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Value Talk: Aesop’s Investment Insight

May 12, 2008
Charles Mizrahi

Charles Mizrahi

19 followers

Charlie Munger, vice chairman of Berkshire Hathaway, has an unusual approach when he considers making a decision. He generally focuses on what not to do. By taking this approach, Munger clears away much of the clutter and is left with the few areas to focus on. One of his favorite sayings is, “All I want to know is where I’m going to die, so I’ll never go there.”

Let’s take a look at a very simple question that everyone would like to know the answer to: how does one make money investing in stocks? Taking the Munger approach, we would need to ask the question a little differently: how can one lose money investing in stocks? If we can figure out how to lose money investing in stocks, we will know what to avoid. Then, all we need to do is make sure we stay away from those decisions which result in losses, and we will be left with how to make money investing in stocks.

It’s That Simple

If I were given $1 million and told that I must lose it all over the next five years by investing in stocks or else physical harm would come to me, what would I do? The surest ways I can think of would be to: (a) buy the wrong stocks, and (b) buy and sell them at the worst possible times. This approach would have worked perfectly during the dot.com bubble. If given the challenge of losing money in the first few months of 2000, I would have invested in companies that had no earnings, flimsy business models, and high burn rates (burning through their cash). I don’t think it would have taken me five years to lose $1 million; I’m sure that I would have achieved my goal in less than 24 months.

If offered the same challenge in 2005 at the height of the housing bubble, I would have invested in homebuilders and sub-prime mortgage lenders, and bought them when they were trading at very high valuations. By knowing what not to do to make money investing in stocks, we can spend our time focusing on (a) buying the right companies, and (b) buying and selling them at the right time. The questions we now need to address are: what kind of companies are the right companies, and how do we determine what price to pay?

600 BCE

Warren Buffett wrote in his letter to shareholders that in 600 BCE, Aesop laid out the formula for valuing all assets. His investment insight of “a bird in the hand is worth two in the bush,” with a little tweaking (pun intended), is just as valid today as it was over two millennia ago. What an investor needs to know is: what is the certainty that there are birds in the bush, when will they emerge, and how many will there be?

Applying this to stock investing, before buying a stock, an investor should have a good understanding of the business. That information can be obtained by reading the company’s annual report and SEC 10-K filings. While you may not know as much as a manager working in the company for the past twenty years, you will have the necessary knowledge to make an investment decision. The economic characteristics of a business are important because they tell you how much cash the business will generate over long periods of time. It is less of a challenge to predict future growth in businesses that are simple and stable than in businesses that are complex and erratic.

 

FactSet’s 95% client retention rate for its financial data, is reflected in the company’s consistent revenue and earnings growth.

That is why it is difficult to have a high degree of certainty when projecting future cash flows from start-ups and companies in rapidly changing industries. In 1985 you would have had a higher degree of certainty projecting future cash flows from a company on Fortune’s Most Admired Corporations than from computer manufacturers.

1985: America’s Most Admired Corporations

  • IBM
  • Coca-Cola
  • Dow Jones Publishing
  • 3M
  • Hewlett-Packard

Source: Fortune, January 7, 1985

 

1985: Most Popular Home Computers

Computer Year Introduced

TRS-80 (1977)
Apple II (1977)
Atari 400/800 (1979)
Commodore VIC-20 (1980)
Commodore 64 (1982)

Source: Wikipedia

Buffett spends his time focusing on businesses in which there is a high level of confidence as to “how many birds and when they will emerge.” Businesses in stable industries and those that have demonstrated their ability to produce consistent and predictable revenue and sales are a much surer pond to fish in.

Predicting the Future

Now that you have a pretty good idea of how to find a company, we need to set up a framework for buying the stock at the right price. It is here that we need to project future earnings. I try to project a company’s earnings over a five-year time frame. I have found that projecting any period longer than five years is a crap shoot—there is too much that can change.

I begin my projections by reviewing the different operating units of the company. For example, PepsiCo operates under three business units: PepsiCo Americas Foods (snack business), PepsiCo Americas Beverages, and PepsiCo International. Each unit has an operating history that you can analyze and use to project future growth. I suggest you keep your projections realistic; lean toward the side of being conservative, and use a margin of safety.

This month’s Prime Time selection is Gentex Corp. The company’s two operating units are automotive products (96% of sales) and fire protection products (4% of sales). Their sales and earnings have been consistent over the past ten years, and they have an 83% market share in automatic-dimming rearview mirrors. Their products are in vehicles around the world. After researching the prior year’s financial statements, I projected that annual earnings growth over the next five years should be between 10% and 12%. I added in a margin of safety and opted for 10.5% of earnings growth.

The trailing twelve-month (TTM) earnings figure of Gentex is $.85 per share. Based on my projections of 10.5% annual earnings growth, Gentex earnings will be $1.60 at the end of five years. At a conservative P/E of 17, Gentex’s share price should be $27.20. When I add in the dividends paid out during the period, my projected price for the stock at the end of year five should be $29.00 per share.

Setting a Yardstick

I recommended the purchase of the stock at a price of $15.00 or lower because I only want to invest in Gentex if I have a high probability of at least a 13% return on my investment. Your choice of return is up to you. I compute my desired return on investment as 10% plus the inflation rate, which currently comes out to 13%.

Based on my projections, the stock should be about $29.00 in five years. If my projections are accurate, I would need to buy the stock at $15.00 to achieve my desired return of 13%. If I purchased the stock at $17.00 and my projections come to pass, I will only achieve a 10% return on my investment. In other words, the more I pay for the stock today, the less my return will be five years from now.

A soaring IQ or inside information are not needed to make money investing in stocks. What is important is to find companies that are in stable industries and have demonstrated a history of consistent and predictable earnings, and then determine the price to pay. Although this process does require some effort, you will be amply rewarded.

Warren Buffett summed up stock investing by saying that:

Stocks are simple. All you do is buy shares in a great business for les than the business is intrinsically worth, with managers of the highest integrity and ability. Then you own those shares forever.

I couldn’t have said it any better.

Berkshire Hathaway Chairman’s letter, 2000

Ibid, 2002

Lowe, Janet, Warren Buffett Speaks (New York: John Wiley & Sons, 1997): 162

About the author:

Charles Mizrahi
GuruFocus - Stock Picks and Market Insight of Gurus

Rating: 4.3/5 (16 votes)

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