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CHAPTER 1
Invest in the Business, Buy the Stock
Investment is most prudent when it is most businesslike.
âBenjamin Graham, The Intelligent Investor
Mention Ben Grahamâs quote to investors, and they all nod their heads in agreement. But for most people, thatâs where the understanding ends. In practice, most individuals approach investing in a very unbusinesslike fashion; they just donât realize it at the time. Often they give more attention to the stock price and what it does than to what the business itself is doing. When markets are in an upswing, this perspective might not matter much. Then again, a value-oriented investment approach is not geared toward bull markets but at bear markets. Riding out the storm relatively unscathed is the name of the game. To invest at sensible prices, it is wise to think first about the business and understanding it and its industry.
I know firsthand the value of investing in the business versus the stock because I thought this was the approach I was taking when I first starting investing in my late teens. Yet years later, I decided to go back and look at some of my investment decisions, and what I found surprised me.
I realized that while I was buying good businesses that I understood, I was letting a moving stock price instruct me as to when to buy and sell. One specific deal that crystallized these thoughts was my 2002 investment in a company called Meridian Medical Technologies. It was a good profitable business, but unfortunately, I was not around to reap the benefits of those profits. Rather, I gave in to Mr. Market at the first sign of trouble. I wrote about this experience in one of my first letters to my limited partners.
Meridian is a manufacturer and supplier of auto-injectors, or ready to use drug delivery systems used by emergency personnel throughout the world. At the time, Meridian owned the auto-injector marketâno other company had FDA approval. The company had no debt, a fair P/E multiple, and large market all to itself.
Meridian was a good business with a very strong competitive advantage at the time in the form of FDA approval. And the valuation implied a decent investment price.
I bought shares around $33 or so. Within a couple of months the stock was down to $27 . . . the next earnings announcement showed that Meridian had posted âmoderateâ top and bottom line growth. The stock tanked that day to $22, and I sold out. Less than a year later, Meridian was trading over $40 a share, and shortly after that, it was bought out at an even higher price by King Pharmaceuticals.
This experience taught me two very important lessons immediately. The first was to accept the fact that investment decisions should be made based on the value of the underlying business, not according to the short-term movements in the stock price. Investors have to learn to come to terms with their decisions. If you can, then assuming you understand and have properly valued the business, you arenât swayed when the stock price of your investment declines 20 percent. Business valuation is both art and skill; I go over valuing a business in greater detail later in this book. Financial markets constantly quote prices others are willing to pay on any given day for a business, usually to the detriment of most investors. Ninety percent of the time, market prices are useless. They serve to distract investors from looking at the whole business and instead lead them to focus on the day-to-day price movements of a ticker symbol. As a result, investors often confuse market value with business value, leading to poor decision making and expensive mistakes. All too often, the terms âluckâ and âskillâ are tossed around the investment field inaccurately. The truth is that investment skill will always lead to certain moments of luck, but in the long term, luck alone simply cannot last long enough to produce a consistent, profitable result.
The second important lesson I learned is to think independently and rely on your own data. My mistake in Meridian was very fundamental: I let the crowd dictate my decision making. My mistake was not that I was wrong but that I decided that the stock price decline implied that I was wrong. I thought I had invested in the business, but I was really invested in the stock. My analysis was sound: a good business with a good product and a market leader with a strong operating performance. But my approach toward the business was far from sound; I let the noise from the market weaken my conviction of the business value.
Warren Buffett has often said that âinvesting is simple, but not easy to do.â I believe that one of the things he was referring to was the difficulty many people have separating the value of the business from the price of the stock. I remember a few years back, I was sitting in a hotel restaurant having a cup of coffee when I struck up a conversation with a gentleman who had spent years on Wall Street. He shared some wonderful (and not so wonderful) stories about his experiences there. At the time, I was still an undergrad student at the University of Georgia, so I was asking this gentleman as many questions as I could. When we got to the topic of the stock markets, the last thing I expected to hear was what he said: âStock markets are essentially obsolete places. We donât need them. They only exist to serve the needs and self interests of the big Wall Street banks.â
What he was referring to, of course, was the existence of the actual floor exchanges like the New York Stock Exchange. With the advent of electronic exchanges like the Nasdaq Stock Exchange, having a floor exchange is essentially unnecessary.
Iâve always remembered that conversation, because it came from an individual who worked for one of the big Wall Street banks that supported having the floor exchanges. I include this encounter not to say that we should shut down the New York Stock Exchange but to add my own spin: You should not equate the value of businesses with the daily volatility of stock prices. For the most part, the market gets it right and generally values businesses fairly. As a value investor, you are not interested in buying fairly valued businesses; you are focused only on selecting undervalued businesses. The stock market should exist only for you to buy an undervalued business and to sell a fairly valued business. Aside from those situations, you too should consider the stock market nonexistent.
Stock Prices Are More Noise Than Information
The majority of the time, daily stock prices are simply random noise movements. Warren Buffett has said that he invests as if stock markets would be closed for years. The truth is, most investorsâand their portfoliosâwould be a lot better off if stock markets were closed throughout the year.
Imagine if the stock market were open only once during the year. Every year on one day, investors would have the chance to buy and sell any investments they wanted. Then they would have to wait until the next year to do the same. What do you think would happen? For one thing, many people would probably cease to participate. Those are the individuals who participate in the market for more speculative reasons.
If you were looking to buy a small business, I doubt that you would buy it with the intention to sell it in a few months unless you were offered a most attractive offer. At the same time, itâs doubtful you would sell it at the first hint of bad news. Stock investing should be handled the same way. If you invest and the market decides to reward you immediately, you can choose to sell a short term investment if you feel the price reflects the company value. Conversely, donât jump to sell because you see a decline in the stock price without first determining if the business has been permanently impaired.
Most important, if markets were only open annually, investors would get really serious about which securities they would want to own. They would spend a lot more time understanding the businesses they invest in, because they would want to be absolutely sure that they were allocating their capital in the most intelligent fashion. In other words, they would invest in the business, not the stock.
Since markets are open every day with willing buyers and sellers, market participants often try to shortcut their way to investing. The shortcuts usually lead to a lot of short-term losses. One of the most âadvantageousâ aspects of the stock marketâits liquidityâis actually also one of the worst. Knowing that you can sell your securities any time the mood strikes you is more of a detriment than a benefit. Equity markets do a great job of making smart people do some really dumb things. The idea that a security should be sold after three weeks or three months because the stock price has declined seems rather foolish. The greatest business success storiesâCoca-Cola, McDonaldâs, General Electricâevolved over decades with plenty of periods of temporary decline. Any investor who abandoned these companies at the first sign of trouble missed out on some extraordinary returns that were to come.
Itâs hard for most people to ignore the useless noise that the market produces day in and day out. Even if today you gave someone a copy of the Wall Street Journal two years into the future, most still wouldnât profit from the information. Why not? Because even knowing with 100 percent certainty that XYZ Corp. would be worth twice what is today, people would still jump ship if the price collapsed on them in the interim.
True value investors ignore such meaningless noise. To the value investor, stock markets have one sole purpose: to allow the purchase of undervalued securities and to facilitate the sale of fairly valued securities. Security prices are there to inform, not instruct. Security prices allow investors to determine whether bargain opportunities exist once the business has been analyzed and appraised. Conversely, when the mood is euphoric, security prices offer the opportunity to dispose of an investment at prices equal to or above fair value.
A Businesslike Approach to Valuing the Business
Contrary to popular belief, most sound investments are made on the basis of very few rational decisions. The most illustrative example is the investment in the Washington Post Company made by Warren Buffett. Back in 1973, Berkshire Hathawayâs Buffett began accumulating shares in the Washington Post Company. At the time, the Post owned a top tier collection of media assetsâincluding Newsweek, the Washington Post newspaper, and several television stations in major marketsâand the entire market capitalization was approximately $80 million. Buffett concluded that the Postâs assets could easily fetch some $400 million or more if they were auctioned off.
While I am certain that Buffett was armed with a lot more information on the company, the major compelling reason for making the investment was that the assets were worth a whole lot more than the current price. Buffett made the investment based on the merits of the business; the stock price informed him that the current valuation was way too low. Interestingly, the market value of the Post continued to decline after Buffettâs investment. Looking at the company through the mind set of a businessman enabled Buffett to ignore the noise of the declining stock price. So what was the end result? Buffettâs company, Berkshire Hathaway, still owns its shares in the Washington Post and considers it one of its âpermanent equity holdings.â The $11 million investment was worth $1.367 billion at the end of 2007.1
Investing in the business is a simple task that gets complicated as the focus shifts away from the businessâs performance and fixates on the day to day fluctuating stock price. Investors should approach buying a single share of stock using the same process they would apply to buying the entire business. A simple example illustrates my point. It demonstrates the businesslike approach of investing in a business; it is not necessarily indicative of an actual business with actual numbers.
Suppose you are interested in buying your hometown bicycle shop that is up for sale. The owner is selling the business for $100,000. Is this price a good value?
Your first approach is very general in nature to allow you to get a feel for the place. This would be akin to reading the annual report of a public company. You look at the location of the shop, find out how long it has been in business and if there are any other competitors in the area.
After this general investigation, you want to determine if the business is a worthy investment based on the sales price. You start looking at the numbers. Sales figures are nice, profits are even better, but at the end of the day, you want to know how much cash is left over after paying the bills. In other words, how much free cash flow does this bicycle shop produce? Looking over the last five years of operation, you see these figures for free cash flow:
Based the on the past five years, the business appears to be doing well. Itâs growing its free cash flow at a nice rate, but that was the past. You are buying the business based on the future anticipated cash flows. And when it comes to predicting future results, there is always an element of uncertainty involved. Looking back at the past five years, you realize that the business has increased cash flow by approximately 10 percent a year.
Going forward, you might be inclined to think that this same rate of growth will occur for the next five years, but I donât think most rational individuals would buy a business based solely on the past. For one, as businesses expand, the law of large numbers kick in. Itâs a lot easier to grow from $100,000 to $110,000 than to go from $1,000,000 to $1,100,000âalthough both figures represent a growth rate of 10 percent.
So, you decide to assume that over the next five years, the business will grow its cash flow by 6 percent a year. A bicycle shop is generally a local business, so at some point market saturation will cause a decline in sales level as the number of bike owners increases in your city. However, the business generates revenue doing repairs and selling accessories, so you can expect to make up for slowing sales growth. You predict that, over the next five years, the business will deliver these numbers:
Remember that money earned in the future is not worth the same as it would be in your hand today, so we have to discount the future sum back to the present. Why use 10 percent? I used it simply for illustrative purposes. The discount rate should be customized to the specific business. If you are buying a start-up, then you would use a much higher discount rate to account for the higher degree of uncertainty involved in the businessâs future operating performance. A higher discount rate will, of course, decrease the present value of the future cash flows, implying a lower business valuation. Conversely, a more established businessâwhich might have lower rates of cash flow growthâwill command a lower discount rate to account for the relative consistency of the cash flows and its more established competitive position. (Think of Coca-Cola or the Procter & Gamble Company.)
The total value of discounted cash flows comes to $67,140. Of course, the business is also worth something as well as it will continue to exist and operate beyond five years. You figure you can easily sell it for five to seven times the free cash flow in year 10, or around $60,000 to $85,000. This sales figure is referred to as the terminal value of a business, a very important concept that is used hand-in-hand with the discounted cash flow analysis to assess the present value of a firm. The terminal value calculation is used to determine the value of the firm for all the years beyond which one can reliably project cash flow using the discounted cash flow. The terminal value can be calculated in several ways. One calculation assumes the liquidation of the firmâs assets in the final year of the discounted cash flow analysis. This method estimates what the market would pay for the firmâs assets at this point. The other two methods assume the firm will continue operations for an indefinite time period. The terminal value is determined either by applying a multiple to earnings, revenues, or book value, or by assuming an indefinite, constant growth rate. Add this figure to the sum of the discounted cash flows ($67,140) and you get a value for the business of approximately $127,000 to $150,000. With this information, you can make an intelligent decision on whether to purchase the business, negotiate a lower price, or simply walk away.
Notice what you donât do. You donât spend much time trying to forecast the individual price of bicycles and basing your decision on lots of moving inputs. The more moving parts you add to your analysis, the more complex and likely inaccurate your valuatio...
