Long-term investment in equities is the best way to create long term wealth for most people.
In the first note in this series, we discussed Benjamin Graham’s view of the market as a voting machine in the short run and a weighing machine in the long run. Market prices can be volatile in the short term depending on sentiment and popularity (votes) and price extremes can be driven by sentiment and manias. These short-term price movements are inherently unpredictable. However, price and values cannot forever be pumped up by hype or excessive optimism or kept too low by excess negative sentiment.
It is like those cartoons where a character runs off the cliff and for a few moments continues running in the air before gravity kicks in and the character falls down sharply.
In the stock market the role of gravity is represented by the economic fundamentals of the company particularly the quantum of its profits and future cashflows. In the long run, share prices will inevitably be driven by economic performance. The market is a weighing machine in the long run and bathroom scales do not lie!
In the previous note we also met Graham’s Mr. Market who is volatile and impulsive but who does not mind being ignored or rejected. The lesson was the investor should not fall under the influence of the market and should try, as much as possible, to arrive at an estimate of the value of securities and businesses which is independent of the market price.
The aim of long-term wealth creation is not to make the maximum possible return but to make the highest possible return without taking excessive risk. We will consider later the nature of the risks and how it should be managed. The awareness of risk is key and the investment process is characterised by conservatism and caution.
The long-term investor has to work hard and do a lot of research to build up a portfolio of a very small number of good quality companies and invest in those companies when they are available at a fair price.
The process is characterised by extreme selectivity and patience.
The process for selecting the companies has to be rigorous and only a very small fraction of the potential universe of companies will make it on the list as eligible investments. As a very general rule, you should only be selecting one in twenty (or 5%) of the companies one looks at.
When such companies have been found and invested in, the investor should be patient and hold on to the investment for a long period. The company should be monitored carefully; the bias should be to hold on for as long as possible to give the investment to compound for a longer period.
In order to select companies, the investor has to research the fundamentals of the company.
The universe of potential companies is large and time is precious. It is not possible to look at many companies in depth. Therefore, one needs some simple criteria to come up with a shortlist. These filters can be qualitative and quantitative.
A qualitative filter could be to restrict research only to those industries that one understands. Nobody can understand every industry. The area of understanding is what Warren Buffet calls the “Circle of Competence”.
The Circle of Competence should be defined conservatively – there is no shame in saying one only understands two or three industries and looking only at companies in those industries – over time and through a process of reading, thinking and more reading – the Circle of Competence will slowly expand. The important thing is not to look at companies which are outside of one’s Circle of Competence.
The quantitative criteria are developed over time, an example of these could be as follows:
Eligible companies should show:
- The last five year’s revenue growth should be at least 15% CAGR.
- The last five year’s profit growth should be at least 25% CAGR.
- The last five years Return on Equity (ROE) should be at least 18%.
- The average debt for the last five years of the company should be no more 120% of the company’s net worth or equity.
- The forward Price Earnings Ratio should be no more than 20 times.
These type of criteria will not work for banks and finance companies.
Once the qualitative and quantitative criteria have been applied, a small manageable list of companies will be derived for further analysis.
In the next essay in this series, we will discuss our process for analysing companies in more detail.