The Warren Buffett Way: High Quality Stocks in Emerging Markets

January 27, 2015

by Baijnath Ramraika, CFA® and Prashant Trivedi, CFA®

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Advisor Perspectives welcomes guest contributions. The views presented here do not necessarily represent those of Advisor Perspectives.

“Shares are not mere pieces of paper. They represent part ownership of a business. So, when contemplating an investment, think like a prospective owner.” – Warren E. Buffett

“It’s far better to buy a wonderful company at a fair price than a fair company at a wonderful price.” – Warren E. Buffett

“The risk of paying too high a price for good quality stocks – while a real one – is not the chief hazard confronting the average buyer of securities. Observation over many years has taught us that the chief losses to investors come from the purchase of low quality securities at times of favorable business conditions.” – Benjamin Graham

In the movie The Silence of the Lambs, Dr. Hannibal Lecter helps Agent Clarice find a window to the mind of the killer. He says, “First principles, Clarice. Simplicity. Read Marcus Aurelius. Of each particular thing, ask, what is it in itself? What is its nature?” When applied to investing in stocks, the pertinent question becomes what is the nature of equity shares. Are they mere entries in one’s investment account or is there more to them?

Warren Buffett answered these questions for us when he said that shares represent part ownership of a business. Consequently, he suggested that when investing in equity shares, one should think like a prospective owner. This advice gives rise to further questions. What does it mean to be a part owner of a business? How does it differ from owning pieces of paper with the intention of flipping them to someone else at a higher price?

In the discussion that follows, we will offer our view on those questions and show how investing in equities provides an opportunity to generate superior returns as a part owner of a business.

It’s all about the mindset: Part owner or speculator

There are key differences between the mindset of a part owner and that of a speculator. While a part owner is chiefly concerned with the future cash-flow generation ability of his business, a speculator is primarily concerned with his ability to sell his holdings to someone else at a higher price, i.e., his ability to find a greater fool. The table below summarizes some of the primary concerns of both kinds of market participants.

Exhibit 1: Part-owner vs. Speculator

Part Owner Speculator
Future cash-flow generation ability Possibility of finding a greater fool
Long-term business value growth Earnings next quarter
Existence, width, and depth of the competitive moat Technical analysis; Support and resistance
Competitive positioning and intensity General market’s direction
Ability to raise prices (pricing power) Possibility of selling at higher prices
Customer’s preferences Central bank’s preferences
Competitor’s actions Earnings surprises

 

Being a part-owner of a business doesn’t mean that you will never sell. However, the decision rules of a part owner are (as they should be) miles apart from those of a speculator. A part owner is much less concerned with day-to-day changes in share prices and much more interested in changes in underlying business value over the long-term. Warren Buffett put it best when he wrote, “Buy into a company because you want to own it, not because you want the stock to go up. … People have been successful investors because they’ve stuck with successful companies. Sooner or later the market mirrors the business.”

In our research paper Long-Term Sources of Investment Returns and a Simple Way to Enhance Equity Returns, we contended that over the long term, investment returns from equities are earned primarily as a result of growth in the underlying business value. This is so because sooner or later, the market mirrors the business. As evidence, we showed that the long-term returns of equity markets have approximated the growth in book value of all businesses. This in turn leads to our assertion that a simple way to generate superior investment return is to invest in a portfolio of high-quality businesses.

What is a high-quality (HQ) business?

The true nature of an HQ business is rather simple – it has sustainable competitive advantages. Warren Buffett  wrote that “The key to investing is not assessing how much an industry is going to affect society, or how much it will grow, but rather determining the competitive advantage of any given company and, above all, the durability of that advantage. The products or services that have wide, sustainable moats around them are the ones that deliver rewards to investors.”

A business that enjoys sustainable competitive advantages is able to keep competition at bay. As a result, over any extended time period encompassing a full business cycle, such businesses are able to grow their economic earnings. Mirroring this, the business value grows as well.

The ability to keep competition at bay manifests itself in measures of economic earnings, specifically in higher returns on capital and superior cash generation especially when adjusted for business-value growth. Superior economic profitability of an HQ business is a result of the existence of competitive advantage and not the other way around. While all businesses with sustainable competitive advantages have the capability to generate superior economic returns on capital, not all businesses that generate superior returns of capital possess sustainable competitive advantages.

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