Value Investing Workshop in Bengaluru (20th Sep.): I wrapped up the Chennai session of my full-day Value Investing Workshop last Sunday, and Mumbai is now sold out.
Which leaves Bengaluru as the one city where the last few seats are still available.
Click here for details and registration.
Now, on to today’s letter.
You buy a business you “like”. It fits the classic description of a “wonderful business.” It earns a return on capital comfortably above its cost of capital, has a clean balance sheet, and the management has a good track record of capital allocation and treating shareholders well.
Now, because we live in a world where everyone and their grandmother also has this same information about the business, you don’t get it cheap and so you pay up to get in.
Then the stock does nothing for two years even as the earnings underneath it rise. You grow tired of the wait, and sell it for less than you put in. And then, as it often happens, soon after you sell, the price catches up with the growth and the stock runs.
See what happened here? You lost money on a business that did everything you hoped. The company was the one thing you analysed well. You asked whether it was any good, answered with a loud yes, and let that yes stand in for two questions you never thought to ask. One, what were you paying for that yes. And two, could you sit still long enough to be proved right.
I know this behaviour because I have done it to myself more times than I would like to admit. When we look at a stock, we run the whole thing through a single feeling, which we call “conviction,” or a gut feeling, or just “I like this one.” And that one feeling is really three different questions and not one:
- Is the business good?
- Is the price good?
- Is the timing good?
What’s worse, these three questions get answered by three different people looking at three different things.
The ‘business’ question is answered by the company, by what it does with money.
The ‘price’ question is answered by the crowd, by whatever mood the market happens to be in.
The ‘timing’ question is answered partly by the world and partly by your own bank balance and your own stomach.
But when you fold them into one feeling (“conviction”), you make the mistake of drowning out a “no” from the other two (price and timing) under a “big yes” to the first (business).
So, let’s understand these three questions one by one, and also see how you can use them to become a better analyst and investor.
Is the business good?
This question is tricky because, a lot of the time, most of us answer it while having one eye on the stock’s price. “If the stock has done well/badly in recent times, there must be something good/bad about the business.” Mixing the business fundamentals with the behaviour of market participants is, I think, not a good idea.
And so, the first rule of answering this question is to, well, answer it without looking at the stock price. The moment the price enters, it starts colouring your judgment of the business, and you end up deciding a company is wonderful partly because the stock has gone up, which is circular and how a lot of people fall in love with stocks when the markets are rising.
Now for the question – what do you look at instead?
You want a business that earns more return on its capital than its cost of capital, and you want to see that across a full cycle (at least 7-10 years), and not in one good year when everything went its way.
You also want its profit to turn into cash (Cash Flow from Operations > Net Profit). This is because a company can report a rising profit for years while the cash leaks out into receivables that are never received, and inventory that never sells.
You also want to know what happened to its margins the last time its input costs shot up. Was the company able to pass on the cost increases to customers (so margins held firm) or not (causing margins to collapse). That single thing tells you more about pricing power than any amount of management commentary.
In a 2010 interview, Warren Buffett explained this eloquently:
The single most important decision in evaluating a business is pricing power. If you’ve got the power to raise prices without losing business to a competitor, you’ve got a very good business. And if you have to have a prayer session before raising the price by 10%, then you’ve got a terrible business.
Next, try to understand the reinvestment runway for the business. This matters immensely for a long-term holding and is often the hardest variable to measure numerically. Ask where the next rupee of profit is actually going to go.
A company earning a 25% return on capital with nowhere left to deploy fresh capital can only grow by returning that cash as dividends or buybacks; if management hoards or misallocates that cash instead, the high return on capital becomes a illusion.
Conversely, a company earning 18% that can continuously reinvest every rupee back into the business for the next 15 years at that same rate will create vastly superior long-term wealth.
Is the price good?
Most investors try to answer this question by forecasting a company’s growth, building it into an Excel sheet, and arriving at a value they then compare to the price. I want to give you the reverse of that, because it is simpler and it fits on the back of an envelope.
Instead of guessing the growth and getting to a value, take today’s price and work backwards to the growth it is assuming. Then ask yourself whether that assumption is sane. Let’s understand with an example.
Say a wonderful business trades at a P/E (price-to-earnings) of 50x. Now, no company holds a multiple of 50x forever. Even an excellent version of it a decade from now would more likely trade at, say, 25x, because the market slowly stops paying up as growth matures.
So over 10 years, that multiple roughly halves. And a halving multiple, spread over a decade, drags your annual return down by around 7% (6.7% to be precise) all on its own (calculation: (25/50)^(1/10)-1), before the business has done anything.
Now, suppose you want 15% a year out of the stock. The earnings now have to grow fast enough to first climb out of that -7% hole and then hand you your 15% on top. Run the arithmetic* and it comes to about 23% annual earnings growth, for ten years straight.
See the above table. The business did spectacularly (23.3% CAGR in earnings). But, in comparison, the stock did merely well (15% CAGR). The gap between those two is the price you paid on day one.
Think about that 23% number. The question is no longer “is this a great company?” which it is. It is “do I actually believe this company grows its earnings at 23% for a decade without a single bad stretch?” Almost no business on earth does that. The price shows you the hurdle right up front. And you don’t have to guess, because you can just work backward.
Though simplistic, that is the entire price discipline, and once you have done it 3-4 times on companies you own, you cannot unsee it.
Is the timing good?
First things first. “Good timing” sounds like I am asking you to predict the market. I would never ask you to do that. I cannot do it and neither can anyone that claims otherwise. This is a different thing.
Timing here needs you to answer a few key questions:
- Where is this specific business in its own cycle? A cement company or a commodity player at the top of a boom is showing you peak margins, and if you mistake that peak for the normal state of things, you will pay a high valuation that’s about to fall. A screen will make it look cheap at exactly the wrong moment.
- Why would the gap ever close? A cheap and good business can stay cheap and good for years because nobody is looking, and while you wait, your money sits there doing nothing when it could have been compounding elsewhere. That is a real cost even though it never shows up as a loss on your statement. It is the return you gave up.
- Can you hold this through the wait? Not in theory, but actually. This question needs to be answered with the understanding of your real liquidity, whether you might need this money in three years, and whether you can watch it fall 40-50% and do nothing. The right business at the right price, bought at a moment when you are later forced to sell at the bottom, is still a loss. And it’s your own circumstances that are part of the timing whether you admit them or not.
None of this requires you to forecast the market or your stock’s price. But all of it requires you to be honest with yourself as an investor.
See this illustration, which shows the combinations of what I just wrote above, and should guide you what to do. Print it, keep it near where you make decisions.
Turning theory into judgment
If I stopped here, I would have handed you a checklist, and checklists have a failure mode.
The investor who waits for all three lights to turn green for a company he understands – good business, cheap price, and perfect timing – ends up buying almost nothing. This is simply because the market rarely lines up all three at once. As it happens in life, if you wait for the perfect moment, you will wait forever.
The three questions are not equal, and their weights shift depending on the answer to the first one.
For a genuinely exceptional business with a long runway, the business answer is so heavy that it can forgive a good deal on the other two. This was the whole turn in Munger’s thinking, and later in Buffett’s.
A great business at a fair price beats a fair business at a wonderful price, because the great one keeps compounding and slowly makes your slightly-too-high entry price look cheap in hindsight.
For a cyclical business, price and timing matter far more than long-term business quality, and no amount of cheapness rescues a bad entry. Get the cycle wrong and the low price you were so pleased about goes lower.
That is the difference between a checklist and a judgment. The three questions stay the same. What changes is how much weight you give to which, and that is decided by your answer to whether the business is truly good.
If you can answer that well, without staring at the stock price, it should tell you how much room you have to be wrong about the rest.
Which brings us back to where we started. That good company you sold too early delivered on its potential. The value was always there, but you lost out because of the price you paid and a lack of patience. Those are the two traps a great business hides until they cost you.
But now you know better (I hope).
So, judge the business quality first, with the stock price out of sight. Then turn to the harder part, which is determining what you are willing to pay for that quality, and whether you can hold long enough to be proved right.
* Your total return from a stock is driven by two factors working together: how fast earnings grow and how the valuation multiple shifts over time.
(1 + your return) = (1 + earnings growth) × (1 + yearly change in the multiple)
The multiple sliding from 50 to 25 over ten years is (25 ÷ 50)^(1/10) − 1 = −6.7% a year. Because multiple compression acts as a multiplicative drag rather than a simple subtraction, you cannot simply add 7% to your target 15% return. To find the required annual earnings growth rate, divide your total target return factor by the remaining multiple value:
(1 + earnings growth) = (1 + 0.15) ÷ (1 – 0.067) = 1.15 ÷ 0.933 = 1.233
This means earnings must grow at 23.3% per year, every year for a decade, just for you to achieve a 15% net annual return on the stock.
My new book, The Long Game, is available now. The book contains reflections from 30 investors who’ve survived decades of market cycles. You’ll learn how to tune out the noise that makes you second-guess yourself, handle the fear and greed that hurt your decisions, and stick to principles that actually compound wealth over time. Click here to get your copy.
Leave a Reply