The Only Two Investments You’ll Ever Need

There are two types of value investors. Those in the Benjamin Graham camp (value) and those in the Warren Buffett camp (compounders). Both look to buy business for far less than they’re worth. However, that doesn’t mean they both look for the same types of businesses.

For example, the Graham camp buys value. They only want to buy business cheap as they see it as the ultimate way to consistently high returns.

The Buffett camp like to buy compounders at reasonable prices. These are the great companies you’ll hear about that can compound shareholders investments many times over.

Using both strategies, you can find amazing opportunities that have a high likelihood of far exceeding market returns.

It’s a comforting thought isn’t it? You only need to look for two investments to become a successful investors.

First, let’s look at the compounders.

Compounders

Buffett is probably the best investor in history. Not because of his analytical genius or because he generates high returns. To me, Buffett is the best because he has changed his investment style over time and still outperforms.

Today Buffett looks for compounders. These are the wonderful businesses he’s always going on about.

But what exactly is a compounder? As the name suggests, these are business which can compound shareholders’ investment at high rates.

To be more specific, return on invested capital (ROIC) is a good yard stick to see if a business is a compounder or not. But rather than talk about a hypothetical business, let’s take a look at one trading in the market right now.

Domino’s Pizza, Inc. (NYSE:DPZ) is one such compounder.

Since 2001, the company has consistently generated a high return on invested capital. Take a look at the graph below.

Over the 16 periods, the pizza business has been able to average a ROIC of 65%, which is amazing. To emphasize the point, let’s do a bit of simple maths to see why compounders make such great investments.

An earnings increase of 144%! But return of 48%

Let’s say Domino’s can average a ROIC of 30% for the next 10-years. Let’s also assume that they only pay out 35% of earnings to shareholders each year. That means, theoretically, Domino’s should be able to increase earnings by 19.5% each year (0.30 × 0.65).

If we start with an earnings per share (EPS) of $4.68 per share as a base, within five years Domino’s could grow EPS by 144%!

This is assuming that Domino’s doesn’t issue any more shares and keeps their dividend payout ratio at 35%.

But how can we know if Domino’s will continue to generate a high ROIC? This is the tricky part. It is impossible to know what will happen in the future or what unforeseen events might occur.

That’s why you need to spend your time understanding the business and its industry. The better you understand, the more confident you will be about a possible future that lies ahead.

But even after all that thinking we’re not done. After we’ve identified a compounder like Domino’s we still don’t want to pay a ridiculous price for the company. At time of writing, Domino’s trades at 41-times earnings, which is pretty high.

Obviously word got out that Domino’s was a compounder.

Now we need to determine whether Domino’s at 41-times earnings, is worth investing in. The likely answer is probably not.

Let’s say you bought in now at 41-times earnings. Because the company won’t grow forever, let’s assume investors will pay 25-times earnings for the stocks in five years’ time. If this happens your potential returns would only be 48% over the five years.

Of course these results are highly dependent upon your assumptions. Had you assumed that Domino’s would maintain a ROIC of 40% and investors would pay 30-times earnings for the stock, your potential return over five years could be 132%.

But instead of this back of the envelope maths, I suggest you use a Buffett favourite – the old discounted cash flow model. That why we can estimate the intrinsic value of Domino’s and determine its likely worth (in cash flows) today.

Overvalued on FCF basis

From 2000-16, Domino’s grew free cash flow, cash owners can theoretically take out of the business, by 20% on average. Some years, like in 2007, free cash flow dropped 63%. And other years, like in 2015, free cash flow jumped 87%.

What’s amazing is how long Domino’s has been able to produce positive free cash flow. Throughout the 16 periods, free cash flow has not been negative once.

Let’s say Domino’s can continue to grow free cash flow by 20% each year on average. We will use $190 million as our base year and use a discount rate of 10%.

Based on our assumptions, Domino’s will have accumulated $5.38 billion in free cash flow within 10-years’ time. On a per share basis, that’s $111.5 of free cash flow, which is below their current market price of $192.40 per share.

So while Domino’s is a great compounder they’re currently far more expensive than you’d likely receive as a shareholder. But let’s not give up. Let’s try to find a company trading below their intrinsic value.

A 38% Margin of Safety

Enter NIC Inc. (NASDAQ:EGOV).The company helps the US government to use technology that they will eventually provide to their citizens. Essentially they build and maintain platforms like the DMV administration and other digital services.

From 2007-16, NIC has maintained an average ROIC of 32.6%, currently sitting at 45%. NIC has also reported positive free cash flow each year over the same period, growing by 24% on average.

OK, so let’s lay out the assumptions. Our base year will be $70 million in free cash flow. Our discount rate will be 10%. And we will assume NIC can grow free cash flow by 15%, on average, each year.

Based on our assumptions, NIC will have accumulated $1.49 billion in free cash flow within 10-years’ time. On a per share basis, that’s $22.44 per share, which far above their current price of $16.25 per share.

Essentially we have a 38% margin of safety (difference between $22.44 and $16.25). That means if cash flows grow at a lower rate or something unforeseen happens, we won’t be punished by our initial buy in price.

It is rare that you’ll find multiple cheap compounders.  As you’d imagine, every investors know compounders are great investment and many times pay far more than they should.

But if there are no immediate compounders you can find for an attractive price you might want to look at the second investment you’ll only ever need.

Value

In the Graham camp, investors care more about value. It’s not necessary that a business generates high returns. What’s more important is the price you pay.

You could say that those in the Graham camp believe price will ultimately dictate your expected returns. And if you think about it, it makes sense. The lower you buy in, the further your investment could potentially climb.

But how do we define ‘cheap’?

Some invests like to look at price-to-earnings (P/E), price-to-book (P/B) and other price-to-fundamental metrics. It’s an easy simple way to gauge investments. However it does not paint an accurate picture.

For example, a low P/E would indicate a cheap stock, relative to earnings. This might mean that earnings will grow slowly or not at all in the future. Yet, this is just what the market ‘expects’.

A low P/E stock could easily surprise the market and grow earnings significantly. Therefore, it’s not a reliable way to tell if a stock is cheap or not, as all you can deduce is the markets opinion.

So instead of looking are widely changing earnings, those in the Graham camp like to deal with more stable values. The assets of the business.

A Win Win situation…almost

In Security Analysis, David Dodd and Graham use one chapter to explain the importance of liquidation value.

To explain the concept, imagine a business that is no longer interested in operating. They’re sick of trying to turn a profit and will instead sell off all assets and return capital to shareholders.

Before shareholder receive the funds, the business has to pay all outstand obligations (liabilities). But after that, the sum is entitled to the owners of the business – shareholders.

This sum – net assets – is what Graham and Dodd called the liquidation value of a business. It was Graham and Dodd’s idea for investors to buy stocks trading below their liquidation values.

Therefore if the company was wound up, investors would profit. And if the company’s prospects improved, the investors would profit. It’s a win win situation. Think of it like buying $1 worth of assets for 50 cents in cash.

But even buying below liquidation value, investors are not guaranteed returns.

What happens if assets turn out to be worth less than the amount stated on the balance sheet?

Consider fixed assets for a moment. If you’ve tried to sell a property, a car or any other illiquid asset, you’ll know it takes time and doesn’t always turn out how you expect.

You might believe your home is worth $1 million and your car is worth $50,000. Yet you might not get buyers to agree.

The same principle applies to businesses. If they want to sell property or equipment, there is no liquid market to offload these assets. And if they do, the price at which they sell could be a lot different from what they anticipated.

Considering the uncertainty surrounding fixed assets, Graham and Dodd simply eliminated fixed assets from the equation. Therefore liquidation value can be stated as:

Current Assets less Total Liabilities.

You could go even further and reduce the values of current assets. Imagine a fashion retailer with millions worth of inventory. Obviously last season’s clothes aren’t going to sell for this season’s prices.

The same principle applies for accounts receivable. If a business has a history of clients who fall short of their payments, it would be intelligent to reduce this value when calculating the liquidation value.

OK so the asset problem is an easy fix. But there’s also another problem that the Graham camp can run into, which can’t be conservatively discounted away.

Irrational Management

Remember the hypothetical business that didn’t want to continue operating anymore? Well, what if they want to continue operations despite poor prospects and continual losses?

This is what happens when you have irrational management at the helm. They care more about their salaries than shareholders’ interests.

No matter how cheap a business is, it’s a terrible investment as long as management cannabises assets to keep operations afloat. The reason why is because you’re margin of safety – the difference between liquidation value and market price – starts to narrow. Eventually, liquidation value will dip below market cap and you’ll have nothing to lean on if the company winds up.

These are value traps that you’ll want to steer clear of. Like the Buffett camp that spends half their time thinking if ROIC will continue, the Graham camp spends half their time thinking about whether a stock is cheap or a value trap.

OK, enough theory. Let’s look at an example of how to pick an extremely cheap business.

A 204% discount

Enter Sino Agro Food Inc. (OTCMAKTS:SIAF). The $64 million company is an agriculture tech and natural food holding company. Meaning they buy and hold equity stakes in a range of agriculture companies.

Over the past five years, the stock has seen some volatility; just take a look at the graph below.

But are they current cheap? Cheap even by the Graham camp standards?

Below is a Sino’s annual report for financial year 2016. As you can see, the business has $320.8 million in current assets with the bulk coming from accounts receivable.

Let’s apply a 25% discount to accounts receivable and a 50% discount to inventories. We will apply no discount to cash.

If we deduct adjusted current assets ($258 million) from total liabilities ($61.7 million) Sino still has $196.3 million worth of current assets left over. With a market cap of $64.5 million, Sino currently trades at a 204% discount to their adjusted net current assets.

OK, so we know Sino is cheap, but that was the easy part. Now we need to think about whether Sino is a value trap, or potentially a great investment.

Well, in 2016, Sino was cash flow negative, meaning they burned more cash than they generated. A lot of it had to do with funding their expansion. Sino paid $54.9 million for construction related activities.

But if we take a look at Sino’s income statement, they’re actually a profitable company. While profits are declining the business still generates around $2 per share.

Also on Sino’s side is their steadily growing liquidation value. Compared to their market cap, which is all over the place, Sino has improved their current assets throughout the years.

So why is market cap so volatile? One word, earnings. Take a look at the graph below showing net income side by side market cap.

Therefore the catalyst that would make Sino’s market cap and liquidation value meet will likely be earnings. Does that mean you have to judge what earnings will do in the near future? Not really.

All you have to wait for is a spike in earnings while monitoring liquidation value. Think of the company like a holding place for your cash. You’re happy to have your money in the stock because it’s undervalued and has limited downside risk.

But there’s also a possibility that at some point, earnings will spike and the share price will follow.

From 2011 to 2012, the stock rose 35%. From 2012 to 2013 it climbed another 32%. And from 2013 to 2014 it spiked 134%.

In a space of three years, I’m sure you’d be happy with these kinds of returns. But what if you bought the stock in 2011 and sold out in 2013, missing out of the 134% gain from 2013-14?

Bad luck. You’ll never be able to pick the top, or the bottom for that matter. So it helps to forget about what you ‘could’ make in these situations and move onto the next investment.

I’ve heard of some investors who have a number in mind that they’re happy to achieve, a 50% return for example. But I suggest you use you’re better judgement and look at the fundamentals of the business.

If the company has improved earnings and the outlook is more of the same, it might be a good time to sell, as investors will have bid the stock up on anticipation of what’s to come.

Some closing thoughts

That’s it, the only two investments you’ll ever need. Using both can enhance you’re returns significantly. But of course, both require different strategies.

For compounders, you want to buy them cheap and hold onto them…preferably forever. Since the business can compound your investment at a high return, there is no point in selling. Your investment will do better over time the longer you capital stays put.

For value, you want to buy companies very cheap and try to get out as fast as possible. The reason why is because we have no idea if the business can grow profits reliably.

That’s why you’ll also want to look for a catalyst, usually earnings, which will spike the share price momentarily.

You could say time benefits compounders and punishes ordinary businesses. The only reason why the value strategy works is because of the extremely low buy in price, thanks to earnings focused investors.