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John Cheshire
John Cheshire

Out Performance and the Art of Investing

July 24, 2007

The methodology of long term investment out performance is no real secret. Studying investment gurus like Warren Buffet, Martin Whitman or Bill Miller reveals a unique consistency of methodology. Simply put all buy businesses below their estimate of intrinsic value, and all have out performed by doing so.

The problem for a beginning or intermediate skilled investor is in learning how to properly arrive at intrinsic value. Analyzing and valuing businesses is an exceedingly tough task, if it could be boiled down to a mathematical equation or model it would have been done so a long time ago and used by quants to rule the markets and out perform.

Instead simple common sense and basic math are all that are truly needed, along with an inquisitive mind and flexibility. We know empirically that out performance is inherently linked to pricing. Money is made at the time of purchase, in the price paid for the asset, and the lower the price paid the higher the potential rate of return.

There are a myriad of studies that demonstrate that the lower the price to earnings, price to sales, and price to book, the higher the rate of return is for a security. It really is that simple. Unfortunately what is not simple is an understanding of what those ratios will be in the future, and there is where the art of investing begins.

The future cash flows from a business are not necessarily predicted by its past earnings history. Looking at a business and getting a true feel for the industry, life cycle, growth potential, competition, and capital structure is sometimes a bewildering exercise. Quite frankly, average business acumen and common sense are in fact all that is needed. Gauging what to pay for a business though is hard. A lesson from Bill Miller and Warren Buffet is that there are some businesses that are worth paying a premium to own.

For example a business with rapidly growing earnings and revenues should merit a premium over a business with static revenue growth. In other words the value of a growing stream of earnings is greater than the value of a slow or no growth earnings stream. The price paid for the business is still critical, but the appropriate price to pay is certainly affected by the growth rate. The same concept of a premium can be applied to a myriad of other factors also in determining a businesses intrinsic value.

Valuation must be used within a framework of understanding the underlying business and its future prospects. What looks cheap solely on valuation metrics may well not be a bargain. Out performance is achieved by investing in businesses trading below their intrinsic value based on a thorough understanding of how to properly value that business. There in lies the art of investing and successful out performance.

About the author:

John Cheshire
Charlie Tian, Ph.D. - Founder of GuruFocus. You can now order his book Invest Like a Guru on Amazon.

Rating: 3.8/5 (8 votes)


Armeetofo - 10 years ago    Report SPAM

assume i am the boss, i do know my business, how to make money and tranform into profit,

now i'm an investor, i need to know when to enter.

the rest i'm waiting for outperformance.
Billytickets - 10 years ago    Report SPAM
businesses like Coke or pepsi or altria or P&G or Hershey or Wrigley or Berkshire or JNJ or Bud are all companies whose goodwill have taken "multiple generations to replicate" . Can "smaller companies be bought at 'appropraite" prices as well Of course they can.But some things are so rare they will"survive" the test of time.Nice article
Roke6362 - 10 years ago    Report SPAM
I have a question for you professionals out there. I have been investing in equities for 2 years. I have owned a business for 11 years, and have been in my career for 23 years (insurance brokerage). I also have a MBA. I started reading all the value investing books and have purchased 20 stocks in the past 2 years. I now own 15 stocks. I have done well in half of them (KO, COP, WMT, JNJ, HD, GE, MSFT, NYB). However, I made some mistakes (BZH, FMT) with others that have made my first 2 years about even money. I bought them at the wrong time. It seems like the key to this game is being able to "stomach" the bad times and wait out the mistakes. If the "bad buys" have decent reproduction costs in a viable industry, one just needs to be patient and average his way down so that his cost basis is at a reasonable level. It also seems like one has to construct an investing strategy that is compatible with one's personality. If my business is anything comparable to the learning curve of this profession, it will take 5 years to really formulate an investing strategy that is both sound and compatible with my personality. Is this correct? If not, I could use the guidance! Thanks.
Billytickets - 10 years ago    Report SPAM
roke6362:You are 100% correct in that you should construct an investment strategy conducive for your personality.Honestly i do not think it takes 5 years to take a strategy that fits your personality.

One thing i disagree with is being able to stomach the bad times and wait out the "mistakes". Only certain stocks will be "worthy" of "averaging down". A person who averaged down on K mart went bust.

This may sound self serving but the reason i wrote my book Consume Consume and Consume More is to give a business owner a"blueprint" ( much liek afranchise does)

Good news is BUSINESS is MUCH harder than investing and being that i sold insurance before i KNOW investing is easier to learn

The KEY is threefold. 1) Picking the RIGHT company: JNJ has been around since the 1800s :they are obviously doing something right

and 2) having the courage and conviction to stick with it when "perception" not the fundamentals look "dim"

Example last tuesday JNJ has 10.2% higher Eps than 2nd quarter but stock has dropped almost 3 points. The "fundmantals" have not deteriotied.Mr market just tried to"discorage you. Those who let Mr Market "guide" them and Not serve them will fall prey to his CRAPP. Take advantage of his stupidity and let him lower your basis.( he is agreat servant but alousy master,just like money itself.lol)

3rd step is MOST IMPORTANT: Focus?stay out of your own way.

No offense but owning 15 stocks is like dating 15 women,Fun but you never pay enough attention to anyone. Personally I think you make alist of the 30 companies you think will be strongest in 50 years and you wouldnt want to compete with and you HAMMER the ONE or TWO BEST DEALS when they are priced favorably( again my book has the formulas and filters,a great "review" was posted yesterday read it and see if my"ideas" fit yours.)

This society is about doing ONE THING exceptional and staying the course. WEB says Iam a better businessman because im an investor and a better investor because i'm a businessman. I agree totally

Ok buy the right company buy it at the right price .KICK MR MARKET in the BALLZ" when he tries to frighten you by pushing down your stock. More he lowers it by 15% you respond by buying. Remember be greedy when others are fearful and fearful when others are greedy

Its like building a house .The one with the strongest"foundations' and best blueprints( my book is a start) will last the longest. Hope this helps. peace

Musto - 10 years ago    Report SPAM
I think if you start with the right education it should not take 5 years.

It should be instantaneous.

Start reading Buffett and Munger and you should improve your returns drastically, and


If not, then maybe investing is not for you, and if making money is your first priority

then go with a reputable value fund instead.

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Performances of the stocks mentioned by John Cheshire

User Generated Screeners

althekearoct 17 user defined screen
althekearPE >50th percentile of INDUSTR
althekearLow EV/EBITDA
althekearLynch inspiret Oct 17
althekearsg hk best
althekearDividends Basic
althekearKISS Dividend Strategy
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