Don't Forget Rule Number One

If one is a long-term investor like myself, what happens in the next 10 years for a company purchased today is very important in terms of the return on the investment over that timeframe. But what may be even more critical is what the company will look like after those ten years have elapsed. The intrinsic value of any company is the present value of future cash flows discounted back. So, not only is the performance of the company over the next 10 years important but equally important in my view is the outlook for the company after those 10 years have elapsed. After all, the value of the company at that time will be based on the subsequent long-term expectations for the business (in other words, discounted cash flows).

To me this is critical. Can we be really sure that a company like Google will have the same powerful forces at play as they currently have today? If those forces aren't at play in 10 years times it will definitely be reflected in a lower market price.

A company may be very valuable today but might not be that valuable in the future. This is why a business having a durable competitive advantage will tend to generate the best returns over time. This is the best way to avoid "losing money".

Don't Lose Money

I came across the transcript for the most recent press conference held by Warren Buffett and Charlie Munger following the Berkshire Hathaway annual meeting from a couple of weeks ago. It's amazing the little pearls of wisdom that come out their mouths even when they're answering somewhat simplistic questions from the general press. This is why I'm not afraid to call myself a Buffett and Munger "junkie".

One "pearl" was what Buffett says here (the first part I've heard him talk about numerous times but it was the last sentence that really struck a chord with me):

During the Internet boom, I gave an exam to a class, with but a single question. That is, describe an Internet company, and then tell me what it's worth. Anyone who gave an answer flunked. That's the problem in high tech -- a few will profit, but a lot will have problems, and it's hard to see who does what in advance. We know that Snickers bars will still be sold and do well in 10 years. That doesn't make candy a better business; it's just that we know who the winner is.

"That doesn't make candy a better business; it's just that we know who the winner is."

I believe this is the most underrated part of the whole Buffett philosophy for wealth generation. Buffett has mentioned in passing many times that there are 2 rules in investing:

1. Never lose money.
2. Never forget rule #1.

Buffett also has clearly stated in the past that he only focuses on companies within his "Circle of Competence". His circle is clearly defined for him and one of the main parts of that circle is his requirement that he have the highest CONVICTION of estimating the future cashflows of the particular business he's interested in. These companies just happen to be in businesses that have some sort of a long term competitive advantage and that CONSISTENTLY grow cash flows and thus earnings over time.

Over the next 10 years, there will be certain businesses that will do better (and many much better) than what a company like Wrigley's will do. But how can one know for certain which they will be? The obvious answer is that no one can truly know. One could say the same about Wrigley's then no? Well, that is true. However, the ODDS of Wrigley still doing what they're doing 10 years from now and doing it well are fairly high. Can one say the same thing of say a company like Google or Yahoo!?

When someone is able to identify great businesses that are not likely to change much over the long-term, the analysis becomes easier. The higher one's comfort level in estimating the future cash flows of a company, the more the analysis becomes comparable to the valuation of a bond where the cashflows are written right into the contract. And the lower the price paid for those future cash flows, the better the return.

Most businesses will have future cash flows that are just too difficult to estimate. These will end up in what Buffett calls the "Too Hard" basket.

So in summary, the number one rule is to not lose money. This is paramount in the goal of maximizing compounding over time.

Durable Competitive Advantage

A few days back I mentioned that buying the right company is critical over time if one wants to maximize compounding. So how does one determine which companies are actually the best? Well, the following are what I deem as important aspects of a great business:

1. Generates high return on capital

• Simply stated, return on capital is really the return that the company generates from the amount of capital employed within the business.
• The median 5 year return on capital for members of the S&P 500 is 10.38%. Any company that can significantly exceed this number warrants a very close look.
• Also important is that the company CONSISTENTLY generate high returns on capital. This will tend to weed out those companies in cyclical industries which could have very volatile earnings streams as a result of the type of business they're in.

2. Competitive Advantage?

• One of the keys for a company to generate long-term, market-beating returns is for it to have some sort of DURABLE competitive advantage.
• Warren Buffett, arguably the world's greatest investor, calls the competitive advantage the preverbial "moat" around the business.
• Those companies having some sort of competitive advantage tend to be the ones having the highest returns on capital.
• However, a company having a high return on capital does not necessarily mean that the company has a competitive advantage that is DURABLE.
• The difference between a company having a competitive advantage and a DURABLE competitive advantage is like night and day and is CRITICAL to the success of a company over a long time period.
• For example in the mid-90's INTEL generated consistently strong returns on capital in the 25% to 30% range. However, today those numbers are down to 13%. This an example of a company having its "moat" eroding over time. They had a competitive advantage by being the best and largest manufacturer of microprocessors for personal computers by taking advantage of economies of scale and solid research and development. That competitive advantage, however was not durable....they were susceptible to competitors in their industry and to the qualities of the industry itself.

3. What will the company look like in 10 years?

• To me this is one of the keys to investing success. If the company has a high probability of change due to the type of business, how can one readily gurantee that the high returns on capital generated today will remain in the next 10 years?

4. Once one identifies the high return on capital companies, the work is just beginning. Other considerations:

• High turnover product?
• Free cash flow generator?
• Brand "mindshare"?
• Quality management in place?
• Solid balance sheet?
• Shareholder-friendly?
• High insider ownership?
• Solid market growth prospects?
• Minimal amount of debt employed?
• Free cash flow near to or greater than net income?

And, of course:

• Is the price reasonable?

Simply Munger

I am a great fan of Berkshire Hathaway's Charlie Munger. He has a terrific wit and a brilliant mind. This one statement eloquently summarizes how to think about the investment process:

"The number one idea is to view a stock as an ownership of the business (and) to judge the staying quality of the business in terms of its competitive advantage. Look for more value in terms of discounted future cash flow than you're paying for. Move only when you have an advantage. It's very basic. You have to understand the odds and have the discipline to bet only when the odds are in your favor."

Right Price...Important, Right Company... Critical

Some of the world's best businesses do not always generate the best returns over certain time periods. Over time one can assume that, in general, the growth in the intrinsic value of the company will equate the return one receives in its stock. This is all premised on the person buying the stock of the company at its intrinsic value or within a reasonable range of its intrinsic value.

There are also times when the market provides an opportunity to buy a good or great business at a discount to its intrinsic value (then one can get a "double-dip" of sorts....the gain in the value of the company over time plus the extra price appreciation as the stock's price eventually gets back to its intrinsic value range).

Does the price earnings ratio of a stock need to be below the market (S&P 500) price earnings ratio in order for it to outperform that index? The answer is a definitive no.

For example, I feel that Coca Cola is truly one of the world's greatest businesses. According to Jeremy Siegel in his book "Stocks for the Long Run" at the peak of the "Nifty Fifty" market of 1973, Coke's price earnings ratio was at, what seemed, a very high 46.4 times earnings. What would the return of the stock have been if one bought it at 46.4 times earnings in 1974 and held it until the end of 2006? Well, not bad....11.7% compounded annually. $1,000 invested would have turned into $38,543 at the end of 2006.

This also happened to be very close to the return of the S&P 500 over that time (11.85%). But the difference between the 2 lies in the valuation....the PE ratio for the S&P 500 in 1974 was a much more reasonable 14.3 times. So, the PE ratio for Coke was 3 times that of the market and it STILL generated market-like returns.

This clearly shows that, in investing, the company that one chooses is CRITICAL to outperforming the market over time, just as long as it's purchased at a reasonable valuation or even better if it can be bought at market-like multiples. In other words, buy only the great businesses at good prices and one is bound to outperform the market over long time periods.

Bubbles

The Chinese stock markets are currently in a bubble as can be seen from this chart of the Shanghai B Share Index:

Source: Bloomberg

The B share index is up a mind-boggling 108% year-to-date. This is even worse than the Nasdaq bubble of the late 90's in terms of magnitude.

This is what happens when bubbles pop:

Source: Bloomberg

This is a chart of the main Saudi Arabian stock market which went through its own bubble less than 2 years ago. As you can see, at one point the index was up over 160% in a little over a year and then crashed and is now down 64.2% from its peak.

Bubbles get popped and one can expect the same result from the Chinese stock market in due time.