Buy Good Companies
This investor invests in "good' businesses. What are "good" businesses?
- They are unchallenged by new entrants.
- They have growing earnings.
- They are not vulnerable to being technologically undermined.
- They can generate enough free cash flow on a regular basis to make the shareholders happy, either through dividends, share repurchase, or intelligent reinvestment.
However, he is
not attracted to companies that have hit a rough patch and need to recover.
Although he buy shares with the expectation that he will one day sell them, he
prefers to hold on to them for a number of years and rides the companies' performance.
If he will commit at least 5% of his assets to a company, he must be sure that it has a
considerably more than a fair chance of working out.
Though he does not want to control the business, he
sees himself as owner of a business and its surplus cash flow.
He expects to
get his returns from the company's profitable operations as these become
reflected in the price of its shares.
(This stance is considerably different from that of value investors who buy cheap stocks that have fallen below the reproduction cost of the assets and wait for the market to realise that it has overreacted.)
He looks for other signs that identify the kind of good businesses he covets.
High profit margins are a positive mark; these make the company's earnings less vulnerable to changes in the level of sales. They may also indicate that the company is
operating within a franchise and is less susceptible to having its profits eroded by a new entrant.
He likes duopolies, because the two firms generally do not compete intensely with one another, and certainly not on price, so each is left with a high return on capital.
Monopolies, by contrast, are always subject to government intervention, either to break them up or regulate their earnings. And even if governments do nothing, they are an invitation to new competitors to try to capture some of their very lucrative business, often by using a newer technology that allows the entrant to leapfrog the incumbent with lower prices or better products.
In making his long-term commitments, he wants to
invest with smart management that has the shareholders' interests in mind. He has had generally bad experiences when he tried to influence managers to change direction, and he is not contentious enough by temperament to enjoy the struggle. It may be true that a company being run by superior executives has nowhere to go but down once those managers leave, and that buying the stock of a poorly run company at a deeply depressed price can position the investor for a profit once management improves. But that is a speculative bet;
sometimes bad management stays in place for decades.
He expects to own his stock for 4 or 5 years. He doesn't want to wait on the chance that better management will show up, and he doesn't want to lead a shareholder revolt to make that happen.
All he needs to know is that the current managers are healthy and young enough to keep the company on course for a few more years.
Buy Them Cheap
He normally holds shares in 10 or even fewer companies, on average he needs to put a lot of money into any one name.
Because great situations are so difficult to find, he is prepared to buy 20% or more of any one company.
While there are around 1,500 or more companies large enough for him to own,
his "good business" requirement probably shrinks that list by 80%, leaving him with no more than 300 possible candidates.
But even within this restricted universe, he is brutally selective.
He is looking for "two-inch putts," by which he means investments that will
provide him with a high rate of return while subjecting him to a low level of risk. There is only one way he can meet that goal.
He has to spot companies that meet all his standards and are still available at a price that will provide him a high rate of return based on future earnings growth.
He is not attracted to turnaround companies or cyclicals, where a successful investment depends on timing. He does not believe in speculating that an
underperforming company will be taken over, because most managements resist selling out. Opportunities to make this kind of investment arise irregularly, and then due to unpredictable circumstances. For example, a change in government regulations can be the vehicle. The newness of the issue, and the volume of shares available at one time kept them cheap, at least initially.
Sometimes a cloud settles over whole industries based on little more than
questionable assumptions about the future. This provides him opportunities to buy good companies cheap.
Glenn Greenberg of the Chieftain Capital Management.
