The best approach to choosing common stocks

Superb businesses

Incremental returns that are enticing

We get our investment ideas from a variety of sources. Once a potential stock comes to our attention, what is the next step? Price is the last thing we want to look at. The first thing is a thoughtful look into the company’s business. After all, we are only looking to invest in superb companies. But what does ‘looking into the company’s business’ really mean. That’s the subject of this post.

Shakespeare

Let’s start by looking at some words of wisdom from a great 16th century real estate investor:

“If you can look into the seeds of time,

And say which grain will grow and which will not,

Speak then to me.”

 – Macbeth, Act 1, Scene 3

Who indeed? Who is to know which seeds will grow?

Warren Buffett

Buffett wrote in 1987: “Whenever Charlie and I buy common stocks… we approach the transaction as if we were buying into a private business. We look at the economic prospects of the business, the people in charge of running it, and the price we must pay. We do not have in mind any time or price for sale. Indeed, we are willing to hold a stock indefinitely so long as we expect the business to increase in intrinsic value at a satisfactory rate.” (Lawrence A. Cunningham, The Essays of Warren Buffett: Lessons for Corporate America, 1998) p63 cited as (Buffett, 1998).

So, the two key things are the ‘economic prospects’ of the business and the ‘people in charge’. I want to focus on the economic prospects of the business.

He expanded on this somewhat in 1992: “Our equity-investing strategy remains little changed from what it was…when we said in the 1977 annual report: ‘We select our marketable equity securities in much the way we would evaluate a business for acquisition it its entirety. We want the business to be one (a) that we can understand; (b) with favorable long-term prospects; (c) operated by honest and competent people; and, (d) available at a very attractive price.’ We have seen cause to make only one change in this creed: Because of both market conditions and our size, we now substitute ‘an attractive price’ for ‘a very attractive price’.” (Buffett, 1998) p85

So, we add the notion we are looking for ‘favorable long term prospects’.

And then from 1996: “Should you choose, however, to construct your own portfolio, there are a few thoughts worth remembering. Intelligent investing is not complex, though that is far from saying that it is easy. What an investor needs is the ability to correctly evaluate selected businesses. Note that word ‘selected’: You don’t have to be an expert on every company, or even many. You only have to be able to evaluate companies within your circle of competence. The size of that circle is not very important; knowing its boundaries, however, is vital. To invest successfully, you do not need to understand beta, efficient markets, modern portfolio theory, option pricing, or emerging markets. You may, in fact, be better off knowing nothing of these.” (Buffett, 1998) p93 (emphasis added)

 “Your goal as an investor should simply be to purchase, at a rational price, a part interest in an easily-understandable business whose earnings are virtually certain to be materially higher five, ten and twenty years from now. Over time, you will find only a few companies that meet these standards – so when you see one that qualifies, you should buy a meaningful amount of stock. You must also resist the temptation to stray from your guidelines: If you aren’t willing to own a stock for ten years, don’t even think about owning it for ten minutes. Put together a portfolio of companies whose aggregate earnings march upward over the years, and so also will the portfolio’s market value.” (Buffett, 1998) p93 (emphasis added)

I have these words riveted in my brain: ‘correctly evaluate selected businesses’, ‘easily understandable business’ and ‘earnings virtually certain to be materially higher five, ten or twenty years from now’!! If any advice approaches biblical authority it is the last two paragraphs. William Shakespeare would also have approved.

What do we call this?

The investing world today is filled with ‘factors’. Could we somehow use a ‘quality’ factor to identify these companies? The answer is no. The exercise to identify and analyse superb companies whose earnings are ‘virtually certain to be materially higher five, ten or twenty years from now’ is not security analysis.

Buffett tells us “When investing, we view ourselves as business analysts – not as market analysts, not as macroeconomic analysts, and not even as security analysts.” (Buffett, 1998) p63.

Growth in sales or growth in earnings

Now we get to the heart of it. It’s not just growth in sales. Let’s see what Buffett says.

He tells us that “Growth benefits investors only when the business in point can invest at incremental returns that are enticing – in other words, only when each dollar used to finance the growth creates over a dollar of long-term market value. In the case of a low-return business requiring incremental funds, growth hurts the investor.” (Buffett, 1998) p86. (emphasis added)

He adds: “…the best business to own is one that over an extended period of time can employ large amounts of incremental capital at very high rates of return.” (emphasis added)

Rise of intangible investment

Here’s the rub. Identifying companies that ‘can employ large amounts of incremental capital at very high rates of return’ is particularly tricky. The measure analysts use is called Return on Capital (ROC).

As I have written before the world has changed. Fifty years ago when we wanted to analyse businesses to see which ones could ‘employ large amounts of incremental capital at very high rates of return’ we looked at Return on Capital (ROC) or its siblings Return on Invested Capital (ROIC), Return on Capital Employed (ROCE) or Return on Equity (ROE). Today the majority of company investment is made in intangibles, much of which is of lasting value. The accounting problem is that this investment is expensed reducing reported earnings and not capitalized thereby not appearing on the balance sheet. See my posts here, here and here.

Michael Mauboussin has written recently: “All things being equal, a higher ROIC is better than a lower one. But as we have seen, a failure to account for intangible investment can lead to distorted, or even nonsensical, ROICs.”

Mauboussin points out that: ““None of this changes a company’s cash flow, of course, but clarity into investment and return on investment provides a sound basis for assessing expectations.”

Mauboussin makes a good point. Company investment in intangibles of lasting value distorts the usefulness of ROIC as a tool. But, use of cash flow and free cash flow is a workaround.

In place of the distorted ROIC or ROC, we can use free cash flow yield as an indicator of a company’s economic performance and a gauge of the company’s ability to employ incremental capital at high rates of return. See my post here.

Free cash flow is not a GAAP or IFRS term. There are some subtleties to its calculation. See my post here.

Finally, there is a measure that is even better than free cash flow. It is called ‘owner earnings’. ‘Owner earnings’ are Buffett’s concept. It is akin to free cash flow and discussed in a post here.

Conclusion

Sorting this out for any potential investment is more than just looking at financial statements. As Warren Buffett put it in his 1986 Chairman’s letter: “…accounting is but an aid to business thinking, never a substitute for it.”

What is required is careful ‘business thinking’ to assess whether this business is a real seven footer whose ‘earnings [are] virtually certain to be materially higher five, ten or twenty years from now’.

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The topic of this post is discussed in more detail in the Motherlode, Chapter 31. General approach to choosing common stocks

That Chapter is divided into these Sections:

31.01 Warren Buffett (1)

31.02 Warren Buffett (2) – hallmarks of a wonderful business

31.03 Buffett (3) – a guide

31.04 Buffett (4) departure from Graham

31.05 Buffett (5) – tenets of companies

31.06 John Templeton

31.07 Philip Fisher

31.08 Fisher final thoughts

31.09 T. Rowe Price

31.10 Peter Lynch – a quirky list

31.11 John Neff – companies laboring outsider the spotlight

31.12 Stephen Jarislowski

31.13 Joel Greenblatt and a magic formula

31.14 Moats – fleshing out the idea

31.15 Board and management

31.16 Common share ownership by management and directors

31.17 Four key features of prospective investments

31.18 Owner earnings

31.19 The business franchise – the Moat

31.20 Management

31.21 Understandable and superior business operations

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New feature. You can reach me by email at rodney@investingmotherlode.com

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Check out the Tags Index on the right side of the Home page that goes from ‘accounting goodwill’ to ‘wisdom of crowds’. This will give readers access to a host of useful topics.

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There is also a Table of Contents for the whole Motherlode when you click on the Motherlode tab.

Want to dig deeper into the principles behind successful investing?

Click here for the Motherlode – introduction.

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