The Forsaken 50%!

What if I told you that 99% of investors (professional and individuals alike) were missing out on a large chunk of the analysis in measuring the value of an investment? How can that be given how quickly news and data flow around these days? What am I smoking?

Well, that is essentially what happens when viewing an investment as a series of discounted cash flows.

As I have mentioned in previous posts, the value of any security or investment is the Net Present Value (NPV) of all future cashflows from the instrument into peretuity, discounted at an appropriate discount rate. While the definition makes a lot of sense, the actual application is much more difficult. What growth rate do we use? What discount rate do we use? We can't use infinity in the number of cash flow periods for the calculation you know. How are we going to do it?

Well, typically, the discounted cash flow (DCF) analysis employed by Wall Street and others (who have the confidence to actually project these numbers--which I have obvious reservations about given that reality is not that simple) use a 10 year model. They tend to take the current EPS or cashflow and put a growth factor of say 10% per year over the next 9 years. For the 10th year they apply a multiple (or a price earnings ratio) of that 10th period cashflow to estimate the "terminal value". Here's an example:


Earnings in year 1 is $100 growing at 7% per annum with a terminal earnings multiple of 15 times earnings (pretty standardised assumptions).

Yr1 100.00
Yr2 107.00
Yr3 114.49
Yr4 122.50
Yr5 131.08
Yr6 140.26
Yr7 150.07
Yr8 160.58
Yr9 171.82
Terminal Value: 2757.69 (171.82*1.07 *15)
Terminal Value Discounted @10%: $1,063.21
Total Value: $3955.49
Total Value Discounted @ 10%: $2,170.24

Now notice how much the discounted value is accounted for by the terminal value....a whopping 49%! ($1,063 / $2,170)

In other words, almost 50% of the "value" of this security is based on what occurs AFTER a 10 year period. Again, 50% of the value is based on what occurs after a 10 year period.

So, why does Wall Street and CNBC and others get mesmerized by quarterly earnings, when the results only really account for a fraction of the actual value of a real business? Beats me, but it sure makes my job as a value investor that much easier. For me this speaks volumes about thinking about investing for the long-term.

Think in Terms of Total Return

Another key component for successful investment management is to think in terms of the total return expectation for each and every investment one makes (including cash).

• the price you pay determines your return.....therefore the lower the price the better the returns
• Graham: "Buy stocks like you buy groceries, not like you buy perfume."
• Example: Buying Coca Cola stock at 50% off today's price will enhance returns nicely over a long timeframe (say 20 years, until the time you really need to "liquify" the holding if at all).
• Again, when you look at your statement each month and see the $ figure of your portfolio, that represents ONLY the amount you would receive if you liquidated your portfolio TODAY. It DOES NOT represent the VALUE of the ultimate liquidation date (which is more than likely many years ahead). Seeing that you are likely to be a NET PURCHASER of holdings until liquidation is required, you want a LOWER price , NOT a higher one.
• SO if I am able to buy Coca Cola stock at a 50% discount today, I love it because it enhances my TOTAL RETURN expectations until I will want to sell (which includes the dramatically increased dividend yield as a result of the lower price)

Simplify

A key component for long-term investment success is in keeping things simple. The markets can actually be quite complex, however there are ways to see things from a more simplistic level, particularly as an individual investor. Here's an example:

Suppose you are a baby boomer who will retire in about 15 to 20 years time and have an investment account where the proceeds will not be required until AFTER that particular date. Then realistically one should NOT be concerned about what happens with the movements (either up or down) of the portfolio during that 15-20 year period or longer. They should only be concerned with what the investments will look like after that period of time. Psychologically it can be quite difficult NOT to be concerned to see an investment portfolio decline in value (like many portfolios did in the crash of 2008).

However, should an individual really be THAT concerned if the $$$ is not required immediately? In fact, an investor SHOULD be happy with such an occurrence because he or she is a NET BUYER of securities so they are able to buy investments at a discounted price. Like Munger says: "Invert, always invert."

• the value of a business today should only be concerning if you are a BUYER....in other words you want a lower price, not a higher one!
• for individual securities: the value of any business is the net present value of future cash flows, so if an investor won't need the $$$ for the next 15-20 years, the value of the their investments will be discounted based on the subsequent long-term discounted FUTURE cash flows AFTER 15-20 years......SO, really the value of one's portfolio should only be viewed based on what an investment's future cash flows are over a 30 year timeframe....how many companies have THAT kind of staying power??? Not many , but there are some :)
• compounding matters more and more as the time frame gets extended.
• therefore, as a 30 year investor, DURABLE competitive advantage of a business is the most critical.
• a finite competitive advantage is a death sentence because people end up overpaying for an advantage that only lasts a short time. DURABLE competitive advantage, on the other hand, is like heaven on earth...paying a reasonable price for such a business and waiting for compounding to do its work is what it's really all about.
• the bottom line is that only a few businesses are required to make one successful as a long-term investor. Buy only the ones maintaining DURABLE advantages at reasonable prices....it's really as simple as that!

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?