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You have to be an independent thinker in markets to be successful because the consensus is built into the price. You have to have a view that’s different from the consensus.
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What are a company’s fundamentals? Buffett’s teacher, Benjamin Graham, taught him that a share is an ownership stake in a company. It’s not just a ticker symbol. Thinking like an owner implies three ideas: We should know what the company does. What is its business? How does it make money? We should know what it owns. What are its assets? What does it owe? We should know who runs it and who owns it. Is management doing a good job? Are the big shareholders paying attention?
There are three reasons: It might have valuable assets. The crowd often sells a stock based on its business alone, ignoring its cash and other assets. Many seemingly scary, bad, or boring businesses turn out to be less scary, bad, or boring than they seem. Poorly managed companies attract outside investors who might buy them or turn them around. This is what private equity firms and activists do for a living. But shareholders don’t have to wait on other investors. They have rights as owners, and they exercise those rights by voting at meetings. With enough votes, shareholders can change a
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They’ll also sell at what looks like the best possible time: profits are high and rising quickly, and it looks like this will continue forever. The stock price is soaring. It’s the best-case scenario. But the stock is expensive, and it offers no margin of safety. It’s time to sell.
Buffett seeks stocks with sustainable profits, those that have what he calls a “moat”—in other words, a competitive advantage. A moat is something that allows a business to beat its competition.
Buffett saw the hard assets being only as valuable as the business’s ability to profit on them. The higher the profit on assets, the higher the value of the business.
This is the most surprising result of Buffett’s theory of value. Not all growth is good. Only businesses earning profits better than the rate required by the market should grow. Businesses with profits below that rate turn dollars in earnings into cents on the dollar in business value.
“The market, like the Lord, helps those who help themselves. But, unlike the Lord, the market does not forgive those who know not what they do. For the investor, a too-high purchase price for the stock of an excellent company can undo the effects of a subsequent decade of favorable business developments.” —Warren Buffett, “Chairman’s Letter” (1982)
Buffett says a wonderful company is one with a high return on equity. What does he mean? Return on equity measures how much money a company makes—the profit—for each dollar invested in it—the equity.
Red Soda has made $2 million in operating earnings. (Operating earnings estimate the income flowing to the owners of a company before any tax or interest is paid.
The second part of Buffett’s rule is a fair price. For this, Greenblatt used what he called the “earnings yield.”39 We call it the Acquirer’s Multiple. To avoid confusion, we’ll call it the Acquirer’s Multiple here.
The Acquirer’s Multiple works better than the PE multiple because it is better at working out a stock’s true price and its true earnings.
A lower Acquirer’s Multiple means we get more operating earnings per dollar spent on shares of Red Soda.
The Acquirer’s Multiple compares the total cost of a business to the operating income flowing into the company. It assumes the acquirer can sell assets, pay out the company’s cash, or redirect the business’s cash flows.
The Acquirer’s Multiple is the enterprise value divided by operating earnings. Think of the enterprise value as the price you pay and operating earnings as the value you get. The lower the Acquirer’s Multiple, the more value you get for the price you pay and the better the stock. Let’s look at each of the parts: enterprise value and the operating earnings.
Enterprise value tells us how much it costs to buy all of the stock and all of the debt (and other things like debt). It’s like looking at an iceberg. Market cap is the bit poking above the water. It’s easy to see. It’s the rest of iceberg under the waterline—the debt—that sinks big ships. That’s why we look there, too.
How would the enterprise value treat these two companies? The enterprise value penalizes the company with debt by adding the debt onto the market cap. It rewards the company with cash by taking away the cash from market cap. The company that owes $5 million in debt has an enterprise value of $15 million ($10 million in market cap + $5 million in debt). The company with $5 million in cash has an enterprise value of $5 million ($10 million market cap – $5 million cash).
The enterprise value includes two other important costs that are like debt: preferred stock and minority interests. Preferred stock is stock that pays its holder a preferred dividend. (It is preferred because it is paid before the common stock dividend and has some other rights the common stock doesn’t have.
is like debt because the dividend is fixed and must be paid regularly, just like interest. The enterprise value penalizes companies with preferred stock by adding the preferred stock on to the market cap.
minority interest is a small stake in a company’s business owned by someone else.
Enterprise value treats the minority interest as another debt. It must be paid by an acquirer of the whole company, just like debt or preferred stock.
Buffett says, “The ‘operating earnings’ of which we speak here exclude capital gains, special accounting items and major restructuring charges.”42 Operating earnings is the income that flows from a business’s operations.
Operating earnings are not reported in a company’s financial statements. They must be worked out from them. They are defined follows: Operating Earnings = Revenue - Cost of Goods Sold - Selling, General, and Administrative Costs - Depreciation and Amortization
Operating earnings allows an apples-to-apples comparison between stocks with different mixes of debt and equity.
The first company with the lower Acquirer’s Multiple is cheaper. This is true even though the companies have the same size market cap ($10 million each) and operating earnings ($1 million each). The debt and cash makes the difference.
Why does the Acquirer’s Multiple’s beat the Magic Formula? Why do fair companies at wonderful prices beat wonderful companies at fair prices? An older study by Greenblatt holds a
Find a margin of safety in a company’s balance sheet. Many, many stocks have sunk due to too much debt. We need to make sure the stocks have more cash than debt or that the debt is small relative to the business. The Acquirer’s Multiple favors exactly these stocks.
Find a margin of safety in a company’s business. The company should own a real business, which should have historically strong operating earnings with matching cash flow, which confirms the accounting earnings are real. It means they are not the creation of a clever embezzler’s mind. We should also look for signs of earnings manipulation. This can be the first step down the road to fraud.
Why do fair companies at wonderful prices beat wonderful companies at fair prices? Because great businesses don’t stay great. They only look great at the top of their business cycle. Mean reversion pushes great business back to average.
The reason great businesses become average businesses is mean reversion. Things go back to normal. It means profits move back toward the average over time. A great business is an outlier. It is more profitable than average. Over time, competitors eat away the unusually high profits until the business earns average profits.
This also happens to bad businesses, which are less profitable than average. Over time, competitors leave the industry until the businesses that stay earn average profits. This is the machinery of mean reversion.
In 1987, De Bondt and Thaler had an idea. Stocks get undervalued or expensive because we overreact. Mean reversion is likely. But we “extrapolate” the profit trend too far. We draw a straight line through the recent profits and assume the trend keeps going.
Book value is the value of a company’s assets (what it owns) less its liabilities (what it owes). It is one measure of a company’s value. Price-to-book value measures how much you pay for that value.
Returns on equity and earnings growth rate mean revert, too. High returns on equity go down. High rates of earnings growth slows. Low returns on equity rise. Low or negative earnings growth rises.
After falling just over 10 percent in April, the market has almost rallied back to its peak. But it won’t regain the highs. A sickening 50 percent plunge winds its way down the pike. The bear market won’t be official—down 20 percent—for another six months.
Value is more important than the trend in earnings. Undervalued low- or no-growth stocks beat expensive high-growth stocks and by a wide margin. Mean reversion pushes up undervalued stocks and pushes down expensive ones.
Undervalued low- or no-growth stocks beat undervalued high-growth stocks. We expect undervalued high-growth stocks to beat undervalued low-growth stocks. We assume high-growth value stocks are good stocks at bargain prices. But the data show mean reversion acts on growth, too. It pushes down on high-growth stocks and up on low- or no-growth stocks.
Undervalued low-profit stocks beat undervalued high-profit stocks. Mean reversion pushes down on high profi...
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Highly profitable stocks only beat the market if Buffett’s moat p...
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“Most decisions should probably be made with somewhere around 70 percent of the information you wish you had. If you wait for 90 percent, in most cases, you’re probably being slow. Plus, either way, you need to be good at quickly recognizing and correcting bad decisions. If you’re good at course correcting, being wrong may be less costly than you think, whereas being slow is going to be expensive for sure.”
We make our own decisions too often, including too much irrelevant data.
One simple rule for beating the market is to buy a portfolio of undervalued stocks. The acquirersmulitple.com website is good source of ideas.
The broadest screener, the All Investable Screener, gives the best balance of return and volatility.
The reasons most people lag the market: cognitive biases and behavioral errors.
Economist John Maynard Keynes wrote, “investment is intolerably boring and overexacting to anyone who is entirely exempt from the gambling instinct; whilst he who has it must pay to this propensity the appropriate toll.” In other words, investing is boring if you don’t like gambling. But if you like gambling, you pay a price.
But you shouldn’t hold fewer than twenty.
This is a simple method for investing systematically: Research: Ignore any stocks you do not want to own for any reason. Hold at least twenty stocks for diversification. Buy: It’s best to buy all your stocks at once. But it’s fine to scale in—make regular portfolio purchases over twelve months. One way to do it is to buy two or three stocks each month. Sell: For taxable accounts, hold winners for one year plus one day. Then sell. That maximizes after-tax returns. If a stock is up and still in the screener after one year and one day, hold until it leaves the screener. If a stock is down and in
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Here’s why: the only way to get a good price is to buy what the crowd wants to sell and sell what the crowd wants to buy.
undervaluation. The Acquirer’s Multiple is a company’s enterprise value compared to its operating earnings. It is the metric private equity firms use when buying companies whole and activist investors use when seeking hidden value.
The enterprise value is the true price we must pay for a company. It includes the market cap, which is the share price multiplied by the number of shares on issue. The market cap alone can mislead because it ignores other costs borne by the owner. The enterprise value also examines the balance-sheet and off-balance-sheet items. It rewards companies for cash, and it penalizes companies for debt, preferred stock, minority interests, and off-balance-sheet debts. These are all real costs paid by the owner.
