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The key to investment success is to buy wonderful businesses. Like many great truths, it may seem obvious, but it is not. As Warren Buffett would put it: It is far better to own a wonderful company at a fair price than a fair company at a wonderful price. 

The philosophical father of value investing, Benjamin Graham, taught Buffett that price is what you pay, and value is what you get. But the emphasis of Graham’s teaching was on buying cheap companies and assets, while the idea of the quality of the business was not focused upon. Graham would love to buy companies well below their liquidation value. But unless you were a liquidator, you might need to wait a long time for the price to equal value, and you might need some kind of event for it to happen. 

If you were to buy a business with very high earning power however, and it would keep returning high returns year after year, the returns of the business will ultimately be the returns of the shareholders. A good business tends to increase its earnings yearly, and thereby increasing its value over time. A bad business has a high chance of getting less valuable further down the road, and consume a lot of the owners’ capital over time as well. While time is the enemy of a bad business, it is the friend of a wonderful one.

Joel Greenblatt, who ran Gotham Capital and averaged an annual return of +40% for two decades, shared some insights during an interview about how hard it is not only to pick a good manager, but also to stick with him. Even with Joel’s performance his investors would find it really hard to stick with him, and he felt it was easier to manage his own money after a while.

Joel started the interview saying that even Warren Buffett says most people should stick with index funds, and he agrees with him. But Buffett doesn’t index himself and neither does he – how come? The answer: If you don’t know what you’re doing, the safest thing to do is index. By periodically investing in index funds, the know-nothing investor can actually outperform most investment professionals. Paradoxically, when ‘dumb’ money acknowledges its limitations, it ceases to be dumb.

If you on the other hand are a know-something investor, Buffett suggests that you should focus on your best ideas.

According to Joel Greenblatt stocks aren’t pieces of paper that bounce around that you put fancy ratios on. Stocks are pieces of ownership in a business, that we try to value and buy at a discount. Investing in stocks is really about valuing businesses and try to buy them at a discount. In doing so, the best strategy, says Greenblatt, is the one that makes sense and that you can stick with.

If you can’t value businesses on your own then you have an alternative to find a manager with a good investing process and sticking with that. The problem is that sticking with a good manager is really hard to do. Human nature tends to work so that we pile in and pile out at all the wrong times. For example the best performing mutual fund in the U.S. in the period of 2000 to 2010 managed to gain an average annualized return of 18 percent. The market was flat in that period so that was pretty good. But the average investor managed to lose 11 percent a year by moving in and out at all the wrong times. After the market went up they piled in, and after the market dropped they piled out. And after the fund outperformed they piled in, after the fund under-performed they piled out. They thereby turned an average gain of 18 percent into an average loss of 11 percent. The example shows that it’s really hard to handle volatility for an investor, and to stick with a good manager even if he has a good process. 

Another study Greenblatt did turned out that about half of the managers in the top quartile performing institutional funds over a ten year period spent at least three years in the bottom performing decile. How many do you think would stick with them?

The problem is that people tend to look at the returns of the last few years to determine whether they should start following the manager’s fund. But according to Greenblatt the last 3-5 years don’t determine the outcome of the following years. What you need to do is look at the manager’s investment process instead. 

Most fund managers don’t want to pick stocks that look like they won’t make a good return over the next three years. But that’s where the opportunities are according to Greenblatt; that’s why you’re getting the stocks at a discount. 

If you’re a stock picker you should focus on time arbitrage; buy undervalued stocks by doing good valuation work, and wait for the market to agree with you.

Buffett was asked: “What piece of advice would you give to people who are looking to succeed in business?”

He answered: “By far the best investment you can make is an investment in yourself. For example communication skills. Many students take advanced degrees and learn complicated formulas. If they just learned to communicate better, both in writing and in person, they’d increase their value by at least 50%! If you can’t communicate, it’s like winking at a girl in the dark… nothing happens!

It’s relatively easy to learn, but it’s hugely important. And if you invest in yourself, nobody can take it away from you!”

Warren Buffett was asked in an interview in the spring of 2019 how closely he is following his biggest stock investment, Apple. The interviewer mentioned that people are concerned that Apple hasn’t released any new products lately and so on, and asked what Buffett thinks about that.

Buffett quickly answered: “Well, if you have to follow the company closely, you shouldn’t own it!” “Really!?” the interviewer said surprised.

Buffett continued: “If you buy a farm, do you go to the farm every day or every other week to look at it? Do you check closely how far the corn has grown, or do you worry about if this is going to be a year of low prices, or of high prices, and whether exports are affecting your earnings?”

“It doesn’t grow faster if I stare at it. It doesn’t help to cheer at it. I know there is going to be some years when prices are going to be good, and there are years when prices aren’t going to be good. I know there will be years when yields are better than others.”

“I don’t care about economic predictions. I do care about whether the farm is well tended to, and whether productivity is increasing over the long term. If you owned the best auto dealership in town, would you go in everyday and check how many customers drop in?”

He summarized: “Things are going to be different in a business day to day, and year to year. You shouldn’t buy the business if the day-to-day is important!”

If you’re concerned everyday about how the business is going and you feel you have to follow it very closely, perhaps you do not own a wonderful business?

The successful investor Joel Greenblatt once told a story about when he was asked to teach a 9th grade class about the basics of investing and how the stock market works. He had shortly before tried to teach the same to a group of surgeons. When the men’s questions after the presentation were in the lines of “The stock market was up 2 % yesterday – what do I do about that? And, “Oil is down $2 – what should I do?”, he figured he had failed his presentation to the intellectuals.

He then thought about what he could do to not crash and burn in the presentation for the kids, so he walked in to the class the first day, and he handed out a bunch of cards. He also brought a big jar of jelly beans, and he handed around the jar, told the kids to try to count the jelly beans, and figure out how many they thought were in the jar, and then write their estimate on their own card one by one.

It turned out that the average guess that the kids wrote down on their cards was 1771 jelly beans. There were 1776 in the jar, so that was a pretty good average estimate.

Before he told them their average estimate, he went around the room, one by one, and asked them to tell out to the class what their guess was. The guess when he went around the room was 850 jelly beans on average.

He explained to the class that the second guess was the stock market.

Everyone knows what they just read in the paper, what the guy next to them said, what they saw in the news, and they are influenced by everything around them – and that’s how the stock market works!

The cold calculating guess, when they were counting rows and trying to figure out what was going on, that was the better guess. That’s not the stock market, but that’s where Joel sees the opportunity that the stock analyst has to do well in the stock market if he does good valuation work.

The Coca-Cola Company has been producing growing earnings for the shareholders consistently over the past decades. Not only has the earnings been growing over the last 30 years since Warren Buffet’s Berkshire Hathaway bought its ownership in 1989, but for a long time before that too. The wonderful company of Coca-Cola was founded in 1886, and it’s been growing its dividends annually for over 50 years. The yearly growth rate has been quite decent, about six percent, outpacing inflation by a good margin.

If you were an owner, shareholder, of The Coca-Cola Company, you would be entitled to a part of the earnings that the company produces for its shareholders.

How it works is that board of the company suggests how much of the earnings be paid out as a dividend, and the shareholders vote upon it in the general assembly. The part of the earnings that the company does not pay out as a dividend remains in the business as capital, which can be used to grow the business and the earnings even more.

Historically the company has retained a major part of its earnings and used the capital for further growth, as well as share buybacks. Yet it has been able to grow its dividends every year.

We’ll cover share buybacks in a later post.

If you were looking for a wonderful company to invest in back in 2009 after the crash, you might have come across Disney. It was then trading at a price which gave investors a dividend yield of not more than about 1%. Keeping in mind that the current dividend yield and the future earning power of a business are not the same, you went ahead and bought a share of ownership in the company.

Let’s say you shared the Warren Buffett idea of having your holding period to be forever and did not sell a share. You’d be happy to see dividends continue increasing for the next ten years. Today your dividend yield would be about five times higher, from about 1 to 5 percent.

What the dividends do not tell is that Disney has retained most of its earnings and compounded them over your holding period. The earning power of each share has also gone up by about fivefold. Your earnings yield on your investment price, not adjusting for dividends, is now more than 28%. It was only about 5% when you bought the shares, but since you bought into a wonderful company at a fair price you did well!

Indeed you can! At least in a way.

You see, if you own shares in The Coca-Cola Company, in the KO stock listed on NYSE, you are a part owner of the business and you are entitled to its earnings. At least in relation to your ownership stake in the company.

It’s no surprise that the company has been earning lots of money every year for a long time. Part of the earnings have been reinvested in the company for further growth or share buybacks, the rest has been paid out as a dividend for its shareholders. That’s where you come in!

You can be an owner of The Coca-Cola Company because it is a public company. At least you can be a part owner. However large or small, each shareholder is treated equal in terms of ownership benefits per share.

Free Cokes you said? How?

We’ll they’re not really free, but if you were an owner of the business, you would earn dividends, and the dividends could cover your Coke consumption for a lifetime. That is to say if you have enough shares in relation to your consumption.

If you’re a US citizen a Coke serving of 16 oz costs about $1.20. Depending on your tax situation you’d need to have an incoming share income, dividend, of a bit more than that. Let’s say $1.50 of dividend income should be enough to be able to buy one serving of Coke.

The Coca-Cola Company pays a quarterly dividend of 40 cents per share and growing. That means one share currently pays you an annual dividend of $1.60, enough to cover the cost of a Coke after tax, and perhaps it also leaves you with some pocket change too!

I’m a big fan of the company (why else would I be blogging about it). Not only am I a consumer of its products, but I’m a part owner of the business too. I like to see that my ownership is big enough to cover my consumption of the products that I love. It’s not there yet, but it can be, and it could for you too.

Imagine having “free” Cokes for a lifetime consumption. You can build your Coke Earning Power over time, by gradually acquiring shares. And once you have enough ownership to cover your consumption, it doesn’t end there. It can be passed on. Your grandchildren can enjoy free Cokes as well. A form of generational wealth!

Let’s say you bought an ownership stake in The Coca-Cola Company ten years ago, and you somehow managed to get your shares at a price equal to book value; you got the shares without paying a premium in other words. That would be far below what the shares traded for, but think of this as a thought experiment. Then let’s say for some reason the stock market was shut down right after you bought your shares, and it still is. How might you think of the outcome of your investment so far?

Since the stock market it closed, and you are not getting any information about what the stock is selling for, you turn to the business figures for an answer.

The last ten years you have collected a dividend well over twice of what you paid. And the dividend has grown by about 6.6% yearly. Your earning power from dividends has made you richer by the year, outpacing inflation. Your current dividend yield on your initial investment has climbed from about 15% to nearly 30%. Over the period your equity per share has decreased somewhat with about 80% remaining. Your equity capital in the business is now lower than what it was when you invested.

In the perspective of earnings on equity, which would be the earnings yield on the amount of capital you have in the business, you’d be glad to know that you have gotten a pretty good average annual return of about 27%.

Would you consider to be invested in a good business? Warren Buffett would certainly say so. For him a wonderful business is a company that manages to earn a yearly return of at least 20% on tangible equity capital. We’ll come back to what that means later.

The point of this post and more posts to come is to address what it means to be invested in a wonderful company versus a fair one. To illustrate the point we might make some thought experiments where we make a few simple assumptions. We might compare businesses in an environment where ownership of companies could be bought and sold at book value only, and there’d be no premium to pay. And to keep things simple we may assume that the stock market is closed.

I hope you will enjoy the ideas and get another perspective to use in your investing journey.