#17: Select securities with a higher expected return than the market

If you want to beat the market, you need to have a clear understanding of what drives market returns. Generally speaking, you can expect the returns of the the S&P 500 to be closely correlated with the growth of corporate earnings. Corporate earnings in turn are closely tied to GDP growth. After all, per Buffett, you can’t expect a component part – corporate earnings – to indefinitely grow at a faster rate than the aggregate to which they belong – the overall economy.

You can provide your own estimates, but assuming that real GDP growth averages 3% and that inflation is at 3%, your would get a 6% return. Add in 1.5% for dividends and you are 7.5%. If you are expecting more than this, then you need to provide and defend your assumptions.

Is the market’s return on equity closer to the high end or the low end of its historic average? Are multiples of earnings high of low? What are your expectations for interest rates going forward? These all play a roll in setting expectations.

What is the point of this exercise if you are trying to best the market?

In sports, top athletes carefully study their opponents so they can get an edge. If you clearly understand what drives overall stock market performance, you can make a rule for yourself that you will only buy securities that offer superior expected returns both as a function of the businesses’ underlying economics and also the price you are paying for their securities.

If you buy better businesses at better prices, you will beat the market.

#18: Handle the basics well

In his 1994 shareholder letter, Warren Buffett extols the phenomenal performance of Scott Fetzer: it earned an extraordinary return on equity without the benefit of a monopolistic position, leverage or strong cyclical tail winds. Scott Fetzer’s return on equity – had it been included in the 1993 Fortune 500 – would have earned it a number 4 ranking. Buffett attributes the company’s success to the managerial performance of Ralph Schey, Scott Fetzer’s CEO.

But here’s the somewhat surprising point. It’s not because of any managerial gymnastics on Schey’s point. It’s because – as Buffett points out – Schey handles the basics extraordinarily well and doesn’t allow himself to get diverted. 

Schey, “Establishes the right goals and doesn’t allow himself to get diverted.”

Buffett explicitly points out that this approach applies not only to the management of a business, but also to investing. Extraordinary things are not necessary to get extraordinary results. Yet, the temptation remains to complicate things. We allow ourselves to be pulled in a million directions, even more so today because of the unlimited potential distractions that the Internet provides.

If you want to beat the market, keep it simple. Decide what your goals are. Put in place a rational process to achieve them and then work hard.

“Before the gates of excellence, the high gods have placed sweat.” – Hesiod

#19: Avoid businesses subject to disruption

The value of a business is the present value of all future cash flows that it will produce. Determining these future cash flows is the serious work of a securities analyst. Ratios that look at past and present performance often reveal little about a business’s future prospects. Thinking is required, and that can’t be automated or delegated.

Frequently, these future cash flows simply cannot be determined with precision. One risk that you must be on guard against is whether a business is subject to disruption. You need to consider what could kill the business? This is a foundational question, perhaps the most important.

If the business is generating a good return on capital – and these are the types of businesses you should be looking at – you can be certain that there are those who would love to storm the castle and steal the gold.

One of the biggest disruptors is the Internet. We all know that it’s a game changer for many businesses. Before making any investment, you need to think long and hard about whether your prospective investment is subject to Internet disruption and, if so, to what degree. It’s the difference between investing in businesses like Borders or Circuit City that were massively affected by the Internet and BNSF that is largely impervious to Internet disruption.

So how do you think about Internet disruption? A checklist is a good tool here. Make a list of the issues and factors you need to think about and then run it down when contemplating a purchase.

I just came across a good one in Bill Ackman’s analysis of Lowe’s (LOW). Ackman is considering the impact of online shopping on home centers such as Lowes and Home Depot (HD).

Here’s Ackman’s checklist of conditions that render on-line shopping most appealing:

  1. Product is relatively high-priced (i.e., sales tax savings are more material)
  2. Product is not needed immediately
  3. Shipping cost is low
  4. Shipping is unlikely to damage the product
  5. Professional installation is not needed
  6. Item is not purchased as part of a larger project
  7. End-user of the product is making the purchasing decision

If you want to beat the market, carefully and systematically think about how your investments could be disrupted. Use a checklist to capture the issues and then have the discipline to put your checklist into practice. You’ll be richer for it.