What Would You Buy If Price Didn’t Matter?

May 18, 2012 — Leave a comment

A Thought Challenge For Value Investors

Dear Fellow Value Investors:

I’m offering you a rare opportunity to indulge yourself in fantasy. So suspend your disbelief for a moment and imagine that you get to own the five companies whose characteristics fan the flames of your capitalist desires. You will own each for ten years.

This will all take place in a mythical market where there are no prices. Instead, investor returns are magically connected to a company’s earnings growth over a long time horizon. If the business compounds earnings at five percent over those ten years, you’ll get five percent; 15 percent gets you 15 percent; 30 percent…whoah, simmer down! Show some self-control here!

Oh yeah, and there are no shenanigans played with accruals that affect reported earnings. It’s all legit in this little magical mystery market of mine.

So, let your mind wander. If you’re freed from the constraints of price…if you get to pick any company you want that trades in the public markets…let your brain get excited and greedy over the exercise, and decide…what five companies would you pick?

The trick in eliminating price as the main consideration is to focus the mind on those variables that drive earnings growth. Namely…

1. Market Size. The business is participating in a large and/or growing market for its offerings, giving it plenty of runway for growth;

2. Competitive Advantage. The business possesses advantages that create barriers to entry and prevent encroachment by competitors, thereby protecting market share (it’s not losing business to the competition) and/or margins (competitors aren’t finding a toe-hold by under-pricing or otherwise doing battle via price);

While putting the following control in place:

3. Economic Profitability. The business has a model that is profitable both from the perspective of gross profits exceeding expenses and earnings exceeding the costs of reinvesting capital. (In other words, no cheating! You can’t buy companies that grow in unprofitable ways…though I doubt many of these could last ten years.)

What are your five companies and why do you think they can compound their earnings at such a high rate?

Let me know your thoughts, and I’ll keep a running update on the blog.

Sincerely,

Paul

You can email me at pauldryden (at) gmail.

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Over the long term, it’s hard for a stock to earn much better than the business which underlies it earns. If the business earns 6% on capital over 40 years and you hold it for 40 years, you’re not going to make much different than a 6% return – even if you originally buy it at a huge discount. Conversely, if a business earns 18% on capital over 20 or 30 years, even if you pay an expensive looking price, you’ll end up with a fine result.

– Charlie Munger

(as quoted on p.233 of Seeking Wisdom: From Darwin to Munger by Peter Bevelin)

 

Paul Dryden

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