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Price Is What You Pay, Value Is What You Get

|Includes:Anheuser-Busch Inbev SA/NV (BUD)

The intro to the latest AMM Dividend Letter released May 3, 2014.

In a recent interview with 60 minutes about his new book "Flash Boys", Michael Lewis declared the stock market "rigged" (see the clip here: Flash Boys is about the world of High Frequency Trading (HFT), and the "edge" that some traders have been able to achieve by using very fast computers to "see" market data ahead of their competitors. While this is disconcerting for short-term traders and speculators, we don't think these concerns are relevant to long-term investors.

Carl Richard in the New York Times sums up this view rather succinctly:

Now, if you're a trader who spends every day making trades for a living, you'll be interested in the conversation about whether there's a system in place for front-running your trades that costs you a bit each time you buy or sell. And if you're a concerned citizen, you'll care whether people are breaking the law. But as an investor, high-frequency trading doesn't matter because you're focused on the boring work of buying good things and owning them for a long time.

First and foremost our goal is to invest (i.e. take an ownership position) in high-quality businesses. We describe high quality as the ability to invest incremental capital at a high rate of return on the shareholder's equity. Unlike traders/speculators who seek to buy a stock and then flip it for a profit a short time later, we seek to become long term shareholders in a business that can provide us an attractive return over time.

If the stock market is "rigged", perhaps it is in favor of the investor that has the patience to own high-quality businesses and who ignores the day-to-day, week-to-week, and month-to-month fluctuations of the stock market. Wealth will compound at a surprising rate for the patient investor who lets high-quality businesses generate high rates of return on capital over many years.

Interestingly, this approach seems to be the exception and not the rule to investing today. A casual glance at the "Investment" section of the local Barnes & Noble shows a heavy weighting toward books on trading, charting and generally trying to game the market. A much smaller section is dedicated to actual investment analysis.

Price is What You Pay, Value is What You Get

The second pillar of our process is to pay a fair price for our investment. Traditional financial theory defines the value of any assets as the sum of all future cash flows discounted back to present day at an appropriate discount rate. This creates a present day or intrinsic value, the price we are willing to pay today for future returns. Buying below present value generates higher returns while paying too much leads to lower returns. If we pay significantly above fair value for an asset it may even lead to negative returns over time, even for a high quality company. Ideally we seek to invest at prices below our conservative estimate of intrinsic value to provide both a margin of safety and the opportunity for higher long-term returns.

Ultimately we want to buy businesses that provide a good or service that consumers will want well into the future. Estimating future cash flows for these types of companies is much easier than for companies with new or untested products. It becomes even easier if the company makes a product consumed by mankind since the dawn of civilization. We can safely assume this product will be desired well into the future.

Anheuser-Busch InBev (NYSE:BUD) is a perfect example.

Disclosure: I am long BUD.

Stocks: BUD