Business-Like Investing For Picking Better Long-Term Stocks
Thinking as an Owner Can Improve Your Portfolio Results and Lower Risk
It was once said that “Investing is most successful when it is most business-like.” (Benjamin Graham) That makes sense because investing in stocks is, quite literally, the act of buying an ownership stake in businesses. Whether you own 100% of the shares of a local jewelry store in your hometown or 1,000/4,405,893,150th of The Coca-Cola Company based on its total shares outstanding in the last 10-K filing, the end result is much the same: There are only three ways you can make money from your stock.
This simple distinction makes it easier to spot flaws in an investment portfolio because it changes your behavior. You suddenly demand a margin of safety in your purchases because you expect to be compensated for the different types of risk to which you are exposing yourself and your family. You require evidence based on facts rather than hope for high growth assumption rather than getting swept away in the euphoria of crowds. During stock market crashes, you can remain rational and buy ownership positions in quality companies at bargain prices despite everyone else rushing for the exit in panic. You seek to understand things such as how the firm generations its underlying cash flow, what types of assets make up the balance sheet, and whether management is following capital allocation and dividend policies that are friendly to you and other owners.
If you don't currently treat your stocks like this, I urge you consider a paradigm shift.
I've spent several years driving home the concept by running case studies of stocks as viewed through the lens of business-like investing; looking at the long-term results generated by holding ownership stakes in businesses as diverse as Chevron, General Mills, McDonald's, Clorox, Hershey's, Nestle, Colgate-Palmolive, Procter & Gamble, Coca-Cola, Tiffany & Company, and the now-bankrupt Eastman Kodak.
Despite being the best long-term performing asset class, I don't think everyone should invest in stock. In fact, you don't have to own stocks to get rich. Plenty of other people have done it by investing in real estate or specializing in something like oil wells or intellectual property. If you aren't capable of business-like investing in even its most basic form -- reading an annual report and understanding simple concepts such as how to analyze an income statement -- it's the equivalent of driving blind in a snowstorm. What rational person would do such a thing? It's insanity. Instead, consider throwing in the towel and investing in a low-cost index fund that buys a widely diversified basket of stocks; something like the Vanguard S&P 500 fund operating at a rock-bottom mutual fund expense ratio.
To help you understand some of the finer points of what it means to practice business-like investing, let's dive in and look at specifics. It might help clarify the importance of what I am saying.
Business-Like Investors Don't Confuse Cash Flow with Profits
Cash flow is all-important. Without the ability to meet your financial obligations when they come due, you won’t be around to play the game.
However, a business-like investor must never forget that, at the end of the day, once basic liquidity needs are met, net profit (more specifically, the return on capital employed), reigns supreme. There are plenty of businesses that look like they are making money when they are, in fact, bleeding the owners dry.
Imagine you own a successful furniture business structured as a limited liability company. Over the past decade, you’ve built up a comfortable working capital position in the form of increased inventory. Your storefront has expanded and the showroom now holds thousands of individual pieces of merchandise.
One day, you realize that you’ve grown tired of the industry. You think it’s boring, you’re weary of dealing with the same people, and you think that you'd rather bake cookies for a living.
After discussing it with your spouse, you make the decision to shuttle the furniture store, liquidate the inventory, and open your own bakery. You inform the store manager of your decision and instruct him to discount all of the merchandise heavily. You then place ads in the local papers and on the news channel advertising a “going out of business” sale.
The week of the sale arrives. There is a tremendous customer turnout and you are generating tons of cash; far more than you’ve seen in the normal course of business. You reinvest little of this in new inventory for the business (you are liquidating, after all). Instead, you use it to begin preparations on your new venture; moving expenses, paying down some personal debt, buying a new home, and such.
Here’s the problem: Unless you have an excellent bookkeeping system, you won’t have a clue how you fared in real economic terms from the liquidation. If you were an accountant by training and knew the specific identification method, you could simply plug in the sales figures to your software and instantly calculate the profit. If, however, you are like many small businesses and you are more entrepreneur than a financier, you may not be aware of the cost associated with each of the items you are selling. The result? The dining room table you sold for $60, marked down from $130, actually cost you $75 three years prior! On an accrual basis, you’ve experienced a very real loss of $15 on that sale. Yet, the check you wrote to pay for that merchandise is long forgotten, the cash in your hand is not.
The larger the business, the more significant the problem. You could experience a drastic shrinkage in real net worth while thinking you are making a tremendous amount of money. The torrents of cash coming into your life mask economic reality, placing your finances in an extremely vulnerable position. I personally know a married couple who mismanaged their business so poorly that they spent half-a-million dollars in retail value inventory over several years after their sales had fallen off a cliff, thinking they were still making money. As the products on the shelf in the store began to decline in both quantity and quality, this led to a death spiral that caused them to go from generating more than $2,000,000 in per annum inflation-adjusted sales to practically nothing. In the end, they wiped out nearly 25 years of work and a company that was paying them six-figures a year because they didn't understand the accrual concept.
Business-Like Investors Think About Profitability and Return on Capital
Cash flow alone is necessary but not sufficient. It's possible to experience positive cash flow while you lose purchasing power and march yourself towards bankruptcy court. Look at the property and casualty insurance industry before the asbestos claims drove a lot of companies out of business. These firms were bringing in millions of dollars a month but didn't understand the cost of the product they had sold, which eventually caught up with them.
The single most important indicator of the inherent excellence of a business is the return on capital employed. You’ve heard the statement, “it takes money to make money.” Those that understand compounding know that the goal is to make as much money with as little invested as possible while avoiding the dangers of leverage.
Think of it this way: It may take a steel mill $100.00 in assets to earn $1.00 due to the large facilities it must build, the shipping costs of moving its product, etc., while it may take a premium candle maker only $1.50 in invested assets to generate that same $1.00 profit. The owner of the candle company could drain the business and reinvest the profit elsewhere, or collect big dividends to enjoy a better life with his or her family, without damaging the profitability of the enterprise. The steel mill owner, on the other hand, must keep that $100 at work in the business. Otherwise, the enterprise will suffer a real shrinkage in earning power. It isn't hard to see why the candle business is a much better business than the steel business.
This principle applies to your own investments. Unless you’ve purchased your stake at a substantial discount, it is not wise to reinvest in a business that is earning sub-par rates of return on capital employed. If you own a farm equipment business with $1,000,000 tied up in the enterprise and it is only generating $30,000 after-tax income each year, you would probably be in a better position if you liquidated the company or sold your position and reinvested in the cash in high-grade municipal bonds. You’d actually walk away with more money each year while spending your entire day on the golf course.
The Bottom Line? Business-Like Investors Know How Much Money It Takes To Generate a Dollar of Profit
Always know how much capital it takes for your businesses – both wholly owned and the marketable securities that make up your portfolio in the form of common stocks – to generate $1 in profit. To learn more, read Return on Equity: The DuPont Model.
One of the primary rules of wealth building is identifying and minimizing risks before they can cause loss to yourself and your company. Indeed, most great investors are masters at discovering seemingly-uncorrelated risks.
Here’s an example: On December 16, 1811, an unfathomable 7.7 magnitude earthquake struck New Madrid, Missouri. It was the first of four such quakes and thousands of aftershocks that plagued the region that winter, the most famous being the New Madrid Quake on February 7, 1812 which damaged structures in St. Louis. Today, scientists estimate there is a ninety percent chance that this fault will, once again, shift by the year 2040. Few, if any, of the buildings in Missouri are built to withstand an earthquake, let alone one approaching the strength experienced nearly two centuries ago.
If you owned a small chain of banks that operated exclusively in the region, you would want to ensure that the homes secured by the bank’s portfolio of mortgages all carried earthquake insurance from a rock-of-Gibraltar-strength company such as Berkshire Hathaway. Or, at the very least, you would want a policy at the bank level that covered losses on earthquake exposure. Otherwise, your bank would be effectively acting as a reinsurance company without earning any premium income; accepting a tremendous risk, potentially wiping out your business and personal net worth.
If you held all of your assets within a geographic region that would be harmed by another New Madrid event, it doesn't matter how diversified they are in terms of industry, sector, or management team. You could wake up one day and, if you hadn't prepared for it, find most of your life work obliterated. That is not an intelligent way to go through life.
The Bottom Line? Business-Like Investors Look for Hidden Threads of Risk, Tying Together Investments That Appear To Be Isolated from One Another
Seemingly uncorrelated risks are most often the deadliest. Charlie Munger, a brilliant intellect and investor, has observed that Fannie Mae, in effect, became a reinsurance company without any of the offsetting premiums due to a scenario such as the one just mentioned. Perhaps a wise mantra to observe would be: “If a wipeout risk exists, just resist.” Walk away. Your pocketbook is likely to thank you and you’ll look downright prescient at some point.
Much success in life is about avoiding mistakes rather than making brilliant decisions. Take, for instance, the fact that economists have long known a single formula that virtually guarantees your family will never end up in poverty if you live in the United States: 1. Graduate from high school and college with little or no debt, 2.) get married and stay married, and 3.) wait until you are married to have a child. As far as predictions go, you can be perfectly mediocre in every other area of your life and that simple checklist of avoiding big mistakes will put you far ahead of income and net worth for everyone else in your age bracket. It's a magic formula of sorts that has been studied, discussed, and debated for the past few decades in some of the most prestigious economic departments in the nation.
For those who practice business-like investing, one of these steadfast rules is that you should avoid dishonest people, especially if they are involved in accounting or management. One such illustration: Recording accounts receivable before an order has been shipped or completed (known as “stuffing the channel”) is a particularly egregious behavior that can result in lots of accrual profits and not enough cash to pay your bills. There are forensic accounting methods you can study that will let you spot when this happening more often than not. Normally, you should take it as a warning sign and run in the opposite direction. Very little good comes of these sorts of games.
The Bottom Line? Only Work with Those You Can Trust (and Even Then, Have Systems In Place that Protect Against Bad Behavior)
No matter how profitable you believe a venture to be, if your business partner, manager, or employee is unethical, the potential liability could be financially fatal. This is true whether you are operating a single location retail shop or investing the common stock of an entity such as Krispy Kreme. Benjamin Graham pointed out in the 1940 edition of Security Analysis that an investor should avoid all commitments to a company if serious accounting issues arise – even the first mortgage bonds secured by the underlying property. He understood that if someone is willing to lie to you once, there is a high probability that they will do it again.
Business-Like Investors Keep an Eye on Cost
Think back to what you learned in one of our time value of money articles. Small increases in the rate of compounding, given enough time, can result in breathtaking differences in wealth level. If, for example, all you managed to do was add 3% per annum to your company’s return on equity for the next 50 years, your business would be worth 3 times what it would otherwise. A tripling in net worth is not something to disregard!
The easiest, safest, and least complicated way to accomplish this incremental return is to be an absolute tyrant on non-essential costs. One famous, well-regarded media tycoon once refused to paint the back of his buildings because he understood what that cash would do if it was reinvested in the business, not paid out to the hardware store. When you're in business with someone like that, as long as they aren't behaving stupidly and making life miserable for the employees, the odds of doing well are markedly increased.
The Bottom Line? Business-Like Investors Understand That Costs Matter. Every Penny Going Out the Door Is a Penny That Can't Be Put to Work Compounding for Your Family.
A tight control on costs can be a good barometer for managerial talent and an insight into how the executive team views shareholders; as merely a necessary evil or the true owners of the business, to whom they are accountable. If excessive stock option grants, floral budgets, and private jets are buried in the 10K and proxy statement of a potential investment, you should raise an eyebrow.