KYC30090 wrote a comment you can read from Oct 9th that included this thought: "Valuation is out of the book. Phil's method is growth and valuation which is totally thrown out of window. The method is backward looking as far as 10 years!! You can't even look back yesterday."
I really want to address this for you guys. I sort of suck at writing but I try to get out the ideas coherently. What I tried to say in Rule #1 and on this blog is that you must follow the 4Ms: Meaning, Moat, Management, MOS. All four of them.
Part of the process is looking back ten years. Twenty would be better.
And what are you looking for? Coherence. Predictability. A solid return on the capital these guys are investing. Low to no debt. We want to see that this thing has a moat. And we have to know what it is and that it's a durable moat. And from those numbers and our expertise in this business and in this industry we can sometimes, SOMETIMES, come up with a solid value. From that we can derive a MOS price.
If You Get it Right, You Will Make Money
Especially now, guys, contrary to what KYC is suggesting, let me suggest that valuation is everything. If you buy $10 of value and only pay $5 for it, you will make money. I don't know when, but I know it's certain that you will make money.
But something in what KYC says about looking backward is important: You can't drive the car by looking at the mirror. The road ahead is different than the road behind. The view out the front windshield of this sort of vehicle is always unclear in the short term, but should be quite clear in the long run. It's sort of like the hood of the car is in the fog, but we can see that far down the road the fog clears and the road is there. We might not stay on it perfectly because of the fog, but we can see we're headed in the generally right direction.
Part of the issue of how well the car will do is how well the car is made and who is driving it. You can know quite a lot about both of those things. Meaning, Moat, Management. But you can't know all. So what to do when we're in a particularly foggy stretch? Reduce your speed.
An Example: GOOG
In investing terms, to reduce your speed means to lower your expectations for this business for the long term. If we've been expecting Google to grow at 22% with a 44 PE, slow down. We're in the fog here. Let's lower our expectations for the speed that Google can go down the road. Take a look at the lowest growth expectations from analysts. Look at the industry growth rate long term through good and bad time.
I'm no expert on Goog. When I own it I own it in my risky biz portfolio. The most pessimistic analyst has 15%. I'm quite sure that GOOG can grow slower than that in this mess. I'd be surprised if it grew it earnings at all. But it has $12 billion in cash and almost no liabilities. So let's assume it can grow long term at, say 12% and will handle a 24 PE.
What is the value then? $280. It's selling for $332, about 4 times its book value. So it's not cheap if we reel our expectations in.
Let's say we buy it somewhat below this low retail value. Small MOS. $250. We get 40 shares with $10,000. And we're wrong in the short run. The stock plummets to $200. BUY MORE. Another $10,000. 50 shares. And now it's at $100. BUY MORE. 100 shares. And finally it hits bottom at $50 and you buy another $10,000. 200 shares. Assuming you bought $10,000 each time, you would have $40,000 in it and you own 390 shares. Your average price was $102.
Let's assume Google survives the meltdown and comes out the other end a better company with a nice solid 12% long term growth rate and a 24 PE. Five years down the road its earnings are nearly $30 a share; so by then your Yield is $30/$102 – about 33% per year and growing. If you owned it all, you'd be making 33% a year on your investment in Google.
It's turned into what Buffett calls an "Equity Bond". But even better, the market has the stock at $600 again. And your return is 600% in five years. That is a compounded return of 43% per year. And all that happened is that Google stock price melted down in a bad economy and then went back up when things straightened out.
Know Your Business
But is GOOG your bag, baby? Or is it JNJ or Pfizer or MSFT or BNI? What do you love? What are you willing to dig into and learn about? You want to be an expert on car credit deals? Look at ACF. It's selling below book. But know your business, gang.
Hang in there. Today we really melted down. We bounced off the floor from 2003. If the low 8000's hold I'd start to consume if I were you.
I'm not, though. The wild swings are gut wrenching. I'm waiting and I'm gearing up to buy private companies. It's a lot less volatile because there is no liquidity. You think the deals look good in the public market? You should see what we're seeing at our private equity company. PE's are way into single digits and the businesses are rock solid. This is going to be a very stressful but very good time if you know what you are doing. I'd say a once-in-a-lifetime sort of time.
Stay tuned. I'll write more about it as it unfolds. And do you think valuation is important in buying a private company? Duh!
Now go play.