Thursday, July 19, 2012

What Would You Buy If Price Didn't Matter? (Take Two)

Somehow, inexplicably to me, this blog has generated a modest (and believe me, my humility in using the term "modest" is well-deserved humility) readership. And here I thought it was an echo chambers for my ears only. Go figure.

A theme you might notice in the blog is that I want to challenge the limited way of thinking inherent to the acolytes of value investing. Before the torches and pitchforks come out, let me say defensively...I'm one of you!  Well, mostly. Probably 90 percent. But the absolute fixation on price to the neglect of those other traits of a good business and a good investment...well, that just keeps me spinning in my own circles, flirting with the (gasp!) growth-story stocks.

I'm using price more as my last box to check off in my investment checklist. I'm interested first in the qualities of the business itself. Does it have a profitable economic model? (i.e., returns on invested capital, cash producing...even if we have to look into the future to see it) Does it possess real competitive advantages? (i.e., scale-price advantage, brand, network effect or other means of making captive demand, or legal protections) And does it have a big market to grow into to compound its earnings?

And then, within the context of those questions, is Mr. Market offering it at a price that's either reasonable or discounted?

Margin of safety is not strictly a function of price. It's provided by the interconnectedness of competitive advantages, economic profitability, and ability to grow.

Perhaps I get burned and the strict-value minds feel vindicated. If that's the case, I will probably never admit it publicly because I'll be too busy panhandling the streets of my small town. 

So, for anyone new or interested, I wanted to re-issue my thought challenge. 

A Thought Challenge For Value Investors

Dear Fellow Value Investors:

I'm offering you a rare opportunity to indulge yourself in fantasy. So suspend your disbelief for a moment and imagine that you get to own the five companies whose characteristics fan the flames of your capitalist desires. You will own each for ten years.

This will all take place in a mythical market where there are no prices. Instead, investor returns are magically connected to a company's earnings growth over a long time horizon. If the business compounds earnings at five percent over those ten years, you'll get five percent; 15 percent gets you 15 percent; 30 percent...whoah, simmer down! Show some self-control here!

Oh yeah, and there are no shenanigans played with accruals that affect reported earnings. It's all legit in this little magical mystery market of mine.

So, let your mind wander. If you're freed from the constraints of price...if you get to pick any company you want that trades in the public markets...let your brain get excited and greedy over the exercise, and decide...what five companies would you pick?

The trick in eliminating price as the main consideration is to focus the mind on those variables that drive earnings growth. Namely...

1. Market Size. The business is participating in a large and/or growing market for its offerings, giving it plenty of runway for growth;

2. Competitive Advantage. The business possesses advantages that create barriers to entry and prevent encroachment by competitors, thereby protecting market share (it's not losing business to the competition) and/or margins (competitors aren't finding a toe-hold by under-pricing or otherwise doing battle via price);

While putting the following control in place:

3. Economic Profitability. The business has a model that is profitable both from the perspective of gross profits exceeding expenses and earnings exceeding the costs of reinvesting capital. (In other words, no cheating! You can't buy companies that grow in unprofitable ways...though I doubt many of these could last ten years.)

What are your five companies and why do you think they can compound their earnings at such a high rate?

Let me know your thoughts, and I'll keep a running update on the blog.



You can email me at pauldryden (at) gmail.

Over the long term, it’s hard for a stock to earn much better than the business which underlies it earns. If the business earns 6% on capital over 40 years and you hold it for 40 years, you’re not going to make much different than a 6% return – even if you originally buy it at a huge discount. Conversely, if a business earns 18% on capital over 20 or 30 years, even if you pay an expensive looking price, you’ll end up with a fine result.
- Charlie Munger
(as quoted on p.233 of Seeking Wisdom: From Darwin to Munger by Peter Bevelin)

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