Whether one is purchasing an entire company outright or purchasing a small piece of a company through the stock market, the inquiry should be the same: (1) is the company one that a rational businessperson would want to own, and (2) is the company available at a rational price. Scott F. Yarnell shares his thoughts.
“The fact that other people agree or disagree with you makes you neither right nor wrong. You will be right if your facts and reasoning are correct.”
Benjamin Graham
Shortsighted thinking predominates in the stock market. Market participants routinely jump in and out of stocks based on emotional responses to ever-changing popular viewpoints about unpredictable events. As a result, most investors fail to outperform market averages. Periods of market volatility such as the recent bout induced by the sub-prime mortgage situation represent short term thinking taken to the extreme. To avoid speculative and irrational behavior, true investors should remind themselves that a stock represents ownership of a business. Long-term ownership of a small number of wonderful companies purchased at attractive prices is the most certain path to accumulating wealth. Exceptional returns may thus be achieved by the investor who, unfazed by the constant noise of the markets, calmly approaches the selection of stocks in a business-like manner.
Whether one is purchasing an entire company outright or purchasing a small piece of a company through the stock market, the inquiry should be the same: (1) is the company one that a rational businessperson would want to own, and (2) is the company available at a rational price. Only a few companies meet the first test, and far fewer meet the second test at any given time.
The right company
The business world is generally divided into two classes of companies. On one side of the spectrum fall the vast majority of businesses, those that deal in commodities and consequently have no pricing power. On the other side of the spectrum is the business franchise which offers its customers something unique. Without a strong franchise, profits and future growth will be whittled away by competitors. A business has a strong franchise when competitors cannot readily provide an alternative source for its products or services. Often a franchise is characterized as operating in an industry with few participants and where there are high barriers to entry. A franchise may result from high customer loyalty, strong brands, products or services with no substitute and/or extensive infrastructure that is not easily replicated. Imagine the ideal company to own. It would undoubtedly possess a strong franchise in a growing industry where it will be generating more and more profits for its owners twenty, thirty, and forty years hence.
The company should demonstrate superior economic attributes. A rational businessperson should want to own a company that will over time produce profits that are high relative to the capital invested. If a company is not generating returns significantly above its cost of capital, it cannot create value for its owners. As a strong franchise generally has strong pricing power, it should earn high returns on equity. Other superior economic attributes are high return on assets and high asset turnover. The truly strong company requires little capital to operate and has little or no debt.
In the absence of proper stewardship, value created by even a strong franchise may not accrue to the owners. Capable and honest management is essential. Fortunately, strong franchises tend to attract the smartest managers, those who understand that it is far more lucrative to avoid difficult business problems than to try to solve them. The best managers, just like the best shareholders, think like owners and view their shareholders as partners. Characteristically, such managers allocate capital rationally, keep costs low relative to competitors, enjoy good labor relationships, have high employee and customer satisfaction, favor profitability and financial stability over self-aggrandizing growth and are candid in their financial reports.
The advantage of owning a strong well-managed franchise is two-fold. First, a strong franchise will create value at a reasonable rate over time for its shareholders. Second, because a strong franchise can be expected to produce somewhat predictable profits well into the future, one can estimate the value of the business and thus determine whether it is available at an appropriate price.
The right price
The stock price of a company fluctuates above and below its intrinsic value. Overpaying for even the best company will undoubtedly penalize an investor’s rate of return. On the other hand, a purchase made below intrinsic value provides a margin of safety and will be well rewarded when the market reappraises the value of the company.
The premise of intrinsic value is simple. Every public company has a value as a business apart from its price in the marketplace, just as a privately owned company has such a value. “Intrinsic value” is defined as the future profits discounted to their present value. Only two inputs are needed for this determination, a reasonable estimate of future profits and an appropriate discount rate for converting future profits to their present value.
As intrinsic value is only an estimate, the better one can estimate future profits, the more accurate the intrinsic value. In estimating future profits, one must bear in mind that net earnings are an accounting construct that often does not truly reflect an owner’s profits. One should instead use what Warren Buffett refers to as owner earnings--net profits plus amortization and depreciation minus capital expenditures. Once one has determined the intrinsic value of a company, one need only compare it to the market price of the company provided by the stock market (i.e., share price multiplied by number of outstanding shares).
Nothing challenges one’s belief in the value of a company like a fall in its share price. However, the investor who knows the intrinsic value of a company has no reason to fret. One would not panic and sell their house merely because they were offered less money for it the day after they purchased it--that would be irrational. Yet, such irrational behavior occurs in the stock market on a routine basis. It is the investor who is completely divorced from the concept of intrinsic value, who will have the propensity to panic. This in turn creates wonderful opportunities for those who know the difference between price and value. The investor who panics creates opportunities for the knowledgeable investor who does not.
Of course, the mere fact that a stock has fallen in price does not necessarily mean that it is a good value. Relative price movements tell one nothing about the value of the company. The critical inquiry is always price to value. On the rare occasion that an exceptional company is available at a good price, one should have the courage of their convictions and make the investment. Indeed, the more that others disagree with one at the outset of an investment, the better one’s eventual return will be provided the investment was based on sound reasoning. Investing may be the one time when it pays to be unfashionable. Patient investors know that a great company will not remain out of fashion for long and that they will be well rewarded for their wait. The price one pays for the right company determines one’s rate of return.
The right portfolio
A businessperson’s portfolio should be the result of a series of wise investment decisions. It should not be a preplanned artificial construct that seeks to have a little of this and a little of that. Contrary to popular opinion, such diversification is merely a protection against ignorance whose cost is mediocre investment results (at best). The business-like investor, armed with knowledge about the company and its value, has no need for such protection. As good opportunities present themselves, such an investor can have the courage of their convictions and make the appropriate investment. The amount of a given company in a portfolio should be proportionate to the investor’s certainty about the value of the company. The result is a rational portfolio.
Such thinking avoids the need to guess which popular “investment strategy” will deliver the best results--forget growth vs. value, large cap vs. small cap., asset allocation, diversification, domestic vs. foreign. All of the angst caused by Wall Street’s marketing-driven labels is avoided by pursuing great well managed companies at reasonable prices.
In this manner, the business-like investor ends up with a rational portfolio designed to create wealth over time with reasonable certainty. Although the businessperson’s job does not end when an investment is made as they must continue to monitor the business results, a decision to sell involves the same analysis as the decision to buy. Generally, one need only sell when the fundamentals of the business change so that the company no longer has a strong franchise, it becomes significantly overvalued by the market, or to free up capital to pursue a better opportunity. When one takes a business-like approach to investing, success is predicated upon the decisions made at the outset of the investment, not later unpredictable events.
Moody’s: a case study
To find a great franchise that is currently out of favor, one need look no farther than to the center of the storm raging in the credit markets. Founded in 1900, Moody’s (MCO, Financial) has a dominant and durable franchise as a member of the credit rating oligopoly that reigns supreme in the growing global fixed-income market. The credit rating business has high barriers to entry by virtue of both its required government designation and the well entrenched positions of its participants established over many decades. Moody’s essentially collects a royalty on the growth of the capital markets. This powerful and well managed franchise demonstrates superior economic characteristics in terms of high return on equity, high profit margins and low capital requirements resulting in reasonably predictable owner earnings. Moody’s generates substantial free cash flow which its management is sensibly using to repurchase its shares.
It is easy to extol the virtues of Moody’s, but one must consider any potential risks as well. Facing the prospect of legal challenges and legislative changes in the wake of the credit crisis, the business is viewed by some as vulnerable to a fundamental change. However, given that all the participants in the industry face the same challenges, there is no readily available alternative, and over any meaningful period of time the bond market that fuels the global economy will undoubtedly grow (even if it experiences a temporary setback), Moody’s franchise will remain relatively unscathed.
Given Moody’s reasonably predictable profits, it is possible to place a reasonable estimate on its intrinsic value. Last year Moody’s generated about $700 million in owner earnings and in 2004 it generated about $500 million in owner earnings. Owner earnings have grown about 25% compounded annually over about the last 10 years. The next ten years will not see that level of growth. A more conservative estimate of Moody’s value involves going back to the 2004 estimate of owner earnings as a base, using 10% for the rate of growth in those earnings and choosing a 9% discount rate, one arrives at a discounted present value of about $15 billion. If one uses a growth rate of 15%, then one arrives at discounted present value of over $18 billion. The current market value of the company is just under $12 billion. Therefore, one can purchase one of the strongest business franchises in the world for a price reasonably below a conservative estimate of its intrinsic value. Even if the fundamentals of the company weaken in response to the current credit crisis, the margin of safety in the purchase will mitigate against permanent loss of capital. This makes Moody’s a company worth owning at a price worth paying. It is not surprising that Moody’s is currently out of fashion.
If the price of the company weakens, whether in response to the credit situation, general market conditions or any other reason, it may present an opportunity to own more of a great company. The business-like investor can build wealth over time by accumulating great companies at increasingly attractive prices.
The author owns shares of the company mentioned in this article.
____________
Scott F. Yarnell, Esq. is a partner in the litigation and intellectual property practice of Hunton & Williams LLP, a major international law firm. He primarily represents pharmaceutical, biotechnology and consumer products companies in patent and other intellectual property matters. He graduated from Drexel University in 1994 and received his law degree from George Washington University Law School in 1997.
“The fact that other people agree or disagree with you makes you neither right nor wrong. You will be right if your facts and reasoning are correct.”
Benjamin Graham
Shortsighted thinking predominates in the stock market. Market participants routinely jump in and out of stocks based on emotional responses to ever-changing popular viewpoints about unpredictable events. As a result, most investors fail to outperform market averages. Periods of market volatility such as the recent bout induced by the sub-prime mortgage situation represent short term thinking taken to the extreme. To avoid speculative and irrational behavior, true investors should remind themselves that a stock represents ownership of a business. Long-term ownership of a small number of wonderful companies purchased at attractive prices is the most certain path to accumulating wealth. Exceptional returns may thus be achieved by the investor who, unfazed by the constant noise of the markets, calmly approaches the selection of stocks in a business-like manner.
Whether one is purchasing an entire company outright or purchasing a small piece of a company through the stock market, the inquiry should be the same: (1) is the company one that a rational businessperson would want to own, and (2) is the company available at a rational price. Only a few companies meet the first test, and far fewer meet the second test at any given time.
The right company
The business world is generally divided into two classes of companies. On one side of the spectrum fall the vast majority of businesses, those that deal in commodities and consequently have no pricing power. On the other side of the spectrum is the business franchise which offers its customers something unique. Without a strong franchise, profits and future growth will be whittled away by competitors. A business has a strong franchise when competitors cannot readily provide an alternative source for its products or services. Often a franchise is characterized as operating in an industry with few participants and where there are high barriers to entry. A franchise may result from high customer loyalty, strong brands, products or services with no substitute and/or extensive infrastructure that is not easily replicated. Imagine the ideal company to own. It would undoubtedly possess a strong franchise in a growing industry where it will be generating more and more profits for its owners twenty, thirty, and forty years hence.
The company should demonstrate superior economic attributes. A rational businessperson should want to own a company that will over time produce profits that are high relative to the capital invested. If a company is not generating returns significantly above its cost of capital, it cannot create value for its owners. As a strong franchise generally has strong pricing power, it should earn high returns on equity. Other superior economic attributes are high return on assets and high asset turnover. The truly strong company requires little capital to operate and has little or no debt.
In the absence of proper stewardship, value created by even a strong franchise may not accrue to the owners. Capable and honest management is essential. Fortunately, strong franchises tend to attract the smartest managers, those who understand that it is far more lucrative to avoid difficult business problems than to try to solve them. The best managers, just like the best shareholders, think like owners and view their shareholders as partners. Characteristically, such managers allocate capital rationally, keep costs low relative to competitors, enjoy good labor relationships, have high employee and customer satisfaction, favor profitability and financial stability over self-aggrandizing growth and are candid in their financial reports.
The advantage of owning a strong well-managed franchise is two-fold. First, a strong franchise will create value at a reasonable rate over time for its shareholders. Second, because a strong franchise can be expected to produce somewhat predictable profits well into the future, one can estimate the value of the business and thus determine whether it is available at an appropriate price.
The right price
The stock price of a company fluctuates above and below its intrinsic value. Overpaying for even the best company will undoubtedly penalize an investor’s rate of return. On the other hand, a purchase made below intrinsic value provides a margin of safety and will be well rewarded when the market reappraises the value of the company.
The premise of intrinsic value is simple. Every public company has a value as a business apart from its price in the marketplace, just as a privately owned company has such a value. “Intrinsic value” is defined as the future profits discounted to their present value. Only two inputs are needed for this determination, a reasonable estimate of future profits and an appropriate discount rate for converting future profits to their present value.
As intrinsic value is only an estimate, the better one can estimate future profits, the more accurate the intrinsic value. In estimating future profits, one must bear in mind that net earnings are an accounting construct that often does not truly reflect an owner’s profits. One should instead use what Warren Buffett refers to as owner earnings--net profits plus amortization and depreciation minus capital expenditures. Once one has determined the intrinsic value of a company, one need only compare it to the market price of the company provided by the stock market (i.e., share price multiplied by number of outstanding shares).
Nothing challenges one’s belief in the value of a company like a fall in its share price. However, the investor who knows the intrinsic value of a company has no reason to fret. One would not panic and sell their house merely because they were offered less money for it the day after they purchased it--that would be irrational. Yet, such irrational behavior occurs in the stock market on a routine basis. It is the investor who is completely divorced from the concept of intrinsic value, who will have the propensity to panic. This in turn creates wonderful opportunities for those who know the difference between price and value. The investor who panics creates opportunities for the knowledgeable investor who does not.
Of course, the mere fact that a stock has fallen in price does not necessarily mean that it is a good value. Relative price movements tell one nothing about the value of the company. The critical inquiry is always price to value. On the rare occasion that an exceptional company is available at a good price, one should have the courage of their convictions and make the investment. Indeed, the more that others disagree with one at the outset of an investment, the better one’s eventual return will be provided the investment was based on sound reasoning. Investing may be the one time when it pays to be unfashionable. Patient investors know that a great company will not remain out of fashion for long and that they will be well rewarded for their wait. The price one pays for the right company determines one’s rate of return.
The right portfolio
A businessperson’s portfolio should be the result of a series of wise investment decisions. It should not be a preplanned artificial construct that seeks to have a little of this and a little of that. Contrary to popular opinion, such diversification is merely a protection against ignorance whose cost is mediocre investment results (at best). The business-like investor, armed with knowledge about the company and its value, has no need for such protection. As good opportunities present themselves, such an investor can have the courage of their convictions and make the appropriate investment. The amount of a given company in a portfolio should be proportionate to the investor’s certainty about the value of the company. The result is a rational portfolio.
Such thinking avoids the need to guess which popular “investment strategy” will deliver the best results--forget growth vs. value, large cap vs. small cap., asset allocation, diversification, domestic vs. foreign. All of the angst caused by Wall Street’s marketing-driven labels is avoided by pursuing great well managed companies at reasonable prices.
In this manner, the business-like investor ends up with a rational portfolio designed to create wealth over time with reasonable certainty. Although the businessperson’s job does not end when an investment is made as they must continue to monitor the business results, a decision to sell involves the same analysis as the decision to buy. Generally, one need only sell when the fundamentals of the business change so that the company no longer has a strong franchise, it becomes significantly overvalued by the market, or to free up capital to pursue a better opportunity. When one takes a business-like approach to investing, success is predicated upon the decisions made at the outset of the investment, not later unpredictable events.
Moody’s: a case study
To find a great franchise that is currently out of favor, one need look no farther than to the center of the storm raging in the credit markets. Founded in 1900, Moody’s (MCO, Financial) has a dominant and durable franchise as a member of the credit rating oligopoly that reigns supreme in the growing global fixed-income market. The credit rating business has high barriers to entry by virtue of both its required government designation and the well entrenched positions of its participants established over many decades. Moody’s essentially collects a royalty on the growth of the capital markets. This powerful and well managed franchise demonstrates superior economic characteristics in terms of high return on equity, high profit margins and low capital requirements resulting in reasonably predictable owner earnings. Moody’s generates substantial free cash flow which its management is sensibly using to repurchase its shares.
It is easy to extol the virtues of Moody’s, but one must consider any potential risks as well. Facing the prospect of legal challenges and legislative changes in the wake of the credit crisis, the business is viewed by some as vulnerable to a fundamental change. However, given that all the participants in the industry face the same challenges, there is no readily available alternative, and over any meaningful period of time the bond market that fuels the global economy will undoubtedly grow (even if it experiences a temporary setback), Moody’s franchise will remain relatively unscathed.
Given Moody’s reasonably predictable profits, it is possible to place a reasonable estimate on its intrinsic value. Last year Moody’s generated about $700 million in owner earnings and in 2004 it generated about $500 million in owner earnings. Owner earnings have grown about 25% compounded annually over about the last 10 years. The next ten years will not see that level of growth. A more conservative estimate of Moody’s value involves going back to the 2004 estimate of owner earnings as a base, using 10% for the rate of growth in those earnings and choosing a 9% discount rate, one arrives at a discounted present value of about $15 billion. If one uses a growth rate of 15%, then one arrives at discounted present value of over $18 billion. The current market value of the company is just under $12 billion. Therefore, one can purchase one of the strongest business franchises in the world for a price reasonably below a conservative estimate of its intrinsic value. Even if the fundamentals of the company weaken in response to the current credit crisis, the margin of safety in the purchase will mitigate against permanent loss of capital. This makes Moody’s a company worth owning at a price worth paying. It is not surprising that Moody’s is currently out of fashion.
If the price of the company weakens, whether in response to the credit situation, general market conditions or any other reason, it may present an opportunity to own more of a great company. The business-like investor can build wealth over time by accumulating great companies at increasingly attractive prices.
The author owns shares of the company mentioned in this article.
____________
Scott F. Yarnell, Esq. is a partner in the litigation and intellectual property practice of Hunton & Williams LLP, a major international law firm. He primarily represents pharmaceutical, biotechnology and consumer products companies in patent and other intellectual property matters. He graduated from Drexel University in 1994 and received his law degree from George Washington University Law School in 1997.
