“In the end, what counts in investing is what you pay for a business – through the purchase of a small piece of it in the stock market – and what the business earns in the succeeding decade or two.”
The above single sentence is characteristically Buffett brilliant in its truth, completeness, and simplicity. Price and profits (and profit growth) – that’s all there is to investing! Equipped with this grandest of wise secrets may produce a feeling of enlightenment for we students of Buffett, but, as investment practitioners, we are challenged to make some greater use from it to make money for our clients. Anyhow, I ruminated a bit on how I can make this simple brilliance of price and profits more useful to my practice and here’s what I came up with.
Business A – profits are stable and predictable, low difficulty
in forecasting them over the medium term (long-term is
always difficult), change occurs slowly and is easier to combat
Business B (the opposite of A) – profits are unstable, wide ranging
and difficult to predict with any accuracy over the medium term,
change can occur rapidly and/or dramatically
Business A above is a good place to play for we value fundamentalists. Furthermore, when we are on our game (and there is never any reason why we should not be), we are prone to hang out in the Good Price column of Business A and, more specifically, the Good Price/Low Profit Growth box as the Good Price/High Profit Growth box opportunities occur only sparingly (e.g. in the throes of the capitulation phase of a bear market…Q1 2009!) Occassionally, our assessments of the growth of our companies are in err to the downside, impacting our portfolios’ returns negatively; however, the good news is that our playground – Business A – is fairly safe and the damage we do when we are wrong is limited. When we buy a stable business for a good price and EPS goes from $2 to $1.50 (e.g. CTAS in my portfolios), we are not hurt too too badly, especially when we are receiving a significant dividend and provided that our company has a survivable balance sheeti.
As for the Business B playground, I emphasize the conditional element of the boxes: results could be good/ok/livable provided you are right about your forecasts. This statement alone is not elucidating as we are (should be) always rewarded when we are right. However, note that we have defined Business B as being a situation where forecasting is inherently difficult and, therefore, being right is just that much harder. The bottom line is that Business B is a lousy place to play, with the important caveat that one man’s Business B is another man’s Business A – I hold out for the possibility that some investors may very well have experienced insights into what most of us would regard as difficult industries to predict.
Two, one historical and one current, examples stand out in my mind with regards to dangerous Business B territory. First, there were the technology stocks of the late 1990’s, early 2000’s. Most technology is difficult to predict and changes rapidly. There are instances where powerful and durable franchises are built (e.g. INTC, AMZN, GOOG, CSCO, IBM, AAPL, arguably MSFT) but these are, in general, the exceptions. In the late 1990’s, we were in the bad (God awful!) price column of Business B technology stocks, and when the profits came down due to the cycle or industry changes or impending obsolescence, the stocks were an absolute disaster for investors. TLAB, a stock I kinda like around these levels, demonstrates well: it peaked at $120 in 2000 with earnings of $1.25 only to be annihilated down to its current level of $5 where it is earning $0.30. Ouch!
My second example of potential danger in Business B territory are the commodity/infrastructure/industrial deep cyclical companies of today. Recently, I read a promoter’s piece about how all the growth was in materials and infrastructure and companies related and that consumer products growth was a thing of the past, an era bygone. He may very well be right. Nevertheless, he touted his side without a single mention of Buffett’s other criterion for investment success – price (perhaps that would have required doing some real/real dull analysis). Price always matters; it will matter less, of course, if the astronomical growth that he is predicting (pushing) comes to pass but it will still matter. And it will really matter if what has happened before in commodity cycles happens again, namely an increase in supply and a technological improvement in materials usage (i.e. more productive use of the same amount of raw material). And what happens if there is a (very plausible) decrease in demand? Resource prices and their related profits will come under extreme pressure as they are very, very sensitive to demand on the margin. The bottom line with this second example is that commodities/infrastructure/industrial deep cyclical may very well perform wonderfully over the next decade, I hold this out as a distinct possibility. But I do caution that it is my belief that you are playing in Business B territory with them…predicting Coca-Cola’s 2020 profits is a much easier game to play than predicting Freeport McMoran’s. Let the players beware.
- Warren Buffett, 2010 letter to shareholders
The above single sentence is characteristically Buffett brilliant in its truth, completeness, and simplicity. Price and profits (and profit growth) – that’s all there is to investing! Equipped with this grandest of wise secrets may produce a feeling of enlightenment for we students of Buffett, but, as investment practitioners, we are challenged to make some greater use from it to make money for our clients. Anyhow, I ruminated a bit on how I can make this simple brilliance of price and profits more useful to my practice and here’s what I came up with.
Business A – profits are stable and predictable, low difficulty
in forecasting them over the medium term (long-term is
always difficult), change occurs slowly and is easier to combat
| Good Price | Bad Price | |
| High Profit Growth | Sweet spot – the dream! | Ho hum, probably better than a bank CD |
| Low Profit Growth | OK | At significant risk of losing money |
Business B (the opposite of A) – profits are unstable, wide ranging
and difficult to predict with any accuracy over the medium term,
change can occur rapidly and/or dramatically
| Good Price | Bad Price | |
| High Profit Growth | Could be good provided your difficult forecasts are right | Could be ho hum provided your difficult forecasts are right |
| Low Profit Growth | Could be OK provided your difficult forecasts are right | A disaster waiting to happen! |
Business A above is a good place to play for we value fundamentalists. Furthermore, when we are on our game (and there is never any reason why we should not be), we are prone to hang out in the Good Price column of Business A and, more specifically, the Good Price/Low Profit Growth box as the Good Price/High Profit Growth box opportunities occur only sparingly (e.g. in the throes of the capitulation phase of a bear market…Q1 2009!) Occassionally, our assessments of the growth of our companies are in err to the downside, impacting our portfolios’ returns negatively; however, the good news is that our playground – Business A – is fairly safe and the damage we do when we are wrong is limited. When we buy a stable business for a good price and EPS goes from $2 to $1.50 (e.g. CTAS in my portfolios), we are not hurt too too badly, especially when we are receiving a significant dividend and provided that our company has a survivable balance sheeti.
As for the Business B playground, I emphasize the conditional element of the boxes: results could be good/ok/livable provided you are right about your forecasts. This statement alone is not elucidating as we are (should be) always rewarded when we are right. However, note that we have defined Business B as being a situation where forecasting is inherently difficult and, therefore, being right is just that much harder. The bottom line is that Business B is a lousy place to play, with the important caveat that one man’s Business B is another man’s Business A – I hold out for the possibility that some investors may very well have experienced insights into what most of us would regard as difficult industries to predict.
Two, one historical and one current, examples stand out in my mind with regards to dangerous Business B territory. First, there were the technology stocks of the late 1990’s, early 2000’s. Most technology is difficult to predict and changes rapidly. There are instances where powerful and durable franchises are built (e.g. INTC, AMZN, GOOG, CSCO, IBM, AAPL, arguably MSFT) but these are, in general, the exceptions. In the late 1990’s, we were in the bad (God awful!) price column of Business B technology stocks, and when the profits came down due to the cycle or industry changes or impending obsolescence, the stocks were an absolute disaster for investors. TLAB, a stock I kinda like around these levels, demonstrates well: it peaked at $120 in 2000 with earnings of $1.25 only to be annihilated down to its current level of $5 where it is earning $0.30. Ouch!
My second example of potential danger in Business B territory are the commodity/infrastructure/industrial deep cyclical companies of today. Recently, I read a promoter’s piece about how all the growth was in materials and infrastructure and companies related and that consumer products growth was a thing of the past, an era bygone. He may very well be right. Nevertheless, he touted his side without a single mention of Buffett’s other criterion for investment success – price (perhaps that would have required doing some real/real dull analysis). Price always matters; it will matter less, of course, if the astronomical growth that he is predicting (pushing) comes to pass but it will still matter. And it will really matter if what has happened before in commodity cycles happens again, namely an increase in supply and a technological improvement in materials usage (i.e. more productive use of the same amount of raw material). And what happens if there is a (very plausible) decrease in demand? Resource prices and their related profits will come under extreme pressure as they are very, very sensitive to demand on the margin. The bottom line with this second example is that commodities/infrastructure/industrial deep cyclical may very well perform wonderfully over the next decade, I hold this out as a distinct possibility. But I do caution that it is my belief that you are playing in Business B territory with them…predicting Coca-Cola’s 2020 profits is a much easier game to play than predicting Freeport McMoran’s. Let the players beware.
i A similar 2x2 square with good and bad prices and high and low profit growth could be done looking at the two business archetypes of Business A – survivable balance sheet and Business B – non-survivable (in downturn) balance sheet. A finding, not unlike the finding of this scribble, of Business A being a much safer playground results.
