How to Get the Most Out of a Great Idea

Some investors I talk to have relatively so-so portfolio returns despite having some very good – even great – ideas. I want to talk today about how to get the most out of your great ideas.

You want to focus on stocks with a long runway. I wrote in a previous article about doing a five-year and 15-year future expected return calculation. That’s because in the short term, extremely good value will outperform just about anything. In the long run, extremely high quality growth will outperform just about anything. It’s really only in the gray zone of about five to 15 years that you would need to worry about the trade-off between deep value and high quality growth. I use the five-year and 15-year approach to approximate a “trade” as something that won’t be longer than five years and an “investment” as something that won’t be shorter than 15 years. Doing this lets me frame the problem of selecting which stock to buy in simple mathematical terms. Let’s talk about the two kinds of runaways a stock can have.

A stock can have big upside in terms of value. I think of this as being the difference between what I have to pay for a stock today – its “price” – and what I appraise the stock for (its “value”). For example, a couple years ago, I appraised Hunter Douglas (XAMS:HDG, Financial) – when it was much cheaper than it is now – at more than twice what it was then selling for. Not long after that, I appraised Omnicom (OMC, Financial) at 90% of its intrinsic value. If I had to pick between owning only Hunter and owning only Omnicom for more than 15 years – I’d pick Omnicom. However, at that time (when Hunter was much cheaper than it is today) I would have picked Hunter over Omnicom if I knew I was only allowed to hold the stock I picked for five years.

The “value” runway for Hunter was huge. I thought it could more than double its price without any increase in its intrinsic value. On the other hand, the “growth” runway for Omnicom was much longer. I thought Omnicom could grow as fast as 5% per year pretty much forever without really retaining any meaningful amount of earnings. There was some earnings “retention” in the sense of free cash flow that would need to be used to buy back stock as an offset to dilution caused by paying employees, but something like much more than 80% of Omnicom’s free cash flow could be used to buy back stock, pay dividends or make acquisitions while the company itself was growing 5% per year. I thought Hunter might grow slower, more like 4% per year.

The much bigger issue is how much earnings I thought Hunter would have to retain. For each additional penny of growth in earnings per share, I thought the company would have to retain between 5 cents and 10 cents of earnings. That’s not a bad trade. But if you think a company might grow as slowly as 4% to 5% per year with a return on equity of between 10% and 20% – the addition to intrinsic value is small. Growth achieved at much below about a 10% return on equity doesn’t really add value any faster than if the company paid a dividend out to me and I put that dividend into the Standard & Poor's 500. It’s really only growth above about a 10% ROE that matters, and I didn’t think Hunter would grow at 8% per year or anything like that long term.

Omnicom, on the other hand, could grow more like 5% a year without any real “cost” to this growth because ROE should be close to infinite. Now, this wouldn’t help Omnicom much versus Hunter for the years 2015 to 2019, but because Hunter was trading at less than 40 euros ($43.31) per share and I appraised the company at more than 90 euros per share in value – it didn’t need to create growth in its value to make a good return as a stock. This is the “value” runaway. At Hunter, the value runway was – in my eyes – a 47% price-to-appraisal value. If you take 1/0.47, you get an upside of 113%. That’s a big number. Value often wins out in five years or less.

Let’s look at what a 47-cent price reaching a $1 intrinsic value gets you over five years. It’s 16% per year. That’s the return from value with no growth addition, but I thought Hunter would grow something like 4% per year. I also thought it would pay a dividend of a couple percent at least. Add those in – and you can get to a 20% plus annual return in five years or less. High-quality growth can’t compete with that. Very few businesses keep compounding value at 20% per year or higher. If you can find a stock you appraise at $100 selling for $47, buy it. The “value” runway is long enough to get you a lot out of this one idea.

In other words, my advice is to look for stocks trading for a 50% discount to intrinsic value rather than wasting time on stocks trading at a 20% discount to intrinsic value. A stock trading at a 20% discount to intrinsic value only gives you a 4% to 5% return from that valuation gap closing over the next five years. Don’t aim for worse than 5% returns from value – aim for better than 15% returns. They may be hard to find. For example, in the more than two years I was writing my newsletter, I found only two to three stocks that we appraised at anything like the discount we gave Hunter. I was working hard to turn up stocks with deep discounts to intrinsic value. I was publishing an issue each month.

I had an “idea” each month. Was it a good idea? I thought it was at the time. Was that monthly idea a “great” idea? In terms of pure quality – I will get to growth in a second – I’d say that only two to three stocks over close to two years would qualify as “great.” Let’s call that one “great” value idea every six months to 12 months. I could be wrong about some of these. I’m just saying they seemed great at that time. It looks like – at best – only 5% to 10% of my “good” ideas would qualify as “great” ideas. I’m not saying it’s easy to find stocks trading for 50% off what they are worth. Every month, I could find a stock trading at a 10% to 20% discount to what I thought it was worth, but only about once a year could I find a stock trading at a 50% to 60% discount to what I thought it was worth. Don’t confuse your good monthly ideas (the 10% to 20% discounts) with your great yearly ideas (the 50% to 60% discounts). The value “runway” is huge in the second case.

Now, what about the growth “runway”? Getting great returns from growth requires three things: 1) A high annual sales growth rate, 2) a low annual net tangible asset growth rate and 3) plenty of room to keep doing what the company is doing even as it gains scale.

I’m going to use Howden Joinery (LSE:HWDN, Financial) as an example because I think it’s easy to quantify. Howden should be able to grow its same depot sales by no less than 4% per year over the next five to six years. I use five to six years because if Howden opens 30 depots a year it will – according to management – fully saturate the U.K. market at 800 depots in about five to six years. This new depot growth rate (from a little over 600 depots to 800 depots) is about 4% per year.

The company’s sales growth rate should be no lower than 4% same depot growth plus 4% depots in the chain growth equals 8% growth. There are economies of scale at both the depot level and the supply chain level. In fact, Howden manufactures some of its own products; it uses its own trucks to supply its stores, etc. There should be – and historically there have been – much greater economies of scale at Howden than at many fast-growing companies. For these reasons, it is not at all impossible that Howden could grow companywide profit at close to 10% per year over the next five years even if it only grows sales at about 8% per year. In addition, I expect the company to shrink its share count at the rate of about 1.5% per year.

We could say that 8% sales growth with no operational leverage and no share buybacks is the low-end scenario. That’s an 8% annual growth in earnings per share over the next five years. That should match or beat the U.K. stock market. Howden pays a dividend. It would return more like 10% if it grew EPS by about 8% a year. The market won’t return 10% a year long term. The high-end scenario for Howden’s EPS growth is pretty impressive though. If there is some operational leverage in the company that causes operating income to grow faster than sales and the company buys back shares at the rate I expect, you get to something like an 11.5% earnings per share growth. It’s best not to be too exact about these things. In broad strokes, I expect Howden to be capable of somewhere between 8% and 12% annual EPS growth for another four to six years.

Now, 8% annual EPS growth for only four years isn’t a ton of upside. It means $100 of Howden stock today would only be worth $136 when I sold it. However, the high-end scenario has what I would consider plenty of “runway.” If Howden can grow EPS at closer to 12% per year over more like six full years, it would mean that $100 of Howden’s value today could become $197 of value six years down the road. Growth rates of 10% or higher over five years or more are decent runways for having a “great” growth idea.

I don’t want to pretend Howden is the next Apple (AAPL, Financial) here. I don’t see much chance for much better than high single-digit growth for half a decade. The current business plan – replicating the same depot model over and over again within the U.K. – will run out of room for growth in about five years. This isn’t a Phil Fisher stock. I like Howden because of the high confidence I have in the low-end scenario and the holding period. I really think Howden can do 4% same-store sales growth and 4% new depot growth while buying back a percent or more of its stock and paying a dividend yield of 2% of my purchase price. You add those together and you get something like an 11% annual return over something like a five-year holding period. This all depends on Howden’s multiple not contracting. That’s a reasonable assumption. Howden’s P/E ratio is just under 15 while its corporate leverage is essentially zero. Howden has a pension deficit and leases its locations. However, it has net cash.

I view the company as trading at a totally normal P/E of 15 and a totally normal leverage situation of close to neither net cash nor net debt. This point – that I don’t think Howden’s multiple will contract over the next five years – is absolutely critical in getting the most out of your great “growth” ideas.

Let’s compare Howden to NIC (EGOV, Financial). NICÂ has a P/E of 25. It has a durable competitive position, and growth costs this company essentially nothing. For those reasons, the company can – during its fast growth phase – add a lot to intrinsic value per share. The problem is that I don’t believe that when NIC is fully mature – that is, once it is winning no new net U.S. states as customers and the average customer has been with NIC for something like three to five years or more – it will grow faster than Howden when it’s fully mature. NIC’s fully mature growth rate should be quite low. It could be in the 2% to 5% range. This is because I’m not sure NIC can carry out any real – above inflation – price increases. Without pricing power, it’s very hard to command a high P/E as a stock once you are no longer quickly growing your number of new customers.

My fear is that NIC’s multiple will one day contract from 25 to 15. The question is how big the company will be when this happens. For this reason, I put NIC in the “too hard” pile and Howden in the easy enough to understand and invest in pile.

So far, we have two rules for getting the most out of your great ideas:

1. When picking value stocks, look for stocks trading at something like a 50% discount to your appraisal of their current intrinsic value.
2. When picking growth stocks, look for stocks with P/E ratios that you don’t expect to contract in the future.

I want to be clear about rule No. 2 here. I’m not saying pick growth stocks with a low P/E ratio. There are stocks that should always trade at high P/E ratios. Omnicom is about 10% too cheap now even though it already trades at a P/E of 18. In other words, the stock should “forever” have a P/E of 20. That’s because it can grow about as fast as other mature companies without adding to its shareholder’s equity from year to year. I don’t think Omnicom’s P/E will contract from 18 to 15 the way I worry NIC’s P/E will one day contract from 25 to 15.

The next rule is true for both value stocks and growth stocks:

1. When picking long-term holdings, look for stocks with unleveraged returns on net tangible assets of no less than 10% per year.

This rule is really, really important. It often gets overlooked when investors think about value investments. It still matters even in deep value. For example, I’ve owned George Risk (RSKIA, Financial) for seven years now. I bought the stock as a net-net. The company has been able to compound book value at 6% per year while I’ve owned it while also paying close to a 4% dividend yield in many years. This ignores the fact I bought it at a good price. The return on intrinsic value has been about 10% per year. Any closing of the valuation gap between the low price I paid and the high value I one day hope to extract from the company will add an above-market rate, but the part of the investment that ensures I’ll get a bondlike return – or even an index fundlike return – over longer periods of time is the decent return on equity the company achieves. It’s much better to pay 50 cents on the dollar for a company with an ROE of 10% than to pay 25 cents on the dollar for a company with an ROE of 5%.

At ROEs as low as 5%, you could lose ground to an index simply by staying invested in a subpar but undervalued business. In the long run, you can actually stay in stocks like George Risk. Here’s another example. It’s an even more obscure one than George Risk, but it illustrates my point. In 2011, I did a “blind stock valuation” about a company called Watlington Waterworks (it trades in Bermuda). This is a microcap water company on the island of Bermuda. I put up its financials – multiplied by 10 to disguise the fact it was so tiny – and had blog readers guess how much it was worth. They almost all picked a price between $20 and $30 per share. The stock really traded for $14 per share.

Readers were – unconsciously – pegging the discount to intrinsic value at 30% to 55%. Since this was a group of investors working blind from six years of historical financial results – this was a good sign the company was really undervalued by about one-third to one-half of its total value. It wasn’t however a good sign that the valuation gap would close anytime soon. In fact, it hasn’t. The stock still trades at a 22% discount to book value. Based on the past cash return on equity and the durable competitive position of the business – it really shouldn’t trade below 1 times book value.

It is still trading at a discount to intrinsic value. The company has really always traded at a discount to intrinsic value. However, you can see that over the last 18 years the stock’s price has increased by 9% a year. It has paid dividends for more than the past 10 years. You are talking about an annual return of probably not less than 10% per year for a stock that – even after an 18-year hypothetical holding period – still ended the period trading at less than 80 cents on the intrinsic value dollar. If the stock had finished the period at the price-book (P/B) value I consider correct, the 18-year return would have been at least 1.5% a year higher.

Yes, it does matter if the valuation gap closes over time, but what matters more is that Watlington Waterworks has tended to earn about a 10% cash return on its unleveraged tangible equity and so – as a result – the stock has tended to return about 10% per year over the last decade or two regardless of whether investors ever embrace the stock as much as I think it deserves to be embraced. The stock has usually been “cheap” and yet it has still returned about 10% per year because it has still earned about 10% per year.

What do you do when you find a stock like Hunter Douglas (when it was priced at less than 40 euros) or George Risk (when it was priced at around $4.50 per share) or Watlington Waterworks (when it was priced at about $14 per share) or Howden Joinery (when it’s priced at about 430 pence, as it is right now)?

I have a two-part answer.

One, you bet big on it.

Two, you hold it long enough to let that bet pay off.

Personally, I try to apply a 20% allocation and five-year approach to my bets on “great ideas.” This means that I try to put no less than 20% of my total portfolio into a new, great idea, and I try to commit to owning that idea for no less than five years.

I know a lot of investors feel uncomfortable with such a concentrated strategy. That’s fine, but I would strongly suggest that if you reduce one of those two rules, you up the other one. Most people have a problem with the 20% of your portfolio. They think that allocation is too big for any one idea. Fine. Then allocate 10% to each great idea, but if you do choose to allocate only 10% to each idea – up the holding period requirement to 10 years. Why?

The payoff that you can get from a single stock pick is a function of three decisions you make:

1. Do you buy the stock?
2. How much of the stock do you buy?
3. How long do you keep the shares you own?

A lot of investors get question No. 1 right and then flunk questions No. 2 and No. 3. If you find the Washington Post as Buffett did in the 1970s, you need to both put a lot of money into that idea and hang on to that idea – or you won’t get everything you can out of the idea.

If you are really committed to as absurdly small allocations as 5% of your portfolio into a single stock, you can still get a ton out of individual positions if you always hold them for no less than 20 years.

The problem here isn’t really that investors are opposed to extreme concentration or that investors are opposed to an extremely long-term investment horizon. The problem is that investors are opposed to both concentration and long holding periods.

You will meet a lot of really smart investors with really great ideas who tend to put about 5% of their portfolios in each idea and tend to hold those ideas for only three years on average.

If you’re going to do that, you should really just use a statistical method of some sort. The picking of individual stocks – instead of the favoring of certain metrics, etc. – just won’t have much influence on your long-term performance. You can have a great idea and yet still not get much out of it if you either allocate as little as 5% to the position or you hold it for as little as three years.

This is one of the hardest things of which to convince individual investors, but the logic here is really unavoidable. Your return in a stock comes from holding that stock. That return depends on how many shares you own and how long you own those shares.

It’s really, really hard for you to teach yourself to have better ideas.

It’s so much easier to teach yourself to make both bigger bets and longer bets. The amount of money you can make on a 20% position held for five years is so much bigger than the amount of money you can make on a 5% position held for three years. If you can’t commit to being an ultraconcentrated investor, please consider committing to being an ultralong-term investor.

I have one “habit” I always try to get individual investors to take seriously. If you save money each year – would you consider limiting yourself to picking just one stock per year and holding that stock literally forever? You’d put all your 2017 savings into just one stock by the end of this year, and then you’d never touch that stock again. You’d move on to finding something totally new in 2018 and holding that forever.

I know you will never run your entire portfolio that way, but if you could – as an experiment – carve out a quarter of your savings each year into this permanent “punchcard” approach, you would see just how much you can get out of great ideas you put into this focused, long-term bucket and how little you get out of the same quality ideas that you size and hold the way you normally size and hold your stocks.

It’s an experiment worth trying.

Here, again are my rules for getting the most out of a great idea:

1. Always pick stocks with long “runways” in general.
2. Focus on “value” ideas with a discount of 50% to intrinsic value instead of say 20%.
3. Focus on “growth” ideas where you don’t expect the P/E multiple to contract.
4. Never buy stocks where the long-term return on equity will be below 10% a year.
5. Allocate the largest percentage of your portfolio into each great idea with which you feel comfortable.
6. Commit to the longest holding period with which you are comfortable.

And then, if you are really averse to high portfolio concentration – consider offsetting this timidity with a longer holding period. I don’t recommend the reverse – making bigger, shorter bets. However, if you had a trader’s mentality – I do have to admit that this approach would also make sense. If you made very short bets, they’d need to be very big bets to get the most out of your great ideas.

Since I’m an investor, I really consider holding periods less than about three years to be purely speculative.

Which rule do I apply personally?

I target a 20% position size and a five-year holding period. That lets me get more out of my great ideas than almost all the investors with whom I talk. They often put too little into their best ideas or they sell those great ideas too quickly.

Ask Geoff a Question

Disclosure:Â Long George Risk.

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