A few years ago I had a blog in which I used to post about the details of deep value investing and some of the methods by which an investor could go about exploiting market inefficiencies. Those posts weren't ever brought over to this site and it dawns on me that despite explaining some theoretical concepts, I've never explained much of anything about how I have been generating our performance over the past few years in basic, practical terms for anyone interested in hearing about it.
In the game of Monopoly, all players start out with a modest amount of play money from which they can begin to invest and build their property empire. As players move around the board over and over again, they buy properties, collect cash, and increase their wealth.
This is by far the most important thing I will ever write about investing and it is essentially mandatory reading for anyone looking to become a client and partner of this firm. If you're not with me on this you likely won't be a good fit for us (or for proper investing in general). What I will explain is extremely simple and in my opinion the most important thing to understand and follow in order to achieve excess returns but for whatever reason, it is difficult for most investors to implement in their practice.
This should be a short piece, but I wanted to use a few examples to describe the assumptions inherent in stock prices and why investors need to think through stock valuations. Given that price is a major factor in predicting future returns, investors should of course be unwilling to pay anything greater than the present value of all future free cash flows, discounted at an appropriate rate for any investment.
Before I start this piece on valuation, I just want to say that nothing in business or finance is as complicated as it looks, and nearly all of it is much simpler than you think. I’m going to get a bit wonky in explaining some terms here but what’s important is that the concepts are understood.
In 2013, Eugene Fama, Lars Hansen, and Robert Shiller won the Nobel Prize in Economics. It was an odd trio, given that Fama is one of the fathers of the efficient markets theory and Shiller wrote a book titled 'Irrational Exuberance' in which he discussed the irrationally high stock prices shortly before the crash of 1999.
“I’d be a bum on the street with a tin cup if the markets were always efficient.” - Warren Buffett
“It is hard for me to see how anyone can consider the stock market efficient.” - Phil Fisher
I'm going to take a step back here and talk a bit about macro-economics. Macro-economics shouldn't be relevant to a value-investor's decision making process, but it is fascinating and interesting to study and speculate on.
In this post I would like to summarize my thoughts on how one goes about analyzing an investment. I will focus on the situation where one is analyzing a potential 'good business' which is expected to compound value over time and which you can hold for the long run.
In any lecture or interview about investing, Warren Buffett often says that you should buy great businesses at fair prices. The idea being that as long as you purchase a great business at a reasonable price, the firm will generate higher earnings in the future than it does now, increasing potential future dividends while using retained earnings to increase the asset base and further improve earnings.
In my last post, I discussed the basics of what gives companies competitive advantage and what makes good businesses. In this post, I want to move from the analysis of a business towards the analysis of an investment. The difference between the two? The price one pays to become an owner of the business.
Why do some companies do well, while others struggle? It's a simple question with a large number of potential answers, all depending on the situation. To broadly answer this question, I'd like to briefly discuss the nature of competitive advantage and why it matters so much.