100 Ways to Beat the Market #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.
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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 Lowe’s and Home Depot (HD).
Here’s Ackman’s checklist of conditions that render on-line shopping most appealing:
- Product is relatively high-priced (i.e., sales tax savings are more material)
- Product is not needed immediately
- Shipping cost is low
- Shipping is unlikely to damage the product
- Professional installation is not needed
- Item is not purchased as part of a larger project
- 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.
100 Ways to Beat the Market #20: Buy Berkshire Hathaway at 1.1x book value or less
One simple way to beat the market is to buy and hold Berkshire Hathaway (BRK.A)(BRK.B) stock at a good price. Buffett acknowledges that it is challenging to find intelligent ways to invest Berkshire’s massive and growing cash holdings. Nevertheless, he is clear that his goal is still to beat the S&P 500 which he believes he can do, albeit at a diminished level of outperformance vis-a-vis Berkshire’s earlier halcyon days. It is worth noting that Buffett is famously conservative in his missives about his ability to continue to outperform.
Berkshire’s recent performance compared to the S&P 500 is noteworthy. Berkshire has outperformed the S&P 500 in each of the ten most recent five-year periods by an average margin of just over 7%. For the record, Berkshire has never had a five-year period where it underperformed the market.
Buffett believes that Berkshire’s stock is undervalued at 1.1x book value (or approximately $109,000 per A share). He’s right. If you net out the equity investments ($67 billion as of Q3, 2011) and use Buffett’s estimate of normalized after-tax earnings ($12 billion), Berkshire has an earnings yield of about 10%. These earnings are being generated by a diversified portfolio of high-quality businesses that includes a number of bullet-proof, growing world-class franchises such as GEICO and BNSF.
Berkshire enjoys a number of advantages which should continue to increase its intrinsic value.
- Berkshire has outstanding veteran managers who are unencumbered by bureaucracy or quarterly earnings numbers. They focus solely on building long-term value.
- Berkshire can not only purchase operating businesses, but also marketable securities. This gives it a much higher likelihood of finding attractive investments compared to the typical S&P 500 corporation which is constrained to allocate capital within its own industry. Moreover, Berkshire has advantaged access to many deals based on Berkshire’s reputation, deep pockets, and ability to act quickly.
- Berkshire has a shareholder-oriented culture. Board members (excluding Buffett) own over $3 billion in stock, and compensation is completely aligned with shareholder interests. Moreover, Berkshire is imbued with a culture of frugality. This means that Berkshire’s wealth will increase the value of shares rather than line the pockets of management.
- Berkshire enjoys cheap leverage in the form of insurance float. Although it is impossible to predict with any amount of precision, it seems likely – based on Berkshire’s track record – that float will continue to grow. Berkshire can also borrow at low rates given its strength.
- Buffett is still at the top of his game and getting better. The IBM purchase shows his savvy and growing circle of competence and, in my humble opinion, has a reasonable likelihood of adding $10 billion in value over the next 10 to 15 years. Todd Combs and Ted Weschler are warming up in the bull-pen and were hand picked by the same guy who spotted Lou Simpson.
Of course, not losing money should be top of mind when considering an investment. Berkshire has a fortress balance sheet with massive cash holdings as a hedge against economic disruption that puts Buffett in a position of strength to take advantage of opportunities when others are scrambling. Also, Berkshire’s commitment to repurchase shares below 1.1x book puts a floor under the stock.
100 Ways to Beat the Market #21: Be prepared
A couple weeks ago, my favorite college football team was playing in their big rivalry game. It was a close game that went back and forth. At the two minute mark, my team had the ball, trailing by three, with an opportunity to win the game, if they could execute their two-minute drill and score a touchdown. Unfortunately, they fell short, not just because they did not make plays, but also because they seemed confused and poorly prepared.
Knowledgeable football fans know that the key to an effective two-minute drill happens long before the actual game. It is all about preparation. There is little or no time to figure it out in real time when you have the pressure of trying to come from behind and win the game.
For me, this was yet another reminder that you need to be prepared ahead of time in the markets. You cannot wake up on the morning of a big down day in the market and expect to make good decisions on what to buy if you have not already done your homework.
These are the days when opportunity presents himself. Buffett recently said he was buying heavily on the big down days in August. Templeton would do his valuation work when the markets were calm and then put in his standing purchase orders at deeply discounted prices. Then he would wait.
You need a well conceived watchlist if you want to beat the market. Your watchlist does not need to be long. It needs to be thoughtful. Start with a short list of high conviction ideas that you truly understand. Determine an appropriate buy price by valuing the businesses on the list and selecting a reasonably discounted entry point.
These optimal opportunities do not come along everyday, but they do happen. If you are honest, you can probably recognize many sub-optimal purchases that you have made because you missed these types of opportunities and were willing to pay too high a price for at least some of your securities.
Resolve to correct these poor tendencies. Read my eBook on the investment process for more advise on improving your process. There are no short cuts or magic valuation algorithms. It is about sweating the details day in and day out. That is how consistent market-beating performance is earned.