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How to think rationally about shares

At times of buoyant markets and relatively easy gains, ask yourself whether your approach to investing in shares and building a portfolio condemns you to a lifetime of returns and emotions that rise and fall with the market. If a rising tide lifts all boats and if it’s easy to mistake a rising market for genius, then it pays to examine the approach you have adopted to investing and ask whether it is rational, repeatable and replicable.

Shares are pieces of businesses

It is cause for increasing dismay that despite the rise in popularity of shares and dividend yields, there has been no trend towards a rational approach. And perhaps surprisingly, this is true of both seasoned professionals and part time ‘investors’. For example in the professional space, fund managers, in an effort to reduce portfolio risk, build portfolios of low covariance stocks – buying even very risky companies simply because their shares move in a different direction to the others. Perhaps even more worryingly, part time investors buy shares in companies without proper due diligence and in the hope they’ll simply go up.

Indeed, John Kenneth Galbraith in his book The Great Crash, wrote that one of the key ingredients of a bubble was the replacement of considerations of an asset’s long run worth, future income and its enjoyment, with base hopes of rising prices next week and next month.

Shares need to be treated as pieces of businesses rather than bits of paper that wiggle up and down on a computer screen. But few investors do this. Witness the professional investor who buys a company loaded with debt and a manufacturer of some generic junk because its inclusion in the portfolio reduces its overall volatility. Witness the same professional who cannot buy the shares of a great business when they are truly cheap, instead having to wait until the shares have risen sufficiently to cause them to be included in the S&P/ASX200. Buying shares this way or simply buying in the hope they will rise, is not the same as buying a piece of a business.

Over time, the value of a business changes only slowly, and much less than their daily prices on the stock market. The purchase of shares without reference to the quality or value of the business is no different to betting on black or red. Similarly, the focus on daily quoted prices of shares encourages the treatment of the stock market as a casino. Gamblers and those who frequent casinos tend to lose. In contrast, treating shares as pieces of a business helps investors outperform those who don’t.

Focus on relatively few excellent businesses

Whether it is because it is seen as too difficult or produces too much volatility, few investors simply purchase at attractive prices, a portfolio of 15 to 20 excellent businesses. This is despite the fact that such an approach can produce substantial outperformance.

There are two steps investors need to adopt: first, identify superior businesses, and second, estimate their true value.

Identifying a superior business is easy. Simply look at its economic performance and earnings power.

In our previous article, Airlines and indices, I described the economics of an airline and explained how the behaviour of equity, debt, profits and return on equity, over years, provides an indisputable picture of the economics of a business as if it were owned in its entirety and how this can be used to select extraordinary businesses.

As Warren Buffett once quipped, “If you aren’t prepared to own the whole business for 10 years, don’t buy a little piece of it for 10 minutes.”

Once you embark on an examination of a business from a business owner’s perspective, using equity and return on equity, you not only create a list of candidates worthy of inclusion in a portfolio but you simultaneously simplify your investment process, by creating a benchmark.

A benchmark is a line in the sand or a corral against which you compare outsiders to those things already inside. Your investment process is simplified because nothing needs to be considered unless it is better than the things already on the inside.

Many investment professionals, and the academics who taught them, agree that you reduce your risk by diversifying broadly. I agree that if you buy shares in a lot of different companies whose share prices move in different directions, you will reduce the overall price volatility of your portfolio. But does it make sense to buy shares in an inferior company simply because its share price moves in a different direction to the others that you already have? Why on earth would you buy shares in your twentieth best thing, when you can buy more shares in your best holding? Why cut down your roses to let the weeds through? I believe you reduce real risk – the risk of permanent capital loss - by only owning superior businesses.

Great businesses have high rates of return on equity, little or no debt, bright prospects and sustainable competitive advantages. A sustainable competitive advantage is the intangible thing about a company that the competition cannot replicate or imitate. It’s the reason people will cross the street to get the product even if the guy on this side has an alternative with a lower price. It’s a barrier to entry or a barrier to imitation. Ultimately, it generates the high rates of return on equity. Over time such business should retain profits at a high rate and increase in intrinsic value at a similar rate to the rate of growth in their equity value. And if I told you that company XYZ’s intrinsic value would rise substantially over the next 5 or 10 years, would it matter if the shares fell today?

Choose quality at the right price

Take the case of a company with a low rate of return on equity and little prospect of improving dramatically in the near future. Exclude it. What about a company with bright prospects for its product or service, no debt and 10 years of stable returns on equity of 30%? Include it. Eventually you fill a corral with companies showing a demonstrated track record of superior economic performance. No longer will you be tempted to dabble in the unknown, punting on whether the market or interest rates, employment or inflation will rise or fall in the next few days. Instead, you will keep a protective eye over a short list of great businesses, any of which are candidates for your portfolio if they become available at a discount to intrinsic value.

In our next column for Cuffelinks, we’ll write about that intrinsic value, a DIY on estimating intrinsic value for popular mechanics.

 

Roger Montgomery is the Chief Investment Officer of The Montgomery Fund. This article is for general education purposes and does not address the specific circumstances of any individual.

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