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The Luxury of Thinking Like An Owner

August 17, 2013 | About:
The Science of Hitting

The Science of Hitting

261 followers
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:

1 2 3 4 5 6 7 8 9 10
Assets/Share 1.00 1.18 1.39 1.64 1.94 2.29 2.70 3.19 3.76 4.44
EPS 0.18 0.21 0.25 0.30 0.35 0.41 0.49 0.57 0.68 0.80


11 12 13 14 15 16 17 18 19 20
5.23 6.18 7.29 8.60 10.15 11.97 14.13 16.67 19.67 23.21
0.94 1.11 1.31 1.55 1.83 2.16 2.54 3.00 3.54 4.18


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:

1 2 3 4 5 6 7 8 9
Assets/Share 1.00 1.06 1.12 1.19 1.26 1.34 1.42 1.50 1.59
EPS 0.06 0.06 0.07 0.07 0.08 0.08 0.09 0.09 0.10


10 11 12 13 14 15 16 17 18 19 20
1.69 1.79 1.90 2.01 2.13 2.26 2.40 2.54 2.69 2.85 3.03
0.10 0.11 0.11 0.12 0.13 0.14 0.14 0.15 0.16 0.17 0.18


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:

The Science of Hitting
I'm a value investor, with a focus on patience; I look to buy great companies that are suffering from short term issues, and hope to load up when these opportunities present themselves. As this would suggest, I run a fairly concentrated portfolio by most standards, usually with 8-10 names; from the perspective of a businessman rather than a market participant / stock trader, I believe this is more than sufficient diversification.

I hope to own a collection of great businesses; to ever sell one, I would demand a substantial premium to the average market valuation due to what I believe are the understated benefits to the long term investor of superior fundamentals and time on intrinsic value. I don't have a target when I purchase a stock; my goal is to replicate the underlying returns of the business in question - which if I've done my job properly, should be very attractive over many years.

Rating: 4.4/5 (44 votes)

Comments

pravchaw
Pravchaw premium member - 1 year ago
Great article and illustration of Buffets words that,"It's far better to buy a wonderful company at a fair price than a fair company at a wonderful price."

Followup article on how we can put this concept into practice will be appreciated.
The Science of Hitting
The Science of Hitting premium member - 1 year ago
Pravchaw,

Glad you liked it; I'll certainly stick to this important topic in future articles. Thanks for the comment!
huang.touchstone
Huang.touchstone premium member - 1 year ago
Excellent job. Brilliant ideas. It is true when people really view where the company value is located. Lots of investors get lost in quarterly or semi-annual earnings. The market price reflects that outcomes but what the real value investors should look is the company moat and the management and the long-term operation history of the company. There comes a great chance when the company's ROA or ROE goes down and the market put the price down and leave the company unnoticed.

Again thanks for your outstanding article.
The Science of Hitting
The Science of Hitting premium member - 1 year ago
Huang,

Good comment, and thanks for your kind words; I look forward to hearing more from you on future articles!

smitshrestha
Smitshrestha - 1 year ago
Compounding is truely the 8th wonder!
Blogging About Money
Blogging About Money - 1 year ago


One of the best articles I have read in the last few years. TSOH, I always look forward to your articles, and have benefited immensely from them.
The Science of Hitting
The Science of Hitting premium member - 1 year ago
Smithshrestha,

Agreed! Thanks for the comment!

SharadDhingra,

I'm glad to hear it and am very thankful for the kind words; I hope to you see comment on some more articles in the future! :)
cubsfan
Cubsfan premium member - 1 year ago
Excellent example that helps me understand the ROE levels and resulting compounding

of BV over time. Thanks much.
The Science of Hitting
The Science of Hitting premium member - 1 year ago
Cubsfan,

Glad you found it useful; I'll make sure to write a future article that addresses ROE as opposed to ROA, and explain why I'm a bit cautious in using that approach in many situations. Thanks for the comment!
parry0843
Parry0843 - 1 year ago
Wonderful article and nice example.

Suggestion- The table you provided with return for both the business are crux of the article in my view. They would have looked very nice had you presented them in graphs.

In table structure they prove the points, no doubts about that, but graphs would make it easier to understand and comprehend.

Thanks for the article and looking forward to here more from you.

Parag

bajjiblow
Bajjiblow - 1 year ago
Excellent article !! Definitely helps investors think like a business owner . But i am wondering which is a better indicator, ROA or ROIC/CROIC ? It would be great if you could explain the concept with two real businesses.

Thanks,

Balaji
The Science of Hitting
The Science of Hitting premium member - 1 year ago
Parag,

Thanks for the advice - I'll definitely look at trying to improve the presentation of numerical data in the future; I'm not too sure how easy it easy to import Excel graphs and charts into an article, but I'll try.

Thanks for the comment!

Balaji,

There are many ways to calculate ROIC, ROC, etc, so I'd be cautious to see how the figures are gamed; my particular concern comes from measures that can be boosted by increased use of financial leverage. This is a discussion well worth expounding upon, and I'll look to do so in a future article.

Thanks for the comment!

parry0843
Parry0843 - 1 year ago
Hi,

It is not too difficult to create a picture.

Create a graph in Excel.

Select the graph and save as picture. Once a picture is created you it can be added into the post.

Hope this helps,

Parag
AlbertaSunwapta
AlbertaSunwapta - 1 year ago
Here's a bit more on Buffett's thoughts on buying companies vs shares and the means to out perform the market through investing. Buffett's memo on pension fund management from 1975... See page 15


19 page memo by Warren E. Buffett:

http://www.scribd.com/doc/160301289/Warren-Buffett-Katharine-Graham-Letter

The Science of Hitting
The Science of Hitting premium member - 1 year ago
Parag,

I'll have to try that - thanks!

Alberta,

That memo is a great read; thanks for posting!

gurufocus
Gurufocus premium member - 1 year ago
You can create charts with GuruFocus Interactive charts in a few clicks. Instance, Wal-Mart eps:

The Science of Hitting
The Science of Hitting premium member - 1 year ago
Perfect - thanks!

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