“Free your mind and the rest will follow.” En Vogue

Warren Buffett’s wisdom is all over the Internet. Type the name “Warren Buffett” into the search engine at Amazon.com and a list of over 2,500 books comes up. Type in the phrase “Warren Buffett’s investment advice” in Google and over 1 million entries show up. So what can we possibly add to all that information about Warren Buffett’s investment advice? The honest answer is not much if anything. So why are we going to write this post then? Because sometimes the advice given by someone is so true and powerful that even endless repetition doesn’t reduce its relevance or wisdom. One such piece of advice given by Warren Buffett is “think like an owner” when contemplating investing in a stock. We believe that more investors would be successful if their investment process and analysis incorporated those sage words. What follows is a discussion as to why we feel this way.

In the Internet Age, the concept of investing and investment analysis has been reduced to sound bites and instant commentary (yes we did not use the word “analysis”) from financial TV talking heads, to financial and investment bloggers (no offense to our colleagues, there are a lot of good ones and we try and link to as many as we can), to web sites that aggregate investment information and news, to Stocktwitters, to virtually any other website even remotely connected to “investing”. When you throw in High Frequency Trading, ETFs and Discount Brokerage Trading Platforms, buying, selling or shorting a security has become nothing more than reacting to “new news” or an “investment theme”. When a “buy and hold” investment product like the SPY ETF can trade over 250 million shares in a day, something is seriously wrong with the capital allocation system called the “stock market”.

“Think like an owner” of a private business

We want to expand on Buffett’s advice to the concept of “thinking like an owner of a private business”. While this may be implied in Buffett’s quote, we think adding those words reinforces the idea and helps an investor to stop thinking about the daily stock price movements as “new information” or “actionable” or even relevant to the investment process. Thinking like an owner of a private business allows an investor to “free your mind” and begin to see investing for what it really is, fractional ownership in a REAL business that generates real sales and cash flow and has real assets and liabilities.

Let’s look at an example that reinforces our point. The owner of a private business solicits three different appraisal firms to value his business for estate purposes. The appraisal firms look at the business and its ability to produce free cash flow, its financial structure, valuation metrics of similar firms and they would derive a value for the firm. The owner takes an average of the three appraisals and puts it into his “net worth” statement. From that point on, the owner would probably return to thinking about how to improve his business and “maximize” the cash return of his business to him as the owner. It is highly unlikely that the owner would call up those three appraisal firms the next day and have them revalue his company based on “new” information like the latest GDP report or employment numbers or another European debt crisis or Fed statements or some other company’s operating results that were reported in the paper (yes we are very old school). Then do it again every day until he sells the firm. It is also highly unlikely that the appraisal firms would dramatically change their appraisal of the company because of these news items or even if the owner earnings over a subsequent 3 month period were “above” or “below” their expectations.

Yet this is what happens every minute of the day to investors when they do not think like an owner of a private business and look at the change in a stock price as new information that, at the very least, be rationalized relative to the news of the day or worse must be acted upon instantly. It is incomprehensible to us how anyone can think it is rational behavior that drives 5-50% swings in stock prices almost instantly after an earnings press release is reported to the public. What makes this behavior even more ridiculous is the fact that most “investors” claim to use some sort of discounted cash flow model to arrive at their valuation estimates and justify their actions. Yet, since 80-95% of the value derived using a discounted cash flow model comes from the out years and the terminal value estimate, the actual impact to those appraisals of a current quarter’s earnings miss or beat is negligible. Investors will try to rationalize this behavior by saying that this “new” information has more “predictive value” than the “new” information just three months ago. This type of behavior reminds us of roulette players or Baccarat players  who study the patterns of the latest outcomes of the ball or cards to decide how they are going to bet next.

So how do we use the concept of thinking like an owner of a private business to help us set up an investment process and do analysis?

The first thing that happens when you think like an owner is that you realize that you are investing for the long run and not just “renting” a stock as long as it is going in the direction you want it to or as long as the “news flow is good” or the “stock chart looks favorable”. When you think long term, you realize that the minute by minute or daily or even monthly change in a stock price is irrelevant to what the company is actually doing or may do in the future or its future value. One important reason owners of private businesses think long term is because there is a large friction component to changing one’s mind and selling at a moment’s notice. With $7 commission stock trades or even no commission trades on many ETFs, there is no frictional cost to make a buy or sell decision. Because investors can buy or more importantly sell, at a moments notice with little transaction costs and only modest liquidity costs, we believe they spend much less time analyzing a company’s fundamentals and more time watching the stock price and news flow. It appears as though the more liquidity there is in a security market, the less analytical work is being done because it is so easy to just “blow out” your mistakes. If investors were forced to sit on their mistakes for weeks or months or years or pay a huge discount to the market to “blow it out”, we think the quality of analysis would improve. We know of many institutional investors that won’t take a position they can get out of “in a matter of hours or days at the most”. Their attitude is, “why do weeks or more of analysis on a position I may hold for hours or days or weeks?”

If you start thinking like an owner, you are probably not watching CNBC or playing around on a Bloomberg terminal or watching your stocks in your E*Trade or Goldman Sachs account. You will have a lot more time now to do real analysis and to think things through. There is no better way to get a feel for how a company actually works than to read several years of annual reports and 10Ks and a few of their competitors’ reports as well. You will begin to gain an understanding of the drivers of the business and how they change (or not) from year to year. For example, are sales growing because the company is selling more units or building more stores or raising prices or a combination of those? If it is building more stores, how are they financed? Which driver seem more sustainable? How stable are gross and operating margins over time? Do they tend to mean-revert and how long does it take? Does management talk more about their stock returns than their business in their annual report? How do these things compare to their competitors? It is also good to look at any presentations. There are usually a few slides that have industry data or comparisons to its peers in them and it shows you what management thinks is important. You may find that management is not focused on the things you as an owner think are important to running a successful business and that gives you a better framework for understanding what might go wrong. You can also take some of this knowledge and use it to analyze other companies.

Thinking long-term also forces the investor to scrutinize the cash flow statement and how the company is financed. Private owners watch cash flow very closely because this is the main way they finance their businesses. If more investors thought like an owner and looked at changes in receivables and payables or pre-paid expenses and their causes (one-time, consistent over time or suddenly different), there would be less of a need for “forensic accounting” experts and “red flag” services. Investors would be able to detect potentially negative changes in the business model more quickly because they have had a continuous history with the cash flow statement and unusual items will automatically standout. Thinking long-term forces an investor to really look at the debt structure of a company and its access to cash and lines of credit. As well as the terms of those credit agreements. This is because over a 3-5 year holding period (or longer), eventually something is going to happen to either the company or the economy that will cause the less diligent investors to suddenly consider  the capital structure of the company and its ability to carry it through a “worst-case scenario.” This is a classic case of “it doesn’t matter until it matters”. Some investors only buy “high quality” companies to avoid this problem, Warren Buffett being one, but about the only time most of those companies reach a valuation that is a bargain is when most investors and the media believe the “world is ending” and very few investors actually take advantage of those valuations. He can do it, we think you probably can’t.

Instead of just doing basic analysis of stock buybacks and dividend growth, investors would have a real understanding for how much of free cash flow is being committed to these “shareholder friendly” items and their sustainability. If a company used to pay 30% of free cash flow out in the form of dividends 5 years ago and now pays out 80%, then the historical 5 year dividend growth rate is pretty much irrelevant when looking at the potential growth rate over the next five years. But if an investor is just using data from the hundreds of websites that provide historical data and not really looking a company, but just the stock price and the data tables, his analysis will suffer. If you are thinking like an owner you will care how the company spends “your money” much more than you do now.

Finally, thinking like an owner of a private business forces an investor to be more demanding as to what the valuation of the company is when he makes his investment. If you were to acquire a private business and knew you were going to run it for 5 or 10 years, but had no better ability to analyze the future than you do now, what multiple of owners’ earnings would you demand for your “margin of safety”? Of course it would depend on a number of variables, but would you feel more comfortable paying an earnings yield of 4% (25X owners’ earnings) or 10% (10X owner’s earnings) for the business. Investors routinely pay 20-50X or more for companies that are growing rapidly today. But study after study shows that, even if the company achieves the expected growth rate (most do not), investors most likely overpaid for that growth and the multiple contracted substantially. This is a major factor as to why value has consistently outperformed growth for decades. If you had to hold on to the business for 5 years and paid 30X for the earnings of the company, how certain are you that you could sell it in 5 years for at least 30X whatever those earnings turned out to be? How confident do you feel now about using a “PEG” ratio to justify that multiple? Do you think your buyer will use the same “PEG” or a different metric?

Common stock was created to allow for fractional ownership in a business. While its function and legal standing hasn’t changed since then, investor’s perception of what it is certainly has. Today, most investors look at buying a stock as a way to make money on a story (Internet gambling) or a picture (technical analysis) or someone else’s intellect (Buffett is buying) and rarely do any real analysis or even bother to read more than an internet post or article in a popular magazine or watch a certain financial TV host (Booyah!!). Since most investors see stocks that increase (or decrease) substantially over much shorter periods of time than years, they tend to focus on the changes in valuation and not the slow incremental changes in the business. Just because you can regurgitate the “story” to explain why a stock is going up or down on an ex-post basis, doesn’t mean you have done enough analysis to consistently make money over time as an investor. If you are not thinking like an owner of a private business, you are not investing.

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About Tim Heitman