How to invest in great businesses
Most investors who invest with us have arrived at a point where managing their own portfolio has become a time-consuming exercise they no longer want to prioritise over seeing family, running their own business or engaging in activities they enjoy.
As the outperformance of all Montgomery funds since their inception has demonstrated, it is entirely possible to beat the market. That’s good news for the many investors who wish to go it alone. This article explains what to look for when identifying high-quality businesses.
First, the difference between speculating and investing. Investing involves treating shares as pieces of businesses. Speculating is betting on the ups and downs of share prices. It is gambling and gambling is for mugs. “Investing is most successful when it is most business-like,” is an oft-quoted aphorism of Benjamin Graham, the late economist and investor.
At Montgomery we are not inclined to own a little piece of a business (stock) for 10 minutes if we would not be prepared to own the whole enterprise for 10 years.
When treating shares as ownership stakes in a business, your entire approach changes; the way you think about which shares to acquire, the way you think about your investment while you own it, and the considerations you make when deciding to sell. Everything changes when you approach investing in a business-like fashion.
Once you have decided to invest in outstanding businesses rather than speculate on stocks, the first step is to employ tools and methods that help identify them. You don’t need tools used for predicting and trading stock prices. In my view, the serious investor has no need for charting or technical analysis. These tools attempt to predict the next up or down move, which is akin to predicting black or red on a roulette wheel.
The tool most needed is a framework. Montgomery’s framework can be distilled into three components: 1) quality, 2) value and 3) cash, when quality and value are unavailable.
How to spot exceptional companies
To understand how we identify and think about the highest-quality businesses it is first important to understand how a company becomes more valuable. Then you can overlay the behavior of long-run share prices.
Consider a bank account with $10 million deposited in it and an interest rate of 20 per cent forever. Assume the account must distribute all the interest earned – $2 million. If we were to auction this account we would quickly discover that, with interest rates where they are, its market value is higher than the equity deposited. In other words, the price it would sell for at an auction (remember the sharemarket is a just a great big auction room) would be higher than $10 million.
For an investor with a required return of 10 per cent, they could pay $20 million for this bank account, which is earning $2 million, thereby receiving a return equivalent to 10 per cent, equivalent to their required return. If someone was happy with a 5 per cent return, they could pay $40 million for an account with $10 million of equity. But would they have paid too much?
Let’s fast-forward 10 years. What would this bank account trade for it were auctioned again? The answer, of course, is that it could be higher or lower than the amount we would have received by auctioning it today.
We know, for example, that the bank account has been paying out $2 million per annum. We also know that inflation has eroded the purchasing power of that income and so the $2 million today is not what it was 10 years ago. That means, all things being equal, I am not going to obtain $40 million unless I speculate that people might be willing to pay a silly price.
We also know the account has been paying all the interest out, so the equity, even in a decade’s time, remains stuck at $10 million (assuming no deposits or withdrawals are made).
At the auction, if someone turns up willing to accept a 10 per cent return they might be willing to pay $20 million, or if interest rates are lower they may be willing to accept a 7.5 per cent return and pay $26.7 million. We can make an educated guess, but don’t know what interest rates are going to be.
If rates jump to 15 per cent, a bank account earning 20 per cent is attractive but not a lot more so than bank accounts going around elsewhere. We are not going to get our $40 million returned to us in the scenario.
So whether we get our money back will depend on interest rates, inflation and where sentiment is at the time. These are not things we can predict.
An alternative approach
Now consider a second bank account being auctioned today at the same event as the first. The second account also has $10 million deposited and earns 20 per cent interest, but in this second example, all of the interest is retained and is left invested to compound at 20 per cent per annum.
At auction today, the account will trade for more than the equity deposited and for more than the first account. What we are interested in, however, is how confident we can be about what it might trade for in a decade’s time.
By then, the second account will have earned 20 per cent of its balance each year and retained that amount. After a decade of compounding, the account will have almost $62 million deposited and still be earning 20 per cent.
At auction in a decade’s time, it is reasonable to assert that not only will it sell for more than $62 million, but it will also trade for more than the price received at auction 10 years ago. The only caveat is that an irrationally exuberant price wasn’t paid previously.
If we had paid $40 million for this bank account 10 years ago, we can be reasonably confident we earned an attractive positive return. More importantly, if sentiment is negative towards the business in a decade’s time, and the economics of the business have not changed, we can be confident in the ongoing increasing value of the business.
We can ignore the vicissitudes of the market and continue to own the business. Inevitably the auction room will be filled with people clamouring for our brilliant bank account.
Importantly, you can now see that real investing – the kind that produces solid returns for investors – has little to do with predicting share prices and everything to do with identifying the right “bank accounts”.
Three criteria to look for
The right bank account is the same as the right business, and the right business has three criteria.
The first is a high rate of return on its equity. In the above example, the return on equity was 20 per cent. You intuitively appreciated that rate of return and the same is true in business. When it comes to returns on equity, May West was right when she observed that “too much of a good thing … is wonderful.”
To be able to sustain a high rate of return on equity, the company requires a competitive advantage. In business, high returns attract competition and a competitive advantage protects a business from would-be competitors.
By way of example, why is it that people pay more for a Tiffany’s diamond, even though diamonds are cheaper elsewhere? Why do people selling their house list it on realestate.com.au or their car on carsales.com.au? Because these businesses have competitive advantages, which produce unusually high returns.
How high the return produced determines how “deep” the competitive advantage is. And how long the advantage might last is a description of how “wide” the competitive advantage is. When it comes to competitive advantages, deeper and wider is better.
Another important consideration is debt. We want businesses whose returns on equity are not artificially boosted by lots of gearing.
Finally, we want a business that generates lots of cash. Aggressive accrual accounting (recognising revenues and expenses when they are incurred, not when cash changes hands) is a no-go zone. It is essential that the company’s cash flow after investing in itself is sufficient to do attractive things, like making rationally priced and synergy-generating acquisitions, buying back shares or paying dividends.
Ultimately we want a business that can take large amounts of equity and generate very high returns on it.
In summary, put together a portfolio of businesses purchased at rational prices, with high rates of return on incremental equity, bright prospects for earnings growth, and little or no debt. Then sit back and watch the market value of the portfolio look after itself.
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