Investing in stocks is about finding good quality companies that are reasonable priced, so you can have a decent return as the company keeps growing earnings and cash flow. The more we think of owning a piece of business, the better investors we become.
That’s why we need to separate the stock market from each individual business that we’re looking at. The stock market is simply a collection of several companies, sorted by market cap. It contains good quality companies and not-so-good quality companies. It contains overvalued, fairly valued and undervalued companies. Our job as investors, is to choose the best companies from the stock market (focus on quality), and buy them when it’s attractively priced (focus on valuation).
I believe Warren Buffett explained it best, on how each individual business has no relation to the stock market, and how one should approach this exercise:
“I have no idea where the market is going to go. I prefer it going down. But my preferences have nothing to do with it. The market knows nothing about my feelings. That is one of the first things you have to learn about a stock. You buy 100 shares of General Motors (GM). Now all of a sudden you have this feeling about GM. It goes down, you may be mad at it. You may say, “Well, if it just goes up for what I paid for it, my life will be wonderful again.” Or if it goes up, you may say how smart you were and how you and GM have this love affair. You have got all these feelings. But the stock doesn’t know you own it.
The stock just sits there; it doesn’t care what you paid or the fact that you own it. Any feeling I have about the market is not reciprocated. I mean it is the ultimate cold shoulder we are talking about here. Practically anybody in this room is probably more likely to be a net buyer of stocks over the next ten years than they are a net seller, so everyone of you should prefer lower prices. If you are a net eater of hamburger over the next ten years, you want hamburger to go down unless you are a cattle producer. If you are going to be a buyer of Coca-Cola and you don’t own Coke stock, you hope the price of Coke goes down. You are looking for it to be on sale this weekend at your Supermarket. You want it to be down on the weekends not up on the weekends when you tend the Supermarket.
The NYSE is one big supermarket of companies. And you are going to be buying stocks, what you want to have happen? You want to have those stocks go down, way down; you will make better buys then. Later on twenty or thirty years from now when you are in a period when you are dis-saving, or when your heirs dis-save for you, then you may care about higher prices. There is Chapter 8 in Graham’s Intelligent Investor about the attitude toward stock market fluctuations, that and Chapter 20 on the Margin of Safety are the two most important essays ever written on investing as far as I am concerned. Because when I read Chapter 8 when I was 19, I figured out what I just said but it is obvious, but I didn’t figure it out myself. It was explained to me. I probably would have gone another 100 years and still thought it was good when my stocks were going up. We want things to go down, but I have no idea what the stock market is going to do. I never do and I never will. It is not something I think about at all.
When it goes down, I look harder at what I might buy that day because I know there is more likely to be some merchandise there to use my money effectively in.” – Warren Buffett’s Lecture at the University of Florida Business School, October 15th, 1998.
It’s a much harder exercise to evaluate quality, valuation and estimate earnings of all companies combined (the market). Hence we shouldn’t care what the market does. It also makes no difference when picking individual stocks, because the performance of the business that you choose might have no correlation with the market – it’s just one company out of the basket. By treating the stock market as supermarket of stocks, we can concentrate on the business that we are dealing with, pick the companies that meet our criteria (quality) and buy them when fairly valued (more on that later).
Now that we separated the stock market from the business that you are looking at, let’s focus on the quality criteria first. To evaluate quality of a business, we want to consider past and future. The past tells about how the resilient the business has been through recessions, crisis and crashes. Please note that this has nothing to do with the stock price performance, I’m talking about operating results for the business and the capacity of that business to grow earnings and cash flow. Hence my first quality criteria is to look at how the business did for the last 5, 10 or 15 years regarding earnings and cash flow growth ratio, which is made of the numbers of their operating performance for each of these years. Regarding the future, it tells me what the estimated earnings are – and that can be done with a much higher degree of confidence than estimating where the market is going, and why it’s important to separate the market from the company that you are evaluating. Also, I do not assume that past growth means future growth. Instead, my initial focus on historical operating results is designed to provide me comfort that the business I am reviewing has a proven record of effectively competing in its industry. Additionally, a review of historical operating performance provides me some insights into the competency of the company’s management team. With this in mind, I feel comfortable to do further due-diligence for the next steps.
Evaluating the past is easy, as the data is known and we just need to plot the number. The big misconception is regarding the future earnings estimates for one business, which is usually mixed with predicting the future for the stock market. Remember, we’re evaluating the operating growth for one business. Management has milestones where they want to be next and what growth / challenges can be expected. Also, keep in mind that this forecast exercise is on the business itself, not on the stock price. The real meaning of forecasting future earnings is so we can determine what the size and amount of the future cash flows that a stock under consideration might be capable of generating for us. This is important, because assessing the net present value of our expected future income stream, is at the heart of determining fair value (intrinsic value). Calculating net present value (NPV) is functionally-related to today’s wide utilization of discounted cash flow (DCF) analysis as a stock selection tool.
The two most critical factors to input are the determination of your expected velocity of the future cash flows (earnings growth rates) and the correct discount rate to use.
The basic formula for discounting cash flow (DCF) and basic net present value formula (NPV) are well known and can be easily calculated. Remember, we are first trying to determine what the business (common stock) is worth today, i.e. its current intrinsic value. Then we’re trying to determine what its future potential might be (long-term growth). Finally, we would like to have some sense about what those future dollars might be worth adjusted for inflation (the time value of money). Since there’s a future component (which is unknown), this calculations are not precise. And it doesn’t have to be. All we need is a reasonable range of probabilities and possibilities that we can use to make reasonably sound investment decisions upon.
As Warren Buffett said: “It is better to be approximately right than precisely wrong.”
Quality is the first criteria to scan for, as it determines “what to buy”. Valuation determines “when to buy”. And when we choose quality companies, it helps with the required temperament to invest. We can’t control price fluctuations, but we can control the quality of the companies we purchase. The higher the quality, the more confident I am that the company will bounce back on any price drops.
Lastly, it’s important to note that not every stock carries the same risk. A very good quality stock has lower risk than a new venture growth company. My strategy is focused on the growth and reliability of income from dividends. The primary determinant of high quality is superior financial strength. Financially strong companies possess the staying power and resources to weather the occasional bad storms that will inevitably occur. Every business will on occasion face challenges and difficulties. Meeting those challenges requires a strong balance sheet and an adaptive and competent management team to guide the company across troubled waters. Regarding safety considerations, cash flows are more relevant than earnings. Because when it comes to the survival of a business, cash flow is king. As it relates to safety, a business surviving as an ongoing concern is the last line of defense. So the same way that it’s important to consider earnings growth when evaluating quality, it’s paramount to evaluate operating cash flow to determine that liquidity and dividend growth is sustainable.
By taking into account corporate guidance and street consensus estimates (from the firms that are specifically covering the business that you are evaluating), you can have a reasonable degree of confidence on what the earnings and cash flow potential growth are. This is simply to tell us what the operating performance should be. It has nothing to do with the stock price so far. To determine what the stock price will do, one can compare the current multiples with its historical multiples and its projected growth to determine what the total return is expected to be. To me, that’s a safe way to invest, as we calculate our margin of safety and how much we expect each dollar invested in a company to return to us in form of dividends and capital appreciation.
Please let me know if you have any questions, and feel free to post your comments or feedback.