Investment Quotes Explored -1
In a series of forthcoming articles, I hope to highlight some famous quotes about investments and to spend some time discussing them in detail. I hope this exercise will bring to light some helpful ideas about investing.
We will kick off with a quote from Charlie Munger. Charles Thomas Munger is an American billionaire investor, businessman, and former real estate attorney. He is 98-year-old and is a Vice Chairman of Berkshire Hathaway, the conglomerate run by Warren Buffet.
The chosen quote is as follows.
“Over the long term, it's hard for a stock to earn a much better return that the business which underlies it earns. If the business earns six percent on capital over forty years and you hold it for forty years, you're not going to make much different than a six percent return - even if you originally buy it at a huge discount. Conversely, if a business earns eighteen percent on capital over twenty or thirty years, even if you pay an expensive looking price, you'll end up with one hell of a result.” - Charlie Munger
Investing in a stock involves buying a share in a business; it should not be viewed as a gambling chip or just a ticker. It is a real living, breathing enterprise which a management team with a specific history competes in a particular market sector and tries to grow sales, achieve profits, generates cash all the while trying to achieve a minimum level of return on the capital deployed in the business.
A potential investor in the shares issued by the business needs to understand something about all these factors to achieve consistent long-term success.
In the long run, the performance of a stock will be driven by the economics of the underlying business and the market structure in which it operates. If a particular business can only generate a return of about 6% on capital over a long period, it is irrational to expect to expect a return of say 18% from an investment in the stock of the company. Investors who have such expectations are likely to be very disappointed.
The main point that Munger is making is that the quality of a business (as measured by its current and future return on capital) is critical. One should look for such companies and should be very selective on the “quality” criteria before committing capital.
However, if you find a truly good quality company, one should invest and not worry too much about the price or valuation that prevails at the time of investment. Indeed, Munger implies, if you invest in a company that generates a return of 18% over the long term, the return you will make from an investment in the stock of that company will be about 18% per annum irrespective of the entry valuation.
In the course of our work, we have looked at the long-term track records of many thousands of companies. We have often been amazed how frequently this general point enunciated by Munger applies.
Munger is saying one should not refrain from investing in a quality company just because the valuation -correctly and thoroughly assessed- appears to be on the high side.
We should not ordinarily expect the market to be so generous, as to give away a company of undoubted quality at a y cheap price.
Munger is making an important general point but we have to be bear some important caveats.
His point cannot be reduced to a general phrase like “valuation does not matter” which one often hears during of period of excessive market euphoria and speculation. The investors must look at various metrics of valuation before investing in any stock to be assess that it is reasonable in relation to the likely returns the business likely to make over the medium to long term.
Another caveat is that Munger’s idea can only be understood in the light of his approach which is highly selective in that it focuses on the very highest quality companies (Press reports suggest that almost all the billionaire’s portfolio is allocated to just three stocks = Berkshire Hathaway, Costco and the Daily Journal Corporation) and has a very long- term investment horizon.
If, an investor is much less selective and investing in more marginal businesses and/or he/she has a shorter investing horizon than Charlie Munger, the entry valuation may be a much more important factor. This investor must pay much greater attention to the entry point valuation.
"There’s not much difference between 20 and 25 times earnings. There is between 20 and 60 but between 20 and 25, I’m trying to be too prudent, and miss the big picture. If you find a great company and it doubles its earnings every 5 years, valuation should be flexible. " - Francois Rochon