In 2010, SimoleonSense posted an interview with Alice Schroeder (here), author of “The Snowball”, a biography about Warren Buffett. For those unfamiliar with Mrs. Schroeder, her resume is quite impressive (it’s covered in the early parts of the interview); she’s been an analyst at multiple firms in her career, including Oppenheimer and Morgan Stanley. During the interview, Mrs. Schroeder was asked about the mindset of analysts and other market participants, like fund managers; her response is very revealing (bold added for emphasis):
“If you’re a hedge fund manager who’s being judged, not just quarterly but monthly, weekly, and even daily, then every minute matters. The brokerage firms all have at most one year rating systems. And often you are judged in shorter increments than that for your stock picking…
There’s a big difference between stock picking – that is, continuously making predictions about exactly which companies in a particular group will do the best over the next few months — and investing, which is a profession in which it pays to realize most of the time you don’t have a good answer to that question. One of the several reasons I left the Street is that I was tired of being a short-term market prognosticator. Almost by definition, that’s a silly thing to do…
They don’t have the luxury of thinking like owners, neither the buy side nor sell side - with the exception of a handful of value managers, the majority of whom continue to manage relatively smaller funds by Wall Street standards.”
It’s likely that few readers find these statements very revealing; most of us know analysts set short term price targets, and understand that the majority of fund managers are deathly afraid of the career risk that comes with underperforming over a time period as short as ninety days.
But I wonder how much people really think about what this means; the implications of these statements are profound for any market participants who think differently than the herd.
Naturally, one could capitalize upon the short-term focus of analysts by taking a longer view of how outperformance can be achieved; how would that view differ from the crowd?
Well, let’s start by thinking about what analysts are most concerned with: (1) near term earnings prospects, and (2) the current valuation offered by Mr. Market, which might be measured by P/E, EV/EBITDA, or countless other multiples. The first factor suffers because it is in many ways illusory, with the ability to be manufactured: it can be gamed by changing depreciation schedules or cutting back on research and development, among other accounting or timing tricks. As the last 15 years have shown, savvy executives can toy with the numbers, at least in the short term.
The second factor – and the one that is often the justification for analyst recommendations – is usually based on arbitrary factors, or simply left unexplained; I’ve seen countless reports that simply slap a random earnings multiple on the analysts EPS estimate to justify some target price (unsurprisingly, usually within shouting distance of the current price) without any explanation as to why 12X, 15X, or 18X is the “right” multiple.
What about for a business owner, someone looking to buy an enterprise and hold it for the next 10+ years - what would they be focused on? Well, price would certainly be a consideration; also, the stability of the denominator in the valuation metric (the “E” and “EBITDA” from above) would also be quite important. However, these factors alone don’t do us much good; is there one correct multiple for all businesses? Should every company trade in-line with the S&P 500? And if that’s not the case, what would cause us to pay a higher or lower multiple for a given business?
I would make the case that return on assets is right near the top of the list in this discussion; while some might quarrel with the denominator (especially in any one period, given the gaming problems mentioned above), I think you could make a solid case that a long term picture of return on assets would be about as useful as any other number you could find in determining an appropriate market multiple on normalized earnings.
A normalized return on assets measure (and also return on equity, but with some important caveats) answers a critical question: how much value can the current business be expected to generate per dollar of assets? If some set of assets consistently generates a higher amount of earnings on average than similar assets held by other enterprises (meaning there's another factor in the mix that likely is not captured quantitatively on the balance sheet), this would be important information to have; if we assume that a company will retain a portion of their earnings and reinvest them back into this same business, it’s important to know whether that’s a sound decision compared to the alternatives.
That decision can get complex in many ways: for example, does this company have a way to retain earnings and reinvest them back in its core - or otherwise comparable - business? If not, capital allocation decisions become increasingly important: if the proceeds of a great business are fretted away chasing less attractive opportunities, shareholders will be worse off at the end of the day; the ability to reinvest back into better than average businesses is absolutely critical (this is what makes Warren’s capital allocation skills so valuable to Berkshire Hathaway - BRK.B).
If these two conditions are met – a company generates an attractive ROA and has the ability to reinvest back into a competitively advantage business protected by a moat – then concerns about the price being paid start to diminish; I’ve mentioned this quote from Charlie Munger in the past, and undoubtedly will share it again in the future:
“Over the long term, it's hard for a stock to earn a much better return that the business which underlies it earns. If the business earns six percent on capital over forty years and you hold it for that forty years, you're not going to make much different than a six percent return - even if you originally buy it at a huge discount. Conversely, if a business earns eighteen percent on capital over twenty or thirty years, even if you pay an expensive looking price, you'll end up with one hell of a result.”
Let’s use Charlie’s figures, and assume two companies will end our twenty year forecast period trading at 15X earnings (and reinvest 100% of earnings every year); if we paid 25X on day one for the business with an 18% ROA – meaning the earnings multiple will contract by 40% over time - what multiple of current earnings would you need to pay for the 6% ROA business to end up with an identical return in 2033?
Think about it for a minute and write down your answer; the correct one might surprise you.
Here’s the math: our first business earned $0.18 on $1 of assets; we’re paying 25X the $0.18 in earnings, or $4.50 per share. Over 20 years, the impact of compounding takes hold in a big way:
In the 20th year, the business earns $4.18 – or 18% - on $23.21 per share in assets. At an earnings multiple of 15X, the stock would be trading at $62.70 per share; in the twenty year period, our shares went from $4.50 to $62.70 – a 20-year CAGR of 14%, and a cumulative return of 1290%.
Now let’s run the numbers for the 6% ROA business:
Our second business earned $0.06 on one dollar in assets; the return on the $0.06 being reinvested back into the business in the second period was also a paltry 6%, adding roughly a third of a penny to the bottom line. We can see that compounding in this example was much less meaningful than it was in the first situation; earnings took 13 years to double, nearly two and a half times as long as in the first example. Assuming that the market would pay a similar 15X for this business in the 20th year, we still need a lot of help to match the 14% annualized return in our first scenario; at 15X the $0.18/share earned in 2033, the market will pay $2.70 for this business. On day one, you would have needed to pay $0.20 per share – or about 3.5X earnings – to match the returns generated by the first business, which you paid twenty-five times earnings for.
This concept evades market participants who are focused solely on the days and week ahead; they're simply incentivized to avoid (or face the risk of) any recommendations that accept short term weakness for long term benefit (as Tom Russo likes to call it, "the capacity to suffer").
I’ve never read an analyst report that discussed this potent combination of solid fundamentals and time; it doesn’t mesh well with a mind that’s ingrained in a game of guessing quarterly margins. As this example clearly shows, long term investors should focus on finding the truly outstanding businesses, and then watch them closely; there’s serious money to be made by holding on with a great business year after year after year.
About the author:
I think Charlie Munger has the right idea: "Patience followed by pretty aggressive conduct."
I run a fairly concentrated portfolio, with 2-5 positions accounting for the majority of my equity portfolio. From the perspective of a businessman, I believe this is sufficient diversification.