GuruFocus Premium Membership

Serving Intelligent Investors since 2004. Only 96 cents a day.

Free Trial

Free 7-day Trial
All Articles and Columns »

100 Ways to Beat the Market: #10, #11 and #12

November 16, 2011 | About:
Greg Speicher

Greg Speicher

42 followers
#10: Focus on maximizing portfolio earnings ten years out

In his 1991 shareholder letter, Warren Buffett wrote that investors should focus on building a portfolio that maximizes look-through earnings ten years into the future. Look-through earnings are your share of the earnings of a company whose stock you own. For example, if you owned 100 shares of Acme Corp. and it earned $1 per share this year, your look through earnings this year would be $100. Focusing on future look-through earnings is rational because your success as a long-term focused investor will be driven primarily by the economic performance, i.e. future earnings, of the businesses in which you invest.

As Buffett points out, this will force you to think about the long-term prospects of the business, rather than where the company’s stock will be in twelve months. It will also cause you to focus on a number of other important questions about the company’s earnings.

What portion of the earnings comprise free cash versus earnings that need to be re-invested to either maintain or grow the company?

What are the prospects for re-investing the company’s earnings and at what rate of return?

Is the management skilled at capital allocation and can it be trusted to put shareholder’s interests first?

How susceptible over the long-haul is the company’s position to competition?

How much are you paying today for your share of the earnings?

The answers to these questions will determine your estimate of earnings ten years from know. Of course, it is not possible to make this estimate for many businesses either because of the nature of the business or your lack of expertise.

Using this framework also allows you to determine you odds of outperforming the S&P 500 over the next ten years. Once you’ve plugged in your estimates of where your portfolio companies will be in ten years, you can compare them against your assumptions for the S&P 500′s earnings.

Given that the S&P’s economic performance is largely driven by the U.S. economy, start with your assumptions for nominal GDP growth, for example 3% real growth and 3% from inflation, along with something for dividends. You’ll also want to plug in your assumptions of where corporate profits stand as a percent of GDP and whether you expect that percentage to increase or decrease. Finally, you may choose to make an adjustment for the growing portion of S&P companies’ earnings that come from outside the United States.

If you can put together a portfolio whose look-through earnings will be higher than what you could expect to get ten years from now by investing in an index fund of the S&P 500 and you build in a margin of safety, you’ll have a pretty good shot at beating the market.

#11: Seek a margin of safety in certainty

Having a margin of safety is the cornerstone of intelligent investing. Buffett has said that chapter 20 of Benjamin Graham’s The Intelligent Investor which deals with the concept of having a margin of safety is one of the most important things ever written about investing. That Seth Klarman named his book Margin of Safety tells you something about the centrality of this concept.

Most often, a margin of safety is thought to reside in the gap between the price you pay and the value you receive, and rightly so. In addition, though, a margin of safety can be found in the certainty with which you believe a company will be worth far more in ten years than it is worth today. This is particularly true if you run a focused portfolio.

Buffett has said that he would sell a stock of a business that he was 90% certain would be worth more in the future if he could replace it with a stock of a business whose prospects were 100% certain. Moreover, he has said that he is not in favor of compensating for uncertainty by using a higher discount rate, which he views as nonsense. This notion of finding a margin of safety in certainty is essentially a positive embodiment of the famed first rule of investment, namely don’t lose money.

Commenting on when he was on Coke’s (KO) board, Buffett once said that, although he understood why it was done, he didn’t see much point in doing an ROI analysis on Coke’s prospective investments in growing the business because of his supreme confidence that the returns would be more than satisfactory.

If you want to beat the market, spend time looking for companies that you are virtually certain will be worth far more in ten years than they are today and then patiently look for an opportunity to buy shares at a reasonable price. Be patient and don’t commit your capital at prices that will lock you into mediocre returns. On the other hand, be reasonable. Businesses of this caliber rarely sell at deeply distressed prices.

#12: Swear Off Market Forecasts

When John Griffin started Blue Ridge Capital in 1996, it was a very difficult period because he did not have a long-term track record, and everyone was fixated on his short-term record, i.e. what he had done in the prior week, month, year, etc.

When Griffin started, he had a large amount of cash to deploy. It was very stressful to go from the comfort of holding cash to putting it at risk. At the time, he wrote on the board in his office, “The future is uncertain; it is always a difficult time to invest.” He constantly reminds himself and his staff of this.

Today the markets feel particularly uncertain. Hardly a day passes when I don’t see an article about retail equity investors dumping their stocks because they can’t bear the high level of volatility. They often claim that they’ll return to the equity markets when things calm down and prospects become clearer.

The problem with this is that the future is never clear. There may be times when people think the future is clear – typically good times or in the latter stages of a bull market – but this is generally self-delusion based on over confidence. Yet, most people continue to be lured by the siren song of market forecasters, and opportunists are happy to oblige as evidenced by cable financial networks ever readiness to put on an endless stream of market prognosticators.

So, what’s the answer? After all, investing inherently involves making judgments about the future. One rational answer lies in focusing on individual companies where you can occasionally – if you work hard enough at it – gain a powerful insight into one of their future prospects that can fuel the level of commitment and certainty necessary to invest a meaningful amount of your capital.

Great companies with important economic advantages have provided satisfactory returns – or better – in spite of the many vicissitudes the markets have faced over the past century. When you find such a company and Mr. Market makes it available at a good price, you commit a costly sin of omission if you sit on your hands because of an uncertain macro environment, provided – again – that you really know what you’re doing. Worse yet would be to sell such a great holding after a sharp decline in its quotational value because you couldn’t stomach the volatility.

About the author:

Greg Speicher
http://gregspeicher.com/

Rating: 4.4/5 (9 votes)

Comments

zhouxiaohui
Zhouxiaohui - 2 years ago
I very much enjoyed reading your "100 ways to beat the market". Keep it up and I look forward to more coming out.
Greg Speicher
Greg Speicher premium member - 2 years ago
Thanks for the comment Zhouxiaohui.

Please leave your comment:


Get WordPress Plugins for easy affiliate links on Stock Tickers and Guru Names | Earn affiliate commissions by embedding GuruFocus Charts
GuruFocus Affiliate Program: Earn up to $400 per referral. ( Learn More)
Free 7-day Trial
FEEDBACK