converge.

The market rewards companies that earn high returns on capital over a long period.

Companies that earn low returns may get an occasional bounce in the short term, but their long-term performance will be just as miserable as their returns on capital.

The wealth a company creates - as measured by returns on capital - will find its way to shareholders over the long term in the form of dividends or stock appreciation.

The market frequently forgets the important relationship between Return on Capital and Return on Stock

Return on Capital

Return on capital is a measure of a company's profitability.

                Return on Capital = Profit / Invested Capital


Return on Stock

Return on stock represents a combination of dividends and increases in the stock price (capital gains).

                Stockholder Total Return = Capital Gains + Dividends




The important relationship between Return on Capital and Return on Stock

The market frequently forgets the important relationship between return on capital and return on stock.

A company can earn a high return on capital, but the shareholders could still suffer if the market price of the stock decreases over the same period.

Similarly, a terrible company with a low return on capital may see its stock price increase

• if the firm performed less terribly than the market had expected, or,  
• maybe the company is currently losing lots of money, but investors have bid up its stock in anticipation of future profits.

Short run

In the short term, there can be a disconnect between

• how a company performs and 
• how its stock performs.

This is because a stock's market price is a function of the market's perception of the value of the future profits a company can create.

Sometimes this perception is spot on; sometimes it is way off the mark.



Long run

But over a longer period of time, the market tends to get it right, and the performance of a company's stock will mirror the performance of the underlying business.




The Voting and Weighing Machines

The father of value investing, Benjamin Graham, explained this concept by saying that in the short run, the market is like a voting machine - tallying which firms are popular and unpopular.  But in the long run, the market is like a weighing machine - assessing the substance of a company.




Message

What matters in the long run is a company's actual underlying business performance and not the investing public's fickle opinion about its prospects in the short run.

Warren Buffett’s $1 test and how to tell if a company is allocating its capital wisely

Buffett is essentially talking about return on invested capital.

• If a company invests $100 in something at the cost of capital of 10%, which in turn earns $7 in earnings forever, it would have a market value of only $70 ($7/10%), failing the $1 test. 
• Earnings of $11 or more would pass the test. 
• When companies make the decision to invest in M&A, CapEx or buybacks, they must make a conscious effort in evaluating if the potential returns would be meaningful and not capital destructive.

------

By The Fifth Investor on October 9, 2017

Companies small or big must make capital allocation decisions on a frequent basis to maximize returns for shareholders. But only a few companies in the world have excellent capital allocators at their helms, most companies are run by excellent operators who alone are enough to generate meaningful profits, which shareholders would find forgiving enough.

Before a corporation invests in machinery, equipment, property or securities, like us they must make comparisons of returns that they’ll get when they allocate capital. These decisions are far more complex than personal decisions as they often involve a giant leap of faith into the unknown.

• How did Google calculate that Android would be a massive hit when they decided to allocate millions of R&D to it? 
• How did Google’s other failures not stop it from deciding to simply invest their monies in stocks or bonds or themselves (share buybacks)?

These decisions are of the highest risk, have a high potential for failure but if successful often give shareholders a multifold return. Although this may seem daunting to a budding retail investor, there are simpler ways to see if a company is allocating capital wisely: think top-down, think big.

1.  Capital expenditures –

• Is the company spending its cash meaningfully in CapEx? 
• What is the return on invested capital for the company? 
• Has the company managed to earn healthy returns on the incremental invested capital over the years? 
• What is their strategy? 
• In CapEx intensive industries, sometimes CapEx is spent not to expand and grow the business, but to just survive. That is often not an ideal situation as there’s no buffer should the market turn. 
• On the other hand, a CapEx-lite industry would see companies compete by spending in other areas that may not appear in the CapEx category.

2.  Share buybacks –

• Is the company spending its precious money buying back shares at all-time highs? 
• There’s a difference between mandated share buybacks and opportunistic buybacks. One is buying back shares no matter the price of the shares, and the latter is buying back shares only if the value of the company is worth more than its traded price (E.g. Berkshire will only execute buybacks when its P/B ratio is below 1.2).

3.  Mergers & acquisitions –

• Is the company acquiring businesses to bolt on to their existing operations? 
• How competent is the current management in the new industry where they’ve acquired a company? 
• How much of a premium have they paid to buy a company? 
• Does it even make sense? 
• A wasteful merger or acquisition can be deadly to your financial health.

4.  Cash –

• Is this company cash rich? 
• Does the management not know what to do with it? 
• What’s holding the company back? 
• Companies that are cash rich often trade at a discount, making them appear cheap, the most famous example would be Apple (although there may be tax reasons why Apple has stashed such a huge pile). 
• There’s a reason why companies like these appear cheap – the market deems the management to be incompetent in redeploying capital to earn a meaningful return for shareholders, and applies a discount to its shares.

Another way to look at it is the simple $1 test that Warren Buffett came up with in the 1980s:

“We feel noble intentions should be checked periodically against results. We test the wisdom of retaining earnings by assessing whether retention, over time, delivers shareholders at least $1 of market value for each $1 retained.

Unrestricted earnings should be retained only where there is a reasonable prospect – backed preferably by historical evidence or, when appropriate by a thoughtful analysis of the future – that for every dollar retained by the corporation, at least one dollar of market value will be created for owners. This will happen only if the capital retained produces incremental earnings equal to, or above, those generally available to investors.”

Buffett is essentially talking about return on invested capital. If a company invests $100 in something at the cost of capital of 10%, which in turn earns $7 in earnings forever, it would have a market value of only $70 ($7/10%), failing the $1 test. Earnings of $11 or more would pass the test. When companies make the decision to invest in M&A, CapEx or buybacks, they must make a conscious effort in evaluating if the potential returns would be meaningful and not capital destructive.

Companies that have heavy R&D spending as opposed to being CapEx-intensive like technology or pharmaceutical firms would require a more sophisticated understanding of their business models. That being said, the fundamentals of capital allocation are like the laws of physics – you can only spend so much cash on multiple failed ventures before the market realizes that you are incompetent.


The fifth perspective

Looking from the lens of an individual, companies are no different from investors at the very root – they’re in the business of making money. There will always be foolish investors and companies alike that waste their money in failed ventures or stupid decisions, and there will always be some rare, exceptional cases that earn outsized returns. Sticking to the basics in asking the most fundamental and simple questions can sometimes save your wealth and/or your company.



http://fifthperson.com/warren-buffetts-1-test-tell-company-allocating-capital-wisely/

Investment Decisions and Fundamentals of Value

Investment Decision Rules:

Accept all investments with Net Present Value greater than Zero.

Accept all investments with Rates of Return greater than their Opportunity Costs of Capital





@ time 39.00

An example:

You are considering an investment opportunity that costs $100,000 and promises to return 10%.

A comparable investment in the financial market returns 15%.

A bank offers to lend you $100,000 at 8% with no conditions.


Questions:

1.  Do you invest $100,000 in the investment opportunity?

Answer:  NO

2.  What is the investment's cost of capital?

Answer:  15%.


Reasons:

You should invest the $100,000 in the financial market that returns 15%.

The financial market provides the investing return standards against which other investments are evaluated.

Financing by the bank loan at 8% was irrelevant to the investment decision.

The investment decision and the financing decision are separate and independent decisions.

After you have made the investment decision, thus:

You are considering an investment opportunity that costs $100,000 and promises to return 10%.

A comparable investment in the financial market returns 15%.

Then you make the financing decision, thus:

A bank offers to lend you $100,000 at 8% with no conditions.

Which company is cheaper? (Understanding P/E, Earnings yield and EBIT/EV.)

Consider two companies, Company A and Company B.

They are actually the same company (i.e. the same sales, the same operating earnings, the same everything) except that Company A has no debt and Company B has $50 in debt (at a 10% interest rate).

All information is per share

Company A

Sales                     $100
EBIT                         10
Interest expense          0
Pretax Income           10
Taxes @ 40%             4
Net Income               $6


Company B

Sales                     $100
EBIT                         10
Interest expense           5
Pretax Income             5
Taxes @ 40%             2
Net Income               $3


The price of Company A is $60 per share.
The price of Company B is $10 per share.

Which is cheaper?

P/E of Company A is 10 ($60/6 = 10).  The E/P or earnings yield, of Company A is 10% (6/60).
P/E of Company B is 3.33 ($10/3 = 3.33). The E/P or earnings yield of Company B is 30% (3/10).

So which is cheaper?
Using P/E and earnings yield, Company B looks much cheaper than Company A.

So, is Company B clearly cheaper?


Let's look at EBIT/EV for both companies.

Company A
Enterprise value (Market price + debt)   60 + 0 = $60
EBIT   $10


Company B
Enterprise value (Market price + debt)   10 + 50 = $60
EBIT   $10

They are the same! Their EBIT/EV are the same.

To the buyer of the whole company, would it matter whether you paid $10 per share for the company and owed another $50 per share or you paid $60 and owed nothing?

It is the same thing!

*You would be buying $10 worth of EBIT for $60, either way!




Additional note:

* For example, whether you pay $200k for a building and assume a $800k mortgage or pay $1 million up front, it should be the same to you.  The building costs $1 million either way!

[Using EBIT/EV as your earnings yield provide a better picture than E/P, of how cheap or expensive the asset is.]

Pretax operating earnings or EBIT (earnings before interest and taxes) was used in place of reported earnings because companies operate with different levels of debt and differing tax rates. Using EBIT allowed us to view and compare the operating earnings of different companies without the distortions arising from the differences in tax rates and debt levels.  For each company, it was then possible to compare actual earnings from operations (EBIT) to the cost of the assets used to produce those earnings (tangible capital employed) and to the price you are paying.

Returns on Capital
= EBIT / (Net Working Capital + Net Fixed Assets)

Earnings Yield
= EBIT / EV
= EBIT / Enterprise Value

As an investor, you are looking for companies with high Returns on Capital and selling for a bargain or high Earnings Yield (EBIT / EV).

REF:  The Little Book that still Beats the Market by Joel Greenblatt

Buffett would always take rates of return on total capital into account

RETURN ON CAPITAL IS VERY IMPORTANT

The example early on this page shows that debt financing can be used to increase the rate of return on equity. This can be misleading and also problematical if interest rates rise or fall. This is probably one reason why Warren Buffett prefers companies with little or no debt. The rate of return on equity is a true one and future earnings are less unpredictable. 

A careful investor like Buffett would always take rates of return on total capital into account. The average rates of return of capital in the companies in Berkshire Hathaway portfolio are:

Coca Cola	39.12
American Express	13.68
Gillette	25.93

A comparison of the rates of return on equity and capital for these three companies is significant and the reader can make their own calculations.

COMPANY RATES OF RETURN ON EQUITY

It is significant that the majority of companies in the Berkshire Hathaway portfolio in 2002 all had higher than average returns on equity over a ten-year period. For example:

Coca Cola	45.05
American Express	20.19
Gillette	40.43

What rate of ROE does Warren Buffett look for?

WHY WARREN BUFFETT THINKS THAT RETURN ON EQUITY IS IMPORTANT

Just as a 10% return on a business is, all other things being equal, better than a 5% return, so too with corporate rates of returns on equity. 

• Also, a higher return on equity means that surplus funds can be invested to improve business operations without the owners of the business (stockholders) having to invest more capital. 
• It also means that there is less need to borrow.

WHAT RATE OF RETURN ON EQUITY DOES WARREN BUFFETT LOOK FOR?

This is a fluctuating requirement. 

• The benchmarks are the return on prime quality bonds and the average rate of returns of companies in the market. 
• In 1981, Buffett identified the average rate of return on equity of American companies at 11%, so an intelligent investor would like more than that, substantially more, preferably. 
• Bond rates change, so the long-term average bond rate must be considered, when viewing a long-term investment.
• In 1972, Buffett implied that a rate of return on equity of at least 14% was desirable. 

Although, at times, Warren Buffett has appeared to downplay the importance of Return on Equity, he constantly refers to a high rate of return as a basic investment principle.

COMPANY RATES OF RETURN ON EQUITY

It is significant that the majority of companies in the Berkshire Hathaway portfolio in 2002 all had higher than average returns on equity over a ten-year period. For example:

Coca Cola	45.05
American Express	20.19
Gillette	40.43

Why Warren Buffett thinks that ROE is Important

Warren Buffett believes that the return that a company gets on its equity is one of the most important factors in making successful stock investments.

DEFINING EQUITY

Benjamin Graham defines stockholders equity as:

‘The interest of the stockholders in a company as measured by the capital and surplus.’

CALCULATING OWNER’S EQUITY

Investors can think of stockholders equity like this. An investor who buys a business for $100,000 has an equity of $100,000 in that investment. This sum represents the total capital provided by the investor.

If the investor then makes a net profit each year from the business of $10,000, the return on equity is 10%:

10,000 x 100
  100,000

If however the investor has borrowed $50,000 from a bank and pays an annual amount of interest to the bank of $3500, the calculations change. The total capital in the business remains at $100,000 but the equity in the business (the capital provided by the investor) is now only $50,000 ($100,000 - $50,000).

The profit figures also change. The net profit now is only $6500 ($10,000 - $3,500).

The return on capital (total capital employed, equity plus debt) remains at 10%. The return on equity is different and higher. It is now 13%:

6,500 x 100
  50,000

The approach to financing its operations by a company can obviously affect the returns on equity shown by that company.

WHY WARREN BUFFETT THINKS THAT RETURN ON EQUITY IS IMPORTANT

Just as a 10% return on a business is, all other things being equal, better than a 5% return, so too with corporate rates of returns on equity. 

• Also, a higher return on equity means that surplus funds can be invested to improve business operations without the owners of the business (stockholders) having to invest more capital. 
• It also means that there is less need to borrow.

ROE and Internet Stocks

As an example, consider the fastest growing segment of 1999, Internet stocks.

Most Internet companies are growing rapidly, but few of them are generating profits.



Apart from America Online AOL and its 25% ROE in 1999, none have generated a high return on capital. 


In 1999, the ROE for market darling Amazon.com AMZN was negative 270%.

• In other words, for each dollar shareholders had invested in the company, Amazon lost $2.70.  
• To replenish the lost capital, the company must either issue debt or turn to shareholders for more money -  and there are still plenty of people willing to pony up the money to own a piece of Amazon.  
• If Amazon is going to justify its price, it will eventually have to generate good returns on capital, and whether it can do that depends on which pundits you listen to.  

But there is no argument that returns on capital are the engine that drives stock prices in the long run.


Companies that go on to earn good returns on capital - ROEs of more than 15% or 20% - will probably make good investments.   

Those that struggle to earn a decent return will probably be wretched investments, regardless of how fast they grow.  

So, if someone tries to talk you into investing $10,000 in a restaurant or a few hundred share of an Internet stock, don't ask how fast the company will grow.  Ask how the heck it is going to earn a good return on its capital.

Why Return on Equity Matters

Let's say you want to open a whole chain of restaurants.

In the early years of building your business empire, you will be adding to your capital base aggressively.  

But because of the costs of opening restaurants, you will probably take losses; most companies in their formative stages lose money.  

If after a few years you have sunk $500,000 into your restaurants but are losing $50,000 annually, your return on capital is negative 10%.

It is not necessarily bad for a company to earn a negative return on equity - if it can earn a high return in the future, that is.

An investor will stomach a negative 10% ROE for his restaurants if he believes they can earn much higher returns in the future.

The trouble is, in a company's rapid-growth phase, when returns on equity are most often small or negative, it is tough to separate a good business (one that can earn a high ROE) from a bad business (one not able to).  After all, each is losing money.

Analyzing such companies means asking questions like

• "Is this a company with enough pricing power to eventually command a premium price for its product?"
• And "Is this a company with enough of a cost advantage that it can undercut the competition?"

It means, in other words, asking whether the company's business can either generate a high net margin (profit/sales) or a high asset turnover (sales/assets), the two key components of a high return on capital. 

Return on Equity - it is the long-term return on capital that excites

The way analysts usually measure return on capital for publicly traded companies is return on equity, or ROE.  

ROE =  Net earnings / Shareholders' equity

Shareholders' equity, or equity capital = Total assets - Total liabilities

Shareholders' equity is the part of the company owned by stockholders - the capital they have invested in the company.

A company X earned an incredible 63% on its equity capital in 1999.   In other words, for every $1 of shareholder money invested in the firm, this company X generated an annual profit of $0.63.

Be careful, though.  It is easier to post a large ROE in a single year than it is to maintain that large ROE over a longer period.

Company Y, for example, earned 58% on its equity in 1999, but if you average the company's ROEs over the five-year period from 1995 to 1999, the figure drops to a much less impressive 19%.

It is that long-term return on capital that we're interested in.

Measuring Returns on Capital

What makes a company great?

It is not rapid growth.

It's not landing on a best-of-the-year list.

Rather, it is the ability to generate high returns on capital.

Suppose you decide to open a business.  The money you spend building the business is your capital.

Whether the business is a good investment depends on how much profit you make as a percentage of that capital.

If you earn a profit of $10,000 in a given year and you've invested $100,000 in building the business, you've made a 10% return on your capital.

Not spectacular, but better than a savings account.

Australia's 10 best businesses

Greg Hoffman

October 5, 2010 - 2:59PM

Computershare is one of the five businesses to make it onto The Intelligent Investor's 10 Best Businesses list two years running. It's produced impressive figures; 40 per cent annual dividend growth over the past decade, a return on capital in the mid-teens and a return on incremental capital (the additional capital that's been put in over the past decade) of more than 20 per cent.

So why has the company's share price lagged the All Ordinaries index over the past 10 years?
In a word, ``expectations''. A decade ago, after a staggering 36-fold increase over the prior five years, investors were paying a price-to-earnings ratio (PER) of more than 100 for Computershare.

A PER much above 20 requires decent profit growth in order to justify it; at over 100 it had become extremely stretched. That fact that investors who paid those tech boom prices have been able to achieve positive returns at all is remarkable enough.

Finest businesses

In what's now an annual, post-reporting season ritual, our team has recently crunched the numbers and arrived at a list of the finest businesses listed on the Australian sharemarket.

It's a subjective exercise, of course, but the process we think is quite robust. Starting with all of the stocks in the ASX 200 index, we passed them through analytical filters such as

• 5- and 10-year dividend growth, 
• 10-year average return on capital employed and 
• return on incremental capital employed.

Share price performance is not one of the measures: if a business performs well on the measures we've selected, its share price is bound to take care of itself.

Computershare is perhaps the exception that proves this rule. It's the only one of the 10 businesses to make our final list whose total shareholder returns have failed to beat the market over the past decade. As renowned investor Ben Graham put it, in the short run the market is a voting machine, in the long run it's a weighing machine.

Competitive advantage

In analysing the final list of Australia's 10 Best Businesses, a number of themes emerged. The most important is that the key to great long-term investment returns is some form of sustainable competitive advantage.

This might be in the form of a strong brand like David Jones, a powerful distribution network of the likes of Woolworths and Metcash, or patented technology from a company like Cochlear. Yes, all these stocks made it onto the list of Australia's 10 best businesses.

Sometimes a competitive advantage can be built by reliably delivering results to clients over a long period, as is the case with Leighton and Monadelphous. But this is potentially a weaker type of advantage and one that could be lost more readily than other kinds.

Also, over a short period (say one to three years), it's difficult to distinguish between profits that are the result of a strong competitive advantage and profits that are the result of a powerful industry upswing.
Another point to consider is that a strong competitive advantage often doesn't last. Recently, shareholders of Tattersalls and Tabcorp have learned this the hard way. Exclusive government licences provide a strong advantage but they have a finite life and most of the `excess value' they generate will probably be competed away in the new licence bidding process.

Each year we find it useful to survey the investing landscape from this long-term, numbers-driven perspective. And, if you're keen to work through such calculations yourself, I'm currently recording a `how to' online video series, using Telstra as a case study. The first two videos are available now, and I'll be posting the others later in the week.

This article contains general investment advice only (under AFSL 282288).

Greg Hoffman is research director of The Intelligent Investor. BusinessDay

 http://www.brisbanetimes.com.au/business/australias-10-best-businesses-20101005-165i0.html

Buffett (1981): Prefers buying 'easily-identifiable princes at toad-like prices'. These 'princes' are able to preserve margins and generate attractive return on capital year after year.

Warren Buffett wrote in his 1981 letter.

"Our acquisition decisions will be aimed at maximizing real economic benefits, not at maximizing either managerial domain or reported numbers for accounting purposes. (In the long run, managements stressing accounting appearance over economic substance usually achieve little of either.)

Regardless of the impact upon immediately reportable earnings, we would rather buy 10% of Wonderful Business T at X per share than 100% of T at 2X per share. Most corporate managers prefer just the reverse, and have no shortage of stated rationales for their behavior."

By making the above statements, Buffett is trying to highlight the difference between acquisition rationale for Berkshire Hathaway and most of the other corporate managers. While for the latter group of people, the motivation behind high premium acquisitions could range from reasons like penchant for adventure, misplaced compensations and a fair degree of overconfidence in their managerial skills, for Berkshire Hathaway, the maximisation of real economic benefits is the sole aim behind acquisitions.

Infact, the company is even happy to deploy large sums where there is a high probability of long-term economic benefits but an absence of ownership control. In other words, the company is comfortable both with total ownership of businesses and with marketable securities representing small ownership of businesses.

The paragraphs that follow bring to the fore some of the biggest qualities of the man and what makes him an extraordinary investor. Warren Buffett has a knack of knowing his circle of competence better than most and also a rather unmatched ability to learn from past mistakes. These could be gauged from the following comment:

• "We have tried occasionally to buy toads at bargain prices with results that have been chronicled in past reports. Clearly our kisses fell flat. 
• We have done well with a couple of princes - but they were princes when purchased. At least our kisses didn't turn them into toads. 
• And, finally, we have occasionally been quite successful in purchasing fractional interests in easily-identifiable princes at toad-like prices."

In the above paragraph, the master uses a childhood analogy and likens managers to princesses who kiss toads (ordinary businesses) to convert them into princes (attractive businesses). Put differently, there are certain managers who believe that their managerial kiss will do wonders for the profitability of a company and convert them from toads to princes. While the master has gone on to add that there are indeed certain managers that can achieve this feat, his own track record is nothing to write home about and hence, he would rather prefer buying 'easily-identifiable princes at toad-like prices'.

Although the opportunities for finding these types of companies are very rare, the master is willing to commit a large sum once such opportunities surface. According to him, such businesses must have two favored characteristics:

1. 
   
   An ability to increase prices rather easily (even when product demand is flat and capacity is not fully utilised) without fear of significant loss of either market share or unit volume, and
2. 
   
   An ability to accommodate large dollar volume increases in business (often produced more by inflation than by real growth) with only minor additional investment of capital.

Indeed, an ability to preserve margins and generate attractive return on capital year after year are the qualities that one should seek in a firm that one wants to invest in.

http://www.equitymaster.com/detail.asp?date=7/25/2007&story=8

Return on Capital

Return on Capital

Abbreviated as ROC, refers to a measure of how effectively a firm uses the money (borrowed or owned) invested in its operations.

Return on Invested Capital is equal to the following:
= net operating income after taxes / [total assets minus cash and investments (except in strategic alliances) minus non-interest-bearing liabilities].

• If the Return on Invested Capital of a firm exceeds its WACC, then the firm created value.
• If the Return on Invested Capital is less than the WACC, then the firm destroyed value.

****Stock selection for long term investors

Overview of the the market and stock selection for long term investors

The Market

There is much volatility in the market. This is due to trading activities. The majority of trades are short term trading. Trading has increased in the market due to various factors:

• Increase turnover rates of mutual funds, hedge funds, off shore funds and pension funds.
• Decrease cost of trading.
• Speed of trading facilitated by technology innovations.
• Investing institution and managers are acting more as agents rather than as investors on behave of their clients.

A minority invests based on fundamentals.

Trading can be in derivatives. The nature of derivative securities is based on price or action of another security. Trading in derivatives has too increased.

Is trading a good thing? It does increase liquidity to the market and this is good. However too much trading and speculation has its downsides. This is akin to breathing 21% Oxygen (life-sustaining) versus breathing 100% Oxygen (too much oxygen has the associated danger of spontaneous combustion).

In this market downturn, questions we have been hearing the most recently are:

• Is it different this time?
  
• How long will it last?
  
• Have we seen the bottom yet?
  

Who knows? These questions are important but not knowable, therefore don’t waste time pondering on these.

The questions long term investors should ask are:

• Are you investing in an easy to understand, wide moat and well run business?
  
• Does that business generate consistent cash flows and has a clean balance sheet?
  
• Finally, are you buying at a large discount to what the business is worth?
  

Strategies for selecting stock for the long term investor

Benjamin Graham: "Investment is best when it is business like. "

However, long term investing is not the only way to make money, there are other ways too.


These 4 strategies should aid one’s investment into equities:
1. Select the business that is long term profitable and giving good return on total capital (ROTC).
2. The business should have managers with talent and integrity in equal measures.
3. Understand the business reinvestment dynamics.
4. Pay a fair price for the business.

1. The business to invest in must make money over time.

• Examine how its revenues and profits are generated. 
• How do its products or services contribute to the value of its business? 
• What are its costs? 
• Look for a business that gives good RETURN ON TOTAL CAPITAL (ROTC), not just those with high ROE. 
• Be aware that high ROE can be due to taking on too much debt. 
• Avoid IPOs, start-ups and venture capitals.

2. Look for managers with a good balance of talent and integrity.

• Those with integrity but lack talent are nice people to have as friends, but they may not be able to deliver good results for the business. 
• Those with talent but lack integrity will harm your business and longer term investment objectives.

3. Is the company able to reinvest its money or capital at a better rate over time?

Basically, be conscious of the reinvestment dynamic of the company.

(a) There are companies giving good return on total capital and able to reinvest their capital at better incremenetal rates over time.

• Invest in these companies as they are effectively compounding your money year after year. 
• This is the powerful concept of REINVESTMENT COMPOUNDING seen in some companies, best illustrated by Berkshire Hathaway. (Reinvestment Compounding)

(b) Some companies have good return on total capital but can’t reinvest this at better rate over time.

• For example, a restaurant business may be dependent on the personal touch of the owner. 
• Expanding the business to another restaurant may not generate the same return on capital. 
• In such cases, the worse approach is to grow the business of the restaurant. This is unlike McDonald. 
• Those investing into such businesses should understand that their RETURNS ARE FROM DIVIDENDS and from RETURN OF TOTAL CAPITAL.

(c) Avoid those businesses with no return on total capital but use more capital all the time.

• An example of this is the airline industry. AVOID such investments.

4. Determining the fair price to pay for the ownership of the business is important.

• For the outside shareholder, the investment should earn the same returns as the company’s business returns.
• If the company earns 10% or 12% or 15% per year for 5 years, the outside shareholders should likewise aim to earn a return of 10% or 12% or 15% per year for 5 years by paying a fair price. 
• Paying a PE of 40 for this company may mean not earning such return as the price paid was too high. 
• On the other hand, paying a PE of 10 – 15 gives the investor a better odd of getting this fair return.
• Paying a fair price for owning a business is important. The company earnings maybe as expected but then your returns failed to match these as you have paid too much to own the business.

What about other factors?


The economy, interest rates, fuel prices, commodity prices, foreign exchange, price of gold and geopolitical situations; should not these influence your investing?

Yes, these are hugely important factors. However, they are not predictable and largely out of our control. They are not knowable in advance. It is better to distance oneself from thinking about them when assessing the business to invest in.

Therefore, the approach adopted should generally not be a top-down macroeconomic one, but a bottom-up microeconomic one. “The implication is with the passage of time, a good business over a long period of time produce results to the investor over time.”


Summary

Identify the company that is in a profitable business giving good return on total capital (ROTC).

The managers should be talented and honest, and have the interest of the shareholders.

The business should be able to reinvest capital at higher incremental rates of returns and with discipline. (Reinvestment compounding).

Also, acquire the company at fair price to ensure a fair return. Avoid paying too much for the current prospect of the company, look long term.

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Effectively the above is the same as the QVM approach.


Quality: A good quality company has consistent and/or increasing revenue, profit, eps, and high ROE or ROC.


Value: This is dependent on the price paid to acquire the business. Using earnings yield or PE enables one to determine the fair price to pay for this business.


Management: Look for businesses where the managers have these 2 qualities in the right balance - talent and integrity.


Search out for companies with high ROE or ROTC and low PE or high earnings yield (indicating "cheapness"). Relate the ROE or ROTC to the PE or earnings yield of the business.


A fair price to pay for the business will be the price that guarantees at least a return equivalent to the returns generated by the business you invest in.


Owning a good quality company with talented and honest managers at a good price (fair or bargain price) incorporates all the elements of investing preached by Benjamin Graham, namely the safety of capital considerations, reward/risk ratio considerations and the margin of safety considerations.

Also read: ROE versus ROTC

GROWTH'S VALUE

GROWTH’S VALUE

Growth is not free.

Its price is the cost of capital necessary to support it.

Growth adds value only when the return on capital exceeds the cost of capital.

When capital costs equal capital returns, growth neither adds nor subtracts value, no matter how much or how little growth there is. The reason is intuitive: If an investor putting in new capital charges the same rate that capital generates, then there is no additional return available to prior investors.

Therefore:

1. If a company can attract capital at a cost lower than returns it generates, growth adds value.
   
2. If it attracts capital at a cost higher than what it generates, growth subtracts value.
   
3. If the cost of capital is the same as the return on capital, growth is neutral to value.

The only businesses in the first category are those possessing franchise characteristics. The only way to capture returns on capital greater than the cost of capital is to keep competitors out.

If competitors can get in, capital costs and returns will soon converge upon each other (or worse, capital costs will exceed capital returns).

To come full circle, growth is not free.


Also read:

1. Income Statement Value: The Earnings Payoff
2. Adjustments in Current Earnings figure
3. Avoid Pro Forma financial figures
4. Avoid Extrapolated Future Earnings Growth figures
5. Estimating Growth in Value Investing
6. Franchise Value
7. GROWTH'S VALUE
8. GROWTH'S VALUE (illustrations)