of time, some years it is less and other years it is more, but on average the stock market returns 12%. In the 26 years since that article was written, the returns have been higher. Also, the Dow Jones return on equity has much more questionable content. Because of so much writing down of book value, there are probably better ways to assess the profitability of a business. What he (Buffett) was doing was normalizing the whole market place. And he was trying to make the point of first, understand what you are buying. And then how much are you willing to pay for that underlying business to earn the returns that you need to earn. If you could buy the Dow Jones at 1982 at book value you would be getting a 12% return for 100 cents on the dollar–like a 12% bond.
In the book, The Davis Dynasty: 50 Years of Successful Investing on Wall Street by John Rothchild, Chris Davis of NY Venture Fund heard in 1999 Warren Buffett tell an audience he expected stocks to return 6% a year for the next 17 years-less than half the payoff during the prior 17 years. Buffett based his sobering forecast on simple math: In 1999, the entire lineup of Fortune 500 companies was selling for $10 trillion, supported by $300 billion in annual earnings. When the annual fees shareholders paid to own those assets—roughly, 1 percent of $10 trillion, or $100 million–were subtracted the actual payoff from their investing was $200 million. Contemporary investors were buying Mr. Market for 50 times earnings. Because an entire market can’t justify a multiple, of 50, Buffett surmised, stock prices would have to give. They might give slowly or give quickly, or meander until the nation’s earnings caught up to them, but they couldn’t rise at their former pace without violating the laws of financial gravity. A $3 trillion price tag on a market with $200 billion earnings might be reasonable—but $10 trillion? No way. (Page-279).
When you start paying a premium, then the financial returns decline.
If there is one thing that Wall Street misses out on–I see almost no mention of it anywhere–is the link between the financial characteristics of the business that you are buying and the return you get as a function of the price you pay for that business. Don’t forget that! The nonsense from Wall Street of X percent growth for 5x earnings. Life is not that simple. There are ways to look at valuing companies that are much more helpful to you.
So we talked about intrinsic value vs. market prices.
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The Specifics of What I Do
I am a financial analyst. I am very interested in the numbers. If you look at companies there is a wealth of information in the financials.
If you speak to management and they have done well, they will say they will continue to do well. Or if they have not done well, then they will do well. Not all companies have superior financial characteristics. As I have grown older, I am increasingly interested in only those companies that have superior financial performance. The relatively few companies that generate high returns on assets and high returns on equity. These companies generate cash in excess of their internal needs and because of their excess cash generation have little or no debt. My personal choice within those types of companies, I restrict my interest to seasoned companies. These are companies that have an operating history of 10 to 15 years.
When I say seasoned, I don’t mean mature or declining. I mean companies that have been around for awhile. And these companies have developed a record that includes some periods of recessions and adversity or other periods of stress. I want to get some feel of the ebb and flow of the business. And the results of the company lend themselves to this normalization process. You can assess the company through difficult periods. Again a personal preference, I am interested in companies of a pretty large size. The amount of money that I manage does not require that I invest in large companies, but that is where my interest is. Very rarely will I invest in companies having capitalizations with less than a billion dollars.
I certainly don’t restrict myself with a label like some money managers who say they are a large cap or a mid cap managers. I find value where a find it–given the other criteria right now for companies being seasoned and having a long track record and also having superior financial characteristics. If a company has been around for 10 or 15 years and has superior financial characteristics, it is not going to be a small company. There are many rewarding opportunities in those (smaller) companies with shorter, 5 or 6 years of operating history, but without the long track record or without the period of adversity—it is arbitrary–but I am adverse to investing in them.
In terms of the companies that pass through all of my filters probably….. If you look at Value Line with more than 2,000 companies there that are included in regular research coverage, there are no more than 50 companies that meet the criteria of size, length of record and superior financial characteristics. I would argue with any of you that it would be possible to have a wonderful career, make a lot of money and be very satisfied in every way if you excluded all but those 50 companies. None of you, of course, will take that advice, but it would be possible. Many investors would be better off if they stuck to those companies.
Also, I would say the bigger companies are like super tankers, they don’t change rapidly; they don’t change overnight. What we see in the papers, a company will miss by a few pennies and the stock will drop 15% to 20% overnight. That is crazy. The value of the company hasn’t changed, and therein lies your opportunity. The value of the company almost certainly hasn’t changed. There is much more price volatility than is appropriate for companies like Coke, Intel, Cisco and the like than the underlying values.
Again I am looking for:
(1) companies that are not very volatile (in their operating and financial characteristics) and
(2) produce consistently good results that lend themselves to normalization. To identify very big companies where there is an attractive opportunity.
Even companies that are so widely followed–they have so much research coverage that they have got to be efficiently priced–I would argue that there are opportunities that present themselves.
There are a Couple of Big Ideas I Want to Talk About.
I gave you an excerpt from Berkshire Hathaway (1996) where Warren Buffett says that the long run performance of the stock is linked to the long run performance of the business. This is not unique to Berkshire. The long run investment return that you make is linked to the long run performance of underlying business in which you are investing. This is where the element of margin of safety comes in. If you can buy a business at a 30% discount and the underlying value is growing, then you will benefit from that underlying growth of the business but also from the narrowing discount between the price discount and the intrinsic value. The market prices the discount in your favor.
If you buy something at 70% of value and the value grows over time then in 5 years then you will benefit by the growth in the underlying business and the accretion of the discount. In five years you will get 6 points a year of narrowing discount (5 x 6% = 30%)—that is the margin of safety. Once you get to 100% of value, your investment will track the growth of the business as long as the relationship holds.
Understanding ROE. ROE = Net Income/(Beginning Equity + Ending Equity)/2
Example: Microsoft had above 30% ROE with no debt in the early
