“Charlie (Munger) realizes that it is difficult to find something that is really good. So, if you say ‘No’ ninety percent of the time, you’re not missing much in the world.” – Otis Booth
Buy good businesses, which are easy to understand. Investors should look for businesses they would feel comfortable with if the markets were to close for ten years. One needs to understand how a business works and where the company’s earnings power is headed over the long-term. Good businesses generate their earnings in cash; have strong balance sheets, and few competitors. When analyzing a strong balance sheet, make sure to watch for liabilities not on the balance sheet as well.
The best indicator of a good business is a high return on capital; companies with superior returns on invested capital usually enjoy competitive advantages. Look for a margin of safety in the quality of the businesses operations, and businesses with few competitors. Warren Buffett likens a company’s competitive advantage to a moat; look for businesses where that moat is widening. An excellent example is Buffett’s investment in Coca-Cola; they enjoy high returns on invested capital, have one major competitor, and have strong demand due to a low cost product which consumers still purchase in recessions.
Buy into good capital allocators. This has a huge intangible benefit. What would an investor have paid for Berkshire Hathaway in the 1970’s? What is the future of Sears Holdings today, with Eddie Lampert running it? A good capital allocator is often woefully undervalued. Each dollar that is earned must be reinvested in either: share buybacks, dividends, short-term cash or securities, acquisitions, a new start up business, or back into the existing business. A good business guards against poor reinvestment into a low return on capital business. A good capital allocator ensures that excess capital will be reinvested at the highest rate of return and will not to make poor acquisitions, or repurchase shares at inflated prices.
How does one judge how well capital has been allocated? A paper trail is the simplest way to judge management’s skill at capital allocation. Mr. Buffett has grown book at 21.4% since 1965; Eddie Lampert has compounded capital in excess of 25% net of fees since he opened his doors. Return on equity is the single most important tool at measuring management’s effectiveness over their tenure. While return on capital measures how good of a business one is in, return on shareholders equity measures how effectively management is deploying the capital with the hand they were dealt.
“With each investment you make, you should have the courage and the conviction to place at least 10 percent of your net worth in that stock.” – Warren Buffett
One should concentrate their portfolio on their best ideas. Warren Buffett has long advocated that “diversification is a protection against ignorance.” Why should one add to their tenth best security? Diversification makes little sense when trying to achieve the highest rates of return. Now if one is trying to minimize volatility then diversification is useful, though it seems asinine to limit returns in order to maintain a lower volatility. Concentration only makes sense if one is skilled at appraising businesses, and disciplined at waiting to purchase these businesses at discounts from their intrinsic value.
An investor’s odds for both success and failure increase as they concentrate their portfolio. A 15 stock portfolio has a 25% chance of beating the market. Where a 250 stock portfolio has only a 2% chance of beating the market. If one is good at analyzing businesses, and restricts their investment portfolio to good businesses with good capital allocators it will pay off in spades to concentrate their portfolio.
With 8 equities, one receives 81% diversification, as long as the industries are diversified and do not correlate. With 32 stocks, one receives approximately 96% diversification. If one purchases the entire market they would have 100% diversification but would still have market risk. Mark Sellers stated, in an excellent speech, that mathematically, “using the Kelly Formula, it can be shown that a 2% position is the equivalent of betting a stock has only a 51% chance of going up, and a 49% chance of going down.” Making investments according to such odds just does not compute.
Eddie Lampert practices this “form of Immersion” that investors should seek to emulate. Before he purchased AutoZone shares he visited dozens of AutoZone’s stores. He had an analyst spend six months calling hundreds of stores, posing as a demanding customer. Lampert says “It's probably overkill.” Investors need to have complete understanding of their businesses in order to concentrate the portfolio in their best ideas. Investor’s must have a reason to believe in their appraisal of a business in times of trepidation.
Buy companies with a margin of safety. After selecting good businesses, with good capital allocators only purchase these securities when they trade at a discount to their intrinsic value. This gives an investor safety in that their estimate of intrinsic value may turn out to be wrong and if the businesses operations deteriorate they are protected by the price they paid. There are multiple ways to measure a company’s intrinsic value, a discounted cash flow valuation, relative value, liquidation value, or sum of the parts. It does not matter how one does it only that the approximation of intrinsic value an investor arrives at is correct. Investors should attempt to avoid dollars converging to fifty cents, by sticking to good businesses where the intrinsic value is growing; increasing their margin of safety over time.
Maintain a low turnover rate. Once an investor finds a good business with a good capital allocator that sells at a discount to intrinsic value, buy a large portion and wait. A low turnover portfolio keeps frictional costs low. More importantly as the intrinsic value of the business grows the price per share will mirror its growth in the market and the investor gains an interest free loan in the capital appreciation built in to the shares owned. The longer an investor holds on to an investment the longer they receive this interest free loan from the government.
When does an investor sell securities? Eddie Lampert was asked that question in a Washington Post article in 1995: "The reality is that when I find something I really like, I don't normally sell it. That said, there are three possible reasons to sell. One is if the facts have changed adversely -- if the economics of the business have deteriorated, if the people running the business have left or are no longer doing a good job. Second is if the price just gets to a point that the valuation is so high we think it is unsupportable and exposes us to the risk of a permanent loss of capital. Third is if there is a better alternative investment, but the burden of proof is always on the new idea."
Following these tenets will lead to successful investments, with low probabilities of capital impairment. These are all derived from the extreme successes of other investors, and predominantly Warren Buffett. Mr. Buffett sums up the goal of an investor quite eloquently:
"Your goal as an investor should simply be to purchase, at a rational price, a part interest in an easily-understandable business whose earnings are virtually certain to be materially higher five, ten and twenty years from now. Over time, you will find only a few companies that meet these standards - so when you see one that qualifies, you should buy a meaningful amount of stock. You must also resist the temptation to stray from your guidelines: If you aren’t willing to own a stock for ten years, don’t even think about owning it for ten minutes. Put together a portfolio of companies whose aggregate earnings march upward over the years, and so also will the portfolio’s market value." – Warren Buffett
-- By Peter Lindmark