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Weekend Edition

Why the world's best investors ignore earnings
Saturday, May 25, 2013

 What if there was a secret way of looking at the stock market and individual companies that allowed you to see the real value of everything – regardless of the current price?
 
 If there was such a method, you could invest your hard-earned capital with much more confidence, knowing you were getting a real bargain. You would never have to worry about using a stop-loss because you'd never, ever lose a penny investing again. All you'd really have to do is look around once in a while and pick up the most obvious bargains.
 
 If you had this kind of ability, you'd not only become a more successful investor, you'd become a vastly more patient investor. You'd have real certainty about your choices. You'd know, every single time you bought something that, sooner or later, it would end up becoming massively profitable.
 
 The good news is... There is such a method. There is a real, bona fide, proven, and easy-to-learn method of developing this kind of worldview, this kind of wisdom.
 
Learning this technique doesn't merely give you an advantage in the markets, either. It gives you a whole new way of looking at the world. You might call it a "value" lens. It's a school of thought... a way of life... a philosophy, if you will. Those who practice it have a few simple things in common. These traits set them apart from other investors even more so than their analytical skills. In short, they see the world in a slightly different way than the rest of us do. It gives them immense power.
 
 Recently, William Thorndike, founder of the private-equity firm Housatonic Partners, wrote a guidebook to this secret world. The book is called The Outsiders: Eight Unconventional CEOs and Their Radically Rational Blueprint for Success.
 
 Before I (Porter) get into the details of this secret way of looking at the world, I'd like to start with a simple example. I'd like to show you three pictures. These are three "snapshots" of a company over the past 15 years. You could derive a few key facts from these charts. What do they tell you?
 
 Most investors have no idea about the real underlying value of individual securities or how to estimate it. And because they know nothing about measuring value, they cannot make wise choices. They're left to gamble. To most investors then, a high-quality business looks exactly like a low-quality business. To most investors, every stock looks something like this one:
 
How Stocks Look to the Average Investor
 
 The chart above shows the nominal price over the last 15 years of a widely traded equity. Some people looking at this chart will say the stock looks good to buy because it made a "base" and is now trending higher.
 
And most investors – I'd wager around 90% of active individual investors – only think in terms of nominal prices. They say, "I bought a cheap stock – only $2 per share. If it goes to $4, I'll double my money. If it goes to $1, I'll sell. But I'll only lose half my money. With even odds, over time I will win."
 
 Some people may point out that our stop-loss advice underscores this focus on nominal prices. That's right. It does.
 
We know that many of our readers will never move beyond their focus on nominal share prices. So giving a clear, conservative exit strategy is crucial for improving their results and protecting them.
 
But one day, I hope they will "see" the market the way I do... the way they should. Like this...
 
Book Value Per Share of an Equity Compared to Share Price
 
 What the top line in the chart above shows you is the book value per share of the same company from the previous share-price chart. What's important is that over the same 15-year period, the book value increased year after year at a substantial rate. Whether the share price went up or down, the actual business grew more valuable every year and continued to produce additional value. That's one of the most important signs of a good business (along with wide profit margins and low capital requirements).
 
 Take a second look at the chart above... The lower line shows us the real price. It shows us how much cash per share the company generated each year. This is how great investors see the situation.
 
This is what Thorndike wrote his book about... people who see the world in a totally different way. When they look at a company, they ignore share price. Instead, they see values and cash generation. Most of the people in Thorndike's book refused to pay more than eight or 10 times this figure... for any business... ever.
 
Think about that for a minute. The last time you bought a stock, how much thinking did you give to its price in terms of cash generation? My bet is close to none.
 
Wall Street prefers to talk about "earnings." Earnings are an accounting fiction. They're derived by taking the income statement and then applying a whole series of tests and guesses. Earnings are easily manipulated by managers, using both legal and illegal means.
 
The world's best investors ignore both earnings and the timing of earnings. All they care about is the amount of cash a company generates over time.
 
 Simple question... Given what you've seen, should you buy this stock? What price would you pay? Here's one more critical clue. The next chart shows you the company's cash profit margins over the last 15 years. You'll notice that they're almost completely unchanged throughout the entire period, which includes the worst recession America has faced since the 1930s...
 
A High Quality Business With Steady Cash Profit Margins
 
These data tell you we're looking at a high-quality business. It has built value at a significant pace. It has steady, cash profit margins.
 
 We started recommending these shares in 2006. A lot of folks said we were nuts at the time. Couldn't we see that the share price was in a downtrend? They didn't get it. They couldn't see the value that was plainly visible to us.
 
The company we've been looking at is Wal-Mart (NYSE: WMT) – the World Dominating retailer.
 
Wal-Mart was my company's No. 1 investing idea in 2006, 2007, and for most of 2008 – when it went up as the rest of the market went down. It survived the 2008-2009 crisis with nary a hiccup. It has produced outstanding returns since. We most recently urged subscribers to buy the stock when a minor scandal erupted over its operations in Mexico. Since Dan Ferris first recommended it in October 2006, Extreme Value subscribers who followed his advice have earned more than 10% annualized profits in this position – with nearly zero volatility.
 
 Most people couldn't recognize the value in Wal-Mart because they didn't understand the numbers. They only understood their own emotions. They saw it as merely a discount retailer with a lot of bad press (largely because of its stand against unions). They wouldn't shop there. They wouldn't buy the stock. Case closed.
 
 The men and women in Thorndike's book are the most successful CEOs in the history of modern capitalism. They include Tom Murphy (Capital Cities), Henry Singleton (Teledyne), Bill Anders (General Dynamics), John Malone (TCI), and Dick Smith (General Cinema).
 
These guys make the CEOs who are routinely celebrated in the media (like GE's Jack Welch) look like wannabes and posers. Thorndike's CEOs all made 20%-30% a year for investors... for decades. That kind of performance made everyone who invested with them – even folks who put in as little as $10,000 – extremely rich.
 
And they all did it the same way. They all managed their companies (and their lives) in a very similar fashion. They all looked at investing in the same way... the way I've outlined here... and the way I write about it constantly in my newsletter.
 
 Why should that matter to you? All of these CEOs followed the same pattern. They spent their time allocating capital – investing. They delegated the operational responsibilities to junior executives. They spent all of their time deciding whether to invest in their existing businesses, whether to buy back their own shares, or whether to buy other businesses.
 
Like you, they were investors, not just CEOs. They made these key investment decisions – and all of the other decisions in their lives – by the same standards of value. They quantified everything.
 
 If you learn to do the same with your investing, you will become vastly more successful. I'd urge you to read Thorndike's book... or at least to ask yourself these three questions before you buy another stock:
 
•   Is this a great business? Does it have the ability to grow its sales and to maintain its profit margins? Is the management team dedicated to rational decision making and rewarding shareholders?
•   Am I paying a reasonable price for these shares? Are the shares trading around book value or at less than 10 times cash earnings?
•   If the stock were to fall by 50%, would I be confident enough to buy more?
 
 All of the CEOs Thorndike wrote about ended up making a few large and crucial investment decisions. They bought other companies (or their own stock) at a size that made up 25%-40% of their company's enterprise value. That would be like putting 40% of your net worth into a single stock. The only way you will ever have the confidence and the knowledge to make that big of an investment safely is by learning to look at the real numbers – not just the share price.
 
 I firmly believe that to be extremely successful as an investor, sooner or later you have to make the big, the very big, investment. Great ideas and great opportunities just don't come along that often in your sphere of competence. When you see a great opportunity that you fully understand... be prepared to swing for the fences. But make sure... make absolutely sure... you've done all of your homework. That starts with only buying great businesses and understanding what they're really worth.
 
 Oh... one more point about these world-beating CEOs. You've probably never heard of any of them before. Part of their way of life was to avoid Wall Street and the media. They figured out that the closer they got to the Wall Street circus, the more cloudy their thinking would become.
 
They didn't want to be influenced by anything but their own rational thinking. So they established their offices and went about their lives as far away as possible from Wall Street and the mainstream business press.
 
That's why, if you're looking for a great investment, I'd recommend staying away from feel-good, front-page stories. The press tends to all think with the herd... which is the opposite of what you ought to do as an investor. (Of course, negative stories are often great buy signals since the press always exaggerates the consequences of bad news... like Wal-Mart's Mexico problem.)
 
Regards,
 
Porter Stansberry




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