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.

Mutual Fund Fees

I just read an article in the Globe and Mail which shows Canadian investors as being the highest payers of mutual fund fees of any country in the world. My point is not debate whether mutual fund fees in Canada are the highest but the impact that fees have on performance and in particular, the compounding of returns over time. Here's an example:

The S&P 500 has returned 11.78% compounded over the past 20 years. $10,000 invested in the Vanguard S&P 500 Index fund 20 years ago would total $92,761 to the end of 2006 (current fees are 0.18% annually).

Now let's suppose that we invested that original $10,000 into an "actively" managed mutual fund whose performance matched that of the S&P 500 (by the way this not a small feat as studies have shown that most mutual funds do not beat the S&P 500 over long time periods). Also, we'll assume that fees are 1.5% per annum. This is being conservative as there are many funds in Canada that charge 2% or higher and hedge funds charge 2% as a base before performance fees. That $10,000 at 1.5% fees turns into $70,798 or 24% less than the index fund. If we were charged 2%, that amount becomes $64,668 or 30% less. Oh and by the way, I haven't even mentioned the "load" fees that can be quite substantial when one either wants to buy a new fund or sell an existing one.

I guess the bottom-line is (and Warren Buffett says as much): if you're an amateur investor with little in the way of time and temperament to analyze companies for investment, then the best way for that person to maximize their returns over time is to invest in an index fund. The other option is to find a great manager with a good track record of outperformance whose fees are not higher than the average mutual fund. Don't worry, there are a few out there.

Equity Markets and the Yen Currency

Below is a graph showing the correlations over the past year or so between equity markets (S&P 500, MSCI World and MSCI Small Cap) and the Yen/Euro exchange rate. Notice the late Febuary sell-off where all markets corrected and the Yen rallied by the same magnitude versus the Euro. To me this shows how much equity markets and global liquidity are potentially being impacted by the Yen Carry Trade.
















Source: Bloomberg


The Yen Carry Trade is the process where a speculator borrows in Yen (as costs to borrow in Japan are tremendously low --- reflecting the Japanese economy) and then takes those borrowings and buys higher yielding securities (say New Zealand Bonds) elsewhere by capturing the spread. These speculators will also use leverage to enhance those spread returns. Now should the Yen currency rally significantly then those borrowings cost more to the speculator, in essence hurting the returns (particularly given the leverage employed).

No one can really be certain how much money is involved but given the magnitude of the speculation out there generally, one can surmise that the numbers are big. The chart above can also act as proof of the potential magnitude given the close correlations.

Well, one could justifiably ask: "Why are you telling us this on a blog about compounding investment returns?" The answer is that one who acts as a speculator usually gets speculator-type results and those usually aren't pleasant ones. So be careful out there and only invest in things you understand and use minimal leverage. As the famous Keynes said: "Markets can remain irrational longer than you can remain solvent."

Investment Guidelines

Over the past 10 years, a lot of reading and thought has gone into developing a list of things that I deem critical for success in this game we call investing. These are by no means set in stone as the thought-process continues to evolve, however I believe that one can become quite successful in the goal of maximizing the power of compounding by following these general rules:


REPUTATION AND INTEGRITY
Reputation and integrity are the most important assets. A reputation is gained over years but can be lost in a heartbeat. Warren Buffett’s recommendation is to not do anything that you wouldn’t want to see on the front page of your local newspaper.

DON”T LOSE MONEY
This is the Number 1 rule.
Capital preservation is paramount and is maintained by employing the “Margin of Safety” principle. In other words, one shouldn’t drive a 19,000 kg truck over a bridge that is estimated to handle up to 20,000 kg.

STOCKS = BUSINESSES
Only think of stocks as part-ownership in a business rather than a piece of paper whose market price wiggles around from day to day.
Only buy great companies at rational prices.

TIMEFRAME
ALWAYS think long-term. When evaluating a potential investment in a company, predictability is the key element. If you can’t foresee what the company will look like in 10 years, then it goes into the “too hard to value” pile. This is a very important concept.

DIVERSIFICATION
Diversification as demonstrated by most financial advisers leads to mediocrity
over 95% of volatility is eliminated after the 12th stock in an equally-weighted portfolio.
Too many stocks/businesses tend to dilute any advantage of generating better than average returns.

GREAT BUSINESSES
Only buy great businesses with a durable competitive advantage that are easy to understand (how and why are they successful?).
Also highlight the quality of management because there will be periods when a great business is run by a less-than-great management team.
Avoiding speculative investments outright will prevent any delay in the power of compounding returns.

COMPOUND INTEREST
Compound interest truly is the 8th Wonder of the World.
Patience, discipline and common sense are required to take advantage of compounding.



PRICE
Price is important but not as important as being in the right business!
Buying 1000 shares of Wrigley in 1985 generated 20% annualized returns ($2.6 M gain on $59,000 investment!)
Buying 1000 shares in Wrigley 3 years later (at a much higher price) in 1988 still generated 15% annualized returns ($808,000 gain on $69,000 investment)
Buying 1000 shares of Xerox in 1985? 7.75% annualized returns ($152,000 gain on $38,000 investment)

COSTS
Avoid transactional and other frictional costs (a 2% Management expense ratio (MER) takes away 2% per year of compounding (and one can see the impact of this compounding when looking at the Wrigley example above).
Buy and hold also avoids impact of capital gains tax. Remember that all gains are taxed (unless under registered plans such as RSP or 401K).

UNDERPERFORMANCE
Underperformance versus a benchmark such as the TSX or S&P 500 will be inevitable over periods of months, quarters and even over 1 to 3 year periods.
Coming from a different angle, if the market were really efficient and out-performance was not attainable then NO OPPORTUNITIES would ever exist. These opportunities rarely get recognized after only one week, one month or even over a year or two. So there will be times of underperformance (see ADHD, James Montier).

INACTIVITY
Inactivity does not equate to not doing the “work”. Only act/invest when the odds are in your favour and with a sufficient amount of one’s portfolio to make a difference over time. It is inevitable that there will be periods of time (possibly quarters and even years) where no activity will take place due to there being a lack of opportunities. This is a natural occurrence for a portfolio of companies one buys to keep (to take advantage of compounding returns).
Too many decisions increase the odds of making mistakes…..we don’t want to be forced into too many decisions. In other words, buy stocks/companies with the intent of holding them indefinitely (unless the original premise for buying changes or the market offers an insanely overvalued price for your business).




FUNDAMENTALS
The intrinsic value of any business is the Net Present Value (NPV) of all Future Cash Flows from the business discounted at an appropriate discount rate.
Calculating NPV is somewhat arbitrary since it is challenging to estimate future cash flows and the discount rate estimate is much too sensitive.
Only buy businesses that generate high returns on capital. This sometimes occurs as a result of a company having some sort of competitive advantage. Some companies will have competitive advantages for a certain time but competition gets attracted to these high return businesses. As a result the competitive advantage will erode over time. Other companies have a DURABLE competitive advantage. These companies tend to maintain high returns on capital for much longer periods. The advantage tends to be derived from a certain characteristic of the business (i.e. Coke’s Brand Name and Distribution System).
The difference between Competitive Advantage and DURABLE Competitive Advantage are like night and day.

PSYCHOLOGY
Success over time has just as much to do with psychology as it does the fundamentals.
All of this stems from viewing stocks as a part ownership of a business. The psychological impact from the noise of the market will be minimized when one thinks in this way.
One of the keys to success is TEMPERAMENT. Having discipline, common sense and focus will increase the odds of outperforming over the long-term.
Don’t let what happens to the stock of a company in the short term determine whether buying or selling was “correct”. Paraphrasing Ben Graham: You are not right because the market says you are right but because your data and reasoning are right. Also paraphrasing Graham: the market is not there to guide you but to serve you.
Discipline is the key. Only invest when the odds are in your favour and be aggressive when the opportunity arises (what Buffett calls the “fat pitch”).


In summary, in order to take advantage of the miracle of compounding, one must:

Minimize disruptions (#1 rule is don’t lose money),
Think long term (overcome short-term noise of the market)
and be disciplined, consistent and focused.

China

From an article called "The Era of China" by Sprott Asset Management:

“China will have built almost
one quarter of the railways that, up until now, it has ever built in its history. This is a massive
project that will require massive amounts of steel and other commodities. China has also
announced a 6500 km pipeline to be completed by 2010. This will be double the length of their
longest pipeline currently, and will require massive amounts of stainless steel; i.e. nickel and
molybdenum.”

“50% of China’s copper consumption currently goes toward power generation and transmission.
It is little wonder, therefore, that China’s copper consumption continues to grow north of 10%
every year.”

“As far as copper is
concerned, China is clearly king. In fact, just the growth in Chinese copper demand is greater
than all the copper that will be used in US housing this year.“

“China recently overtook Japan as the second largest auto market in the world and, if it
continues to grow 30% as it did last year, it won’t be long before it is the world’s largest auto
market. But 90% of all cars in China are bought with cash.”

Incredible.

http://www.sprott.com/pdf/marketsataglance/04-2007.pdf