Most stocks are losers. Think about that. For all of the bits and bytes used, ink spilled, and exhaustive research, most equity investments wind up losing money.
Where’s the money made? In the long-term, big-time, 100-fold winners.
That is, if you’ve got the know how to find them in the first place, and the patience to ride out big drawdowns, stagnation and uncertainty.
If you believe in the company, and hold through thick and thin, chances are you can make yourself lots of money.
That’s a loose translation of this article by Chris Mayer, co-founder and Portfolio Manager of Woodlock House Family Capital, and author of the investment book, 100-Baggers.
by Christopher Mayer, co-founder & Portfolio Manager, Woodlock House Family Capital
I dream of what our portfolio might look like, say, ten years from now. I am confident we’re going to have a couple of giant winners that become outsized chunks of the portfolio.
The biggest challenge will be holding on. Benign neglect sounds easy. In practice, it isn’t. There is no escaping the ups and downs. Equanimity is key.
Most stocks are losers. The returns come from the big winners. My book 100 Baggers studied the best and my conclusions from that work inform our investment process at Woodlock House.
Can we put ourselves in a situation to net those big fish? I think the answer is yes. The easier way to tackle the problem is to invert the question.
Meaning, let’s think about the businesses we’d want to avoid, that have no chance, or very little chance, of creating those kinds of special returns.
A partial list:
- Businesses that aren’t growing much.
- Businesses that generate poor or mediocre returns on capital.
- Businesses that use a lot of debt.
- Businesses that do not have ample opportunities to reinvest.
- Businesses without strong competitive advantages, or moats.
- Businesses run by shareholder unfriendly management teams.
Believe it or not, just this list takes out most businesses.
What is the central idea behind our portfolio?
An owner-operator culture is the central idea expressed in our portfolio. Boiled down to our essential raison d’être, that’s it. We invest with talented people who have skin the game.
In other words, we invest in businesses where management and/or the board own a significant amount of stock.
Once we’ve checked this box, we look for several other attributes.
A business that earns consistently high returns on capital
A business that has the ability to reinvest and continue to earn those high returns
A strong balance sheet (we avoid financial leverage)
A businesses we can understand
An attractive purchase price
Those are the essentials, everything else is detail.
What About the Big Picture Questions?
I don’t spend much time on questions about where the market will go, or what interest rates will do or whether inflation will pick up, because there are no ways to generate reliably useful answers.
The mountains of errant forecasts by “experts” attest to this.
Still, we cannot ignore the big picture. For example, even if you’re just focusing on individual companies, you have to come up with a price you’re willing to pay.
To do that, you need to discount future cash flows to the present day. To do that, you need a discount rate — which is based on interest rates.
So you may not have an explicit forecast of where interest rates are going, but you have an implicit one in your discount rate, even if you don’t acknowledge it.
As a matter of fact, every investment decision is embedded with a number of assumptions about sales, profits, growth rates, etc., which embed further assumptions on the big picture questions.
This is our dilemma.
So, how do we deal with such uncertainty?
Fortunately, there are some buoys bobbing out in the harbor that we can be mindful of as the good ship Woodlock House makes its way out to sea again in 2021.
With interest rates low already, I’d rather not own anything that may suffer unduly from rising rates.
So, warning buoys encircle a bunch of stocks out there trading as “bond proxies” because they pay a nice dividend and are stable or slow-growing.
They have done well, by and large. Yet these stocks, like bonds, would get hammered if rates rose. I’d rather avoid those.
Another warning buoy marks off companies that depend on rolling over sizable debt loads on a regular basis. As rates go up, they will find themselves paying up.
Moreover, if interest rates pick up, it probably means inflation is picking up, too. I’d rather avoid businesses that struggle during periods of rising inflation.
Capital intensive industries tend to struggle more because they have to replace more of their capital stock every year. During a period of inflation, they will have to do this at higher and higher prices.
Conversely, capital-light businesses with pricing power tend to fare relatively better.
In summary: While I’m not making any predictions about where I think interest rates and inflation go, I am trying to prepare for scenarios where both go up.
If both stay the same or go down, I’m much less concerned. The ten-year Treasury is already under 1% and anything lower just makes equities more compelling.
Valuations should remain generous for most businesses in such a case.
Besides, we can only do so much without cutting off our long-term return potential. At some point, big picture fluctuations are something we just have to accept, like the weather.
They’ll be good weather and bad weather. Either way, we’re going through it.