Selecting Good Companies (ROE, PB and PER)

[Musicwhiz]

To d.o.g.,

I guess the basic premise of any investment is to examine the business model of the Company in question, to at least be able to ascertain if it has a comptitive advantage and deep enough moat to be able to protect its margins and profits. Since you mentioned a lot about the dynamics of such commodity businesses, I guess it should be clear to investors that any profits made in the interim could be "supernormal" and are thus only temporary, before reverting back to the mean.

Commodity businesses also generally do not have FCF, as they need to invest in significant amounts of capex to ensure they keep up with the competition or rate of technological advancement. Margin erosion is also a common result of such businesses.

Though I would agree as well - on hindsight this all seems clear. Yet, the idea is to learn lessons from it and try to avoid investing in such businesses in the first place.

To Kazikurai,

I guess what was not mentioned was whether he pumped in additional capital to boost his portfolio in the first place. Giving a start and ending figure isn't very useful unless you assume he did not add in or withdraw any capital at all during the 30 years. And did he account for dividends as well?

My view is that he probably helped himself a great deal by being frugal and having good spending/saving habits. So this is all part of being a value investor - you seek value in all aspects of your life!

I also don't think he intentionally "diworsified"; it could be that he's already financially independent and has a very good cash stream so he can afford to try out something new without too much risk (i.e. he did not pump too much $ inside these ventures).

To yeokiwi,

Yep, I agree with you on this. d.o.g. also mentioned before that having a good work ethic is important. So what we need to do is work hard, save hard, insure against disaster, and invest for better returns; in that order!

[thinknotleft]

Hi d.o.g, Musicwhiz

I beg to disagree with you on avoiding investing in commodity business. I believe that given a sufficiently low price and shareholder-friendly management, it is worthwhile to invest in a commodity business.

I guess, while we practice value investing, we look at different sides of the coin.

[Musicwhiz]

I beg to disagree with you on avoiding investing in commodity business. I believe that given a sufficiently low price and shareholder-friendly management, it is worthwhile to invest in a commodity business.

Hi there,

I did note that you adopt a value-oriented approach to your investing, as I've visited your blog before.

But maybe you can explain in a little more detail - why do you think commodity-type businesses are worth investing in? When you mention a "sufficiently low price", I think you have to clarify if you mean "low valuations" or "low absolute price".

My take - valuation (i.e. PER) may be low for the business because of its commodity nature and its inability to maintain pricing power over its competitors. Hence, the market accords it a low valuation as its growth potential may not be very high.

Interested to hear your views on this, thanks!

[d.o.g.]

I believe that given a sufficiently low price and shareholder-friendly management, it is worthwhile to invest in a commodity business.

Let me be clear that I am not advocating avoiding commodity businesses, as defined by businesses that produce or trade commodities such as coal, rubber, corn, wheat, crude oil, iron ore etc.

What I am talking about are businesses that produce commodity-type returns. Notice that I have not mentioned any traditional commodity businesses. Instead I named businesses that either manufacture products or provide services e.g. synthetic fibre, steelmaking, airlines etc.

Take, for example, SIA. It is arguably one of the best managed airlines in the world and has the best record of profitability. Yet, despite the hard work of the management team, SIA's return on equity has averaged only about 10% in the last 10 years. 10% is fantastic for an airline. It is extremely ordinary for any other business. A business that averages a 10% ROE would not normally be worth more than book value to a private owner.

If the "best" company in an industry averages only 10% ROE over 10 years, I take it as a sign that the entire industry is terrible and should be avoided except for "special situation" investments.

One might argue that SIA is worth a premium because of its branding etc. But clearly the branding hasn't helped it to produce extraordinary returns, at least in the absolute sense. Which means the branding has essentially no value when compared to other "lesser" brands in Singapore like Tiger Beer, Tiger Balm or Brand's Essence of Chicken.

SIA is worth a premium compared to other airlines because its brand/management/whatever help it earn more than other airlines. But SIA is not worth a premium compared to other non-airline companies, because other non-airline companies can generate much better returns on equity.

I personally think it is better to buy a business at 2x book value, if that business can get a 20% ROE, then to buy a business at 1x book value, with a 10% ROE. Assuming the "expensive" business compounds internally at 20% and the "cheap" business compounds internally at 10%, what happens after 10 years?

For the expensive business:

You pay $2 for $1 of book value, which becomes $6.19 of book value. So if the business now sells for 1x book value you've tripled your money. More likely, it will still sell at 2x book value or $12.38, so you've probably sextupled your money. At an in-between valuation of 1.5x book value you get $9.27 which means you still more than quadruplued your money.

For the cheap business:

You pay $1 for $1 of book value, which becomes $2.59 in book value. At book value you've more than doubled your money. But it will probably still sell at book value, so no premium there.

So who has done better - the guy who bought the "expensive" good business, or the guy who bought the "cheap" lousy business? Both guys made money, but the guy who bought the good business has a better chance of becoming seriously rich.

As for traditional commodity businesses, I agree that if a company is honestly managed and is bought at a low price, it can be a good investment, especially if the company's production cost is low. I made a lot of money on just such a commodity company last year. I would be happy to buy back in if the price came down.

[thinknotleft]

I am implying to commodity-type business.

I recall Shai ask similar question to Warren Buffett some years back (see http://www.gurufocus.com/news.php?id=4363). Buffet's reply, if I recall correctly, is both approaches are fine.

d.o.g wrote: I personally think it is better to buy a business at 2x book value, if that business can get a 20% ROE, then to buy a business at 1x book value, with a 10% ROE

Well, the question is how low the 10% ROE business should be priced before it becomes attractive for an investor. At 1/2x book value? At 1/4 book value? Given a finite horizon, one will bite given sufficiently low valuation.

d.o.g wrote: Assuming the "expensive" business compounds internally at 20% and the "cheap" business compounds internally at 10%, what happens after 10 years?

Personally, I am a pessimistic person. I feel that not many 20% ROE business now can maintain the 20% ROE for the next 10 years, unless the business gives very high dividends.

If the 20% ROE business become a 10% ROE business somewhere down the road, it remains unknown whether the investor who buys the 20% ROE business at 2x book will be better off than the investor who buys the 10% ROE business at 1x book.

d.o.g wrote: If the "best" company in an industry averages only 10% ROE over 10 years, I take it as a sign that the entire industry is terrible and should be avoided except for "special situation" investments.

I do not disagree with you on this point. Nonetheless, there may be times where it is worthwhile to invest in airlines.

As noted in the book, Investing the Templeton Way, John Templeton bought those airline stocks that falls x% after 9/11 incident. And, he makes a pile out of those purchases. You may define these distressed situations as "special situations".

To conclude, I feel that for most businesses, whether they be businesses with low moat or high moat, I will buy if the prices (or valuation) are sufficiently low.

[d.o.g.]

Well, the question is how low the 10% ROE business should be priced before it becomes attractive for an investor. At 1/2x book value? At 1/4 book value? Given a finite horizon, one will bite given sufficiently low valuation.

Point conceded. You will notice that I did not compare a good business at 2x book value and an average business at 1/2 book value. That is a much harder comparison and I suspect that empirical evidence would favour the latter.

Personally, I am a pessimistic person. I feel that not many 20% ROE business now can maintain the 20% ROE for the next 10 years, unless the business gives very high dividends.

Also agreed.

Charlie Munger did say that finding such "great" companies shouldn't be easy, since one or two of these, bought in sufficient size, would ensure great success over the long term regardless of whatever other investment decisions were made. Basically, it's the Coca-Cola investment method. Those who put 10% of their net worth into Coke 20 years ago ended up with over 50% of their net worth in Coke, because Coke grew and grew and grew.

[mrEngineer]

Personally, I am a pessimistic person. I feel that not many 20% ROE business now can maintain the 20% ROE for the next 10 years, unless the business gives very high dividends.

Hi thinknotleft, thanks for your informative post. I have a question that I couldnt quite figure out. Why do you say that to maintain high ROE, it is required to have high dividends? Are you referring to the DDM formula of g = RR X ROE? Where RR is (1-Div). Is there a qualitative explanation for this? Intuitively I cant link both giving dividends and ROE together..

[d.o.g.]

Intuitively I cant link both giving dividends and ROE together.

Most companies cannot invest their cash to get the same rates of return as their existing business. Therefore, over time, the money gets invested in worse and worse projects, so the overall ROE falls. If the company pays out most/all of its cash this problem is avoided since equity then consists mostly of the great business rather than a mixture of great/so-so businesses.

[mrEngineer]

Thanks d.o.g. Just like the old days, your posts are as always so compelling to read.

I notice that your activity in the forum correlates to impending extreme periods of market cycles. haha. perhaps I should consider using you as a indicator on market timing. Just kidding. =)

[Musicwhiz]

Hi thinknotleft,

So let's say you can find a business which does return >20% ROE for 10 years consistently, does this mean you would pay a premium over book value for it? And how high is your threshold before you will think it's not worth paying for?

Although I would agree investing is NOT looking at merely the rear view mirror, historical financials do give a good peek at the Company's business model and hence track record which one can use to reliably project into the future. Barring exceptional circumstances or Acts of God or political upheavals, I should say a Company which generates very good FCF and high ROE should continue to do so.

For investing, my personal belief is one should not be a pessimist; neither should one be an optimist. Instead, one should strive hard to be a realist, and always a business analyst. A realist should look at the world through an objective and rational lens, and be as neutral as possible in his analysis (devoid of emotional factors).

Just my 2-cents.