The secret behind many billion investors is the power of compounding. Already Albert Einstein pointed out that, “The most powerful force in the world is compound interest.” Warren Buffett has made it known to the investment world. His investment company Berkshire Hathaway is maybe the most famous compounding machine.
First, I have to admit that I’m strongly – but not completely – deep value investor. It’s easy to find out various studies where dirty cheap stocks always win growth, momentum etc. stocks. These studies are true, but they always miss one thing – holding period. Usually stocks are picked based on some value measure and and then after 1 year they are replaced with a new set of stocks that match that valuation criteria.
Yes, valuation means the most if holding period is only 1-3 years. But what about, if you plan to hold your stocks for longer periods of time, 5-10 years, or even longer. In that case quality becomes much more important than valuation. Funny, after over two decades of investing I have more deep value positions, but I have much more money in a few quality stocks!
But what means compound interest? First you have to bear in mind that compounding is not a get rich quick method. It takes time – and in many occassion lots of it. The overall stock market has compounded wealth 8-10% a year over the long run. It takes time to compound investment wealth, but that doesn’t make the principles of compounding any less powerful. Even modest amounts, when allowed to compound at relatively low rates but over long periods of time, add up to really staggering sums.
According to Warren Buffett, “All there is to investing is picking good stocks at good times and staying with them as long as they remain good companies.” That’s great, but how do we find them? How can we identify exceptional investment targets to realize compounding effect? It might be good first defining what kind of companies we are looking for.
We should invest in:
- Companies with durable strong competitive advantages (moat)
- Shareholder friendly businesses and
- Companies trading at fair or better prices
A company must have two characteristics to claim that it has a competitive advantage. The first is that it must generate, or have an ability to generate, returns in excess of the cost of capital. Second, the company must earn an economic return that is higher than the average of its competitors.
The company with strong competitive advantage (moat) must have the capability to outperform its competitors by achieving high returns on capital and increasing market share. They also should have some structural advantages in operational efficiencies and for instance in technology. And to be sustainable the company’s business model should offer “moat” at least over a period of 10 to 20 years. So, at the end there are always two dimensions – how much economic profit a company earns and how long it can earn excess returns. Remember also, that some industries are more likely to produce long-term winners than other industries.
Major sources of moat:
- Network effect: The more people who use a network, the more powerful a network becomes.
- Switching costs: Once a company’s product becomes rooted in the business operations of customers, the harder it becomes to remove the product or system and replace it with another.
- Intangible assets: This can include patents or licenses and products or services that are legally or from a regulatory standpoint the only option.
- Pricing: Sometimes market leaders can simply outprice the smaller ones.
- Cost advantage: In this case a company can provide a better service at a lower cost than its competitors.
The role of management
For an investor it’s important to find a company which management have a skin in the game and think like an owner. Figure out how they have treated shareholders in the past. Then management’s ability to allocate capital play very important role. They have to integrate capital allocation with long term thinking to earn sustainable good returns.
But remember always what Warren Buffett has said: “when a management with a reputation for brilliance tackles a business with a reputation for bad economics, it is the reputation of the business that remains intact”. The same message in different words said also noted investor Peter Lynch: “invest in businesses any idiot could run because someday one will.”
Nowadays, business management can also change very quickly making it harder to evaluate their long-term work results. Don’t forget to look at their salaries comparing to company’s revenue and above all its ability to profit.
How to value a company with a durable competitive advantage?
Evaluating these companies, we should take return based approach. When you are looking for companie’s financial statements there are some main points to evaluate. As we mentioned earlier these companies have to achieve high returns on capital. First, we should calculate ROIC to know what return retained earnings can make. Generally, the higher the number the better.
Then look at Return on equity (ROE). ROE is considered a measure of how effectively management is using a company’s assets to create profits. If ROE has increased due to an increase in net margin or asset turnover, it’s a good sign. On the other hand, if it is the equity multiplier doing most of the work in ROE, that is a sign to watch out for. You should target ROE above the average for the peer group. And finally, check out that high ROE is not a result of aggressive borrowing. High leverage can be destructive in bad times.
High margins indicate that the company is generating effectively revenue for each dollar of cost. Companies with competitive advantage can price their products and services well in excess of its costs. We should look at companies with durable – at least last ten years – high gross, operating and net margins. Because industry specific differences can be great, the company’s margin % should be compared to its peers.
We already mentioned the risk of high debt when talking about ROE. Right amount of debt can boost profits in good times, but too much debt can cause serious problems, if interest rates jump or creditors decide to close loaning. As a rule, companies with a long-term durable moat require little or no debt to maintain their business operations.
The primary driver of profitability is revenue. The more you grow revenue the more likely you are to grow profits. Identifying growth opportunities should be very important item on any company’s goal list. Growth for a business is essential making the company bigger, increasing its market and ultimately making it more profitable. Growth only creates value when a company generates returns on investment that exceed the cost of capital. Because growth requires investments the return on the new capital must be higher than the cost of that capital. In practice it is only possible when the company has competitive advantage.
All well up to now, but how much are you willing to pay for a great company? It really depends, and Buffett’s fair price neither help us very much. Anyway, I’m not recommending paying 30-50x normal earnings—even for great businesses. Future is always too uncertain and it’s difficult to be sure to consistently pick out the next big winner.
Do not underestimate the importance of buying great company inexpensive. Even though, a long investment period equalize profits you get and an extra percentage point earned a year may not seem like a lot when viewed in isolation, but the cumulative impact of a minor change can be enormous.