Building on a theme started back in March (How Bad Will This Get), I think it is safe to say that the US economy is weakening. We can choose to ignore the fact that millions of homeowners have zero equity and super-high mortgage payments they can't afford; we can pretend that $4.20 per gallon gas prices have little effect on people, other than "mild" discomfort and anger.
When it comes to business and investing, it doesn't pay to be an optimist or a pessimist; the big money is made by realists. If you can take all of the emotion — yours and that of others — out of your investing, you can begin to more clearly predict the future with a degree of confidence and competence. Forget tomorrow. There is no tomorrow.
Here's your crystal ball question.
What Will Happen Five Years From Now?
If you can answer that question with a fair degree of certainty, you will make very satisfactory returns over your lifetime. It is a question that great value investors like Buffett are able to answer with confidence, which is precisely why they can earn high returns and ignore short-term volatility, all while sleeping peacefully at night.
If you know what is going to happen five years from now, you needn't care less what will happen tomorrow.
The Price of Gas, Gold, and More...Five Years From Now
The truth is that I have no idea where gold, gas prices, or interest rates will be in five years. Because of that, I have absolutely no business investing in gold, buying or shorting oil, or betting on or hedging against interest rates. On one side of the argument are oil bulls screaming that US gas prices are headed to $10 a gallon; on the other side, oil bears are calling a top. They both use statistics and compelling arguments to make their points.
I don't understand it; so, I have to stay away. I trust Homer Simpson on this one:
Oh, people can come up with statistics to prove anything, Kent. 14% of people know that.
Your Business in Five Years
When you look at a company — any company — you need to first ask yourself, "Where will this company be in five years, regardless of where it has been or where it is now?" Whether or not your business is growing is inconsequential (though admittedly, I prefer growing businesses). It's pretty easy to say that Coca-Cola will be here in five years. Then again, everyone knows that, which is why you will rarely find opportunities for growth in Coca-Cola's stock.
Where you do make money is when you buy companies that Wall Street is unsure on for whatever reason. Peter Lynch does a great job explaining why Wall Street doesn't look at these companies in his book One Up On Wall Street; so, I won't rehash what he already said. Instead, let's look at the Wall Street mentality versus that of the intelligent individual investor.
The Small Company
Many investors, and particularly Wall Street and mutual funds, find comfort in "big" companies — companies with a market capitalization over, say, $1 billion or $5 billion (or even $10 billion). And for a seemingly good reason — stock prices of small companies are often much more volatile. Then again, if you know that price is a tool, not a guide, and that price follows value over the long term, why would you ever equate volatility with risk? Is a business "riskier" because speculators are trying to profit on price movements?
In the early 1970s, Wal-Mart was a small company with a small, or even nonexistent, moat. By 1974, it had just 78 stores open, a number that would grow to 276 five years later. A great growth story? Yes. But most people never looked at the stock, which is why early investors that rode the volatile, value investing wave made immense profits.
How small and "scary" was Wal-Mart? It wasn't until early 1981 that Wal-Mart became a billion dollar company on Wall Street. The graph below shows the daily market capitalization for Wal-Mart from August 1972 to August 1974 — a $60 million to $260 million company. Was it a crazy ride? You bet. Buying Wal-Mart on August 25, 1972 would have seemed like a disaster six months later when your investment was down 30%. By July of 1973, you would have been down more than 50%. Ouch.
The 77% Loss
It's now December of 1974. You're down 77% on your Wal-Mart investment, insisting that the company is much more valuable than the current price. Wal-Mart trades as low as $56.9 million of market capitalization. It's small...real small. Still, you content that Wal-Mart will be more valuable in five years than it is today. It's a tough pill to swallow; still, that's the markets for you.
Five Years Later...
August 25, 1977. You're sweating bullets. You still contend that Wal-Mart will be more valuable in five years than it is today, but you're finally "even" on your investment. You remember the pain of being down 77% — of almost losing everything. Can you go through it again if the markets don't reward you soon? Your portfolio is right back where it started; you've lost five years.
The company is definitely growing. When the hell will the stock price follow?
Another Five Years Pass...
August 25, 1982. Wow. What was a tiny, growing company just a few years earlier is becoming one of the greatest American growth stories of all time. Wal-Mart is trading at $2 billion, and you have hit pay dirt. A 23% average annual return — your $10,000 investment is now worth $77,500. Had you continued to add to your position in the mid-1970s, when this valuable business was trading for $60 million, you would have had even more astronomical returns.
Still, you think Wal-Mart is even more valuable; so, you hold.
Another Five Years Pass...
Wal-Mart is trading at $20 billion, and your $10,000 investment is now worth $830,000 — the result of earning 34% for fifteen years. Not too shabby.
I'll Spare You The Rest
We all know the Wal-Mart growth story. Now a $220 billion business, Wal-Mart was once a $60 million company — trading well below the radar of anyone on Wall Street. It had a small, hidden moat in its pricing, but Wall Street was convinced it would easily be crushed by its larger competitors. From its August 25, 1972 open — trading at just $250 million — a $10,000 investment would have growth to $8.7 million, excluding any dividends you would have earned (and assuming you didn't sell when it became fairly priced in the early part of this decade).
It All Comes Down To The First Question
Where will this company be in five years? It's very easy to look back in time and say, "Sure. I would have held on and enjoyed my 21% average annual return." Easier said than done. Can you stare at a 50% or 77% loss in the face and comfortably and confidently say, "I'm right"? Knowing that price is a tool, not a guide, can you answer the question and then wait five or ten years to be proven right?
Peter Lynch talked about "ten baggers" — stocks that would increase tenfold, the holy grail of investing. Don't expect to find ten baggers in $20 billion stocks. Sure Wal-Mart grew from a $22 billion to $220 billion market cap, but it took eighteen years to do so, providing investors with a 13% average annual return during that time (excluding dividends). In the eighteen years prior to that, from August 1972 to March of 1990, Wal-Mart grew from $255 million to $22 billion — an eighty eight bagger — returning 29% a year to investors, excluding dividends.
Had you continued to increase your position during the "bad" years (that is, when Wall Street was offering an even better price), your returns would have been as high as 48% a year for nearly two decades. (From 12/1974 to 3/1990, Wal-Mart was a "398 bagger")
Don't Fear The Small Companies. Embrace Them.
Buffett once said he could "guarantee" 50% annual returns if he were working with smaller sums of money — say, $1 million. How would he do it? He told Shai Dardashti in a letter that he'd invest in small companies at extremely deep discounts.
If you can say with confidence where your business will be in five years, who cares if it's selling for $60 billion or $60 million? So long as you purchase at a discount and its "business as usual", you can make money in the long-term. Just remember: Until the company hits Wall Street's radar and gets picked up by analysts and institutions, you're likely headed for a bumpy ride in very small companies. So long as you predict the future with a degree of accuracy and confidence, you'll make some very satisfactory returns.