By Curtis W. O’Keefe
In the past seven years my portfolio has grown 303% (25% average compound annual growth) by following the advice and approach to investing of the great value investors such as Warren Buffett and Benjamin Graham. Granted the overall market increased during the past 7 years, but I managed to beat the S&P index handedly by 157%—an average of 22% per year.
I approach investing as an owner of the companies that I am buying. This impacts how I buy and hold stocks.
Investing in stocks: Buying marketable equity shares
I evaluate buying marketable equity shares of companies in much the same way I would evaluate a business for acquisition entirely. I want the business to be (a) easy to understand, (b) run by able and honest managers, (c) with an enduring competitive advantage (moat) and favorable long term prospects, and (d) at an attractive price (discount to its intrinsic value which is the discounted value of the cash that can be taken out of the business during its remaining life).
There is a tremendous advantage of being an individual investor. Portions of outstanding businesses sometimes sell in the securities markets at very large discounts from the prices they would command in negotiated transactions involving selling the entire business. Consequently, bargains in business ownership, which are typically not available directly through corporate acquisition, can be obtained indirectly through stock ownership.
This takes the guess work out of buying (trading is guessing) and mitigates the downside.
Investing in stocks: Be patient and wait with your bat
I like Buffets analogy of exerting a Ted Williams discipline with investing. In his book The Science of Hitting. Ted explains that he carved the strike zone into 77 cells, each the size of a baseball. Swinging only at ball in his “best” cell, he knew, would allow him to bat .400; reaching for balls in his “worst” spot, the low outside corner of the strike zone, would reduce him to .230. In other words, waiting for the fat pitch would mean a trip to the Hall of Fame; swinging indiscriminately would mean a ticket to the minors. Be patient and wait with your bat on your shoulder for the right opportunities in the strike zone.
In terms of selling I don’t. I want to own these superstar companies as long possible. This also removes the concern over guessing about what is happening, or might happen, with the overall economy. In other words, if you owned 100% a great company generating incredible returns on invested capital, you would not sell simply because there is an economic problem in Europe. With that said, why sell partial ownership shares of solid companies if there is a problem with the overall economy? The only thing that I worry about, after buying partial ownership of great companies, is whether the aforementioned reasons for buying are preserved. I only sell if the company no longer provides excellent economics or is run by able and honest management.
Investing on your own takes a lot of time and patience. If you are not willing or able to spend the necessary time to properly evaluate companies, including reading annual reports and financial statements, then stick to buying a low fee index fund.
Investing in stocks: How to properly value a business
It took me several years to learn how to properly value a business. You cannot simply go by Earnings per Share (EPS) because the quality and sources of the earnings can be quite different amongst companies. My favorite metric is Return on Invested Capital (ROIC). It measures how much each dollar re-invested can produce in earnings. For example, a 24% ROIC will tell you that for every $1.00 the company re-invests it has produced 24 cents of earnings. Let’s say that company XYZ earned net 10 million this past year. If they issue a 1 billion dollar bond, after interest expense, they earn an additional 10 million in that following year, then earnings will have increased by 100% but the ROIC will only be 1% (10 million / 1 billion = 0.01, 1%).
You can, therefore, see why calculating ROIC gives the investor insight as to how much of a reinvestment it takes just to generate profit. Think of comparing two basketball players who double their points per game from 15 to 30. If player A has to take 30 more shots to do so, while player B takes only 20 more shots to double, player B has a better field goal percentage.
Ideally, you want 2 key things. a) For every $1.00 invested into the business you want as much back of that dollar in profit (retained earnings) as possible. Each year the pot of retained earnings compounds, therefore, the net-worth and value of the company compounds. b) Employ as little as debt as possible.
Another benefit of the buy and hold style of investing, aside from reduced stress, is the tremendous tax advantage. If you really look at how much impact taxes have on investments you’ll see why buy and hold benefits tremendously over a more frenzied approach in which you’ll pay taxes along the way (sell a stock, pay taxes, take the post-tax proceeds and reinvest into another stock). This is one of the many reasons Buffet has grown his net worth to billions and beaten all of the mutual funds.
Investing in stocks: Expert from Buffett’s 1988 shareholder letter
Following is an expert from Buffets 1988 shareholder letter which shows the difference as an example in real dollars.
Because of the way the tax law works, the Rip Van Winkle style (buy and hold) of investing that we favor – if successful – has an important mathematical edge over a more frenzied approach. Let’s look at an extreme comparison. Imagine that Berkshire had only $1, which we put in a security that doubled by yearend and was then sold. Imagine further that we used the after-tax proceeds to repeat this process in each of the next 19 years, scoring a double each time.
At the end of the 20 years, a 34% capital gains tax that would have paid on the profits from each sale would have delivered about $13,000 to the government and we would be left with about $25,250. Not bad. If, however, we made a single fantastic investment that itself doubled 20 times during the 20 years, our dollar would grow to $1,048,576. Were we then to cash out, we would pay a 34% tax of roughly $356,500 and be left with about $692,000. The sole reason for this staggering difference in results would be the timing of tax payments.
Patience, discipline, and emotional intelligence (self-awareness) are the main factors in investing on your own. Most investors are their own worst enemies—buying and selling too often, ignoring the boundaries of their mental horsepower. Individual investors tend to buy with the herd after prices are already highly inflated and sell in a panic when the market drops. Instead, focus on buying great companies with the aforementioned qualities when the market price is publicaly trading at a discount to its intrinsic value. This is where the individual investor has a huge advantage over the professional; most fund managers don’t have the leeway to patiently wait for exceptional opportunities.
See my publically shared portfolio and annual results http://socialize.morningstar.com/NewSocialize/PortfolioSharing/SharedPortfolioSnapshot.aspx?q=F140495716499AC9