John D. Rockefeller began his career as a bookkeeper at the age of sixteen. Even though he started with nothing, he eventually became a titan of the oil industry. In his book, The Obstacle Is the Way, Ryan Holiday describes how John D. Rockefeller, who at the time was a small-time financier in Cleveland, Ohio survived the Panic of 1857. What began as a financial crisis eventually turned into a depression that lasted years. The Panic of 1857 probably more closely resembled the Great Recession of 2008 than today’s Great Lockdown. However, the point Holiday makes is that even though Rockefeller was a young man at the time and just starting out in his career, he never let fear take control. Holiday wrote the following:
“But even as a young man, Rockefeller had sangfroid: unflappable coolness under pressure. He could keep his head while he was losing his shirt. Better yet, he kept his head while everyone lost theirs.”
Holiday, Ryan. The Obstacle Is the Way.
All great investors must eventually learn that the market is inherently capricious. If you can’t maintain an even keel, you’ll be taken along for a ride during a correction or a major crash. Despite the common narrative that great investors are just born that way. I believe that you can learn to see the opportunity in every adversity.
The Right Type of Investor
If you asked Warren Buffet what type of an investor he is, his response would most likely be that he’s an “intelligent” investor. Although he’s become famous for being a “value” investor, in his view all investing has some component of value in it. For example, even a trader will only buy a stock if they expect its value to increase. I think the more important distinction is not whether you’re a “value” or “intelligent” investor, but whether you follow sound fundamental valuation principles. Investors do, and speculators don’t. You just need to decide whether you want to be the former or the latter?
All successful investors must separate the underlying value of the business from the share price. The intrinsic value of a business is derived from the long-term cash flow it can generate. A stock can essentially be viewed as an extremely long duration bond that pays a coupon equal to the free cash flow generated by the business annually. To calculate the value of the stock, you would simply discount back the future cash flows at an appropriate discount rate. I’m not a big believer in CAPM. I’ll probably write an article at a later point about why I don’t believe in it. In general, I consider the 10-year yield on a government bond as an appropriate discount rate. Ideally, you would calculate all future cash flows the company could generate until its eventual demise. From a practical perspective, cash flows more than 10 years into the future are discounted so heavily they have little impact on the ultimate valuation. So you actually don’t need to forecast cash flows out until infinity.
Share prices are determined by the supply and demand of shares on the exchange on any given trading day. At times intrinsic value per share and share price will converge. However, under most scenarios the share price may be lower or greater than intrinsic value per share. Great investors inherently understand this distinction and take advantage of it. They are buyers when intrinsic value per share is below market value and sellers when market value is above intrinsic value.
Own High-Quality Businesses
Ultimately, the returns that you receive as an investor will be dependent upon the growth in sales, profits, and cash flow a company can deliver. High-quality companies produce better than average results for each of these key measures. Thus, high-quality companies produce better than average returns for shareholders. If you rely on discounted cash flow analysis to value a company, you need to focus on high-quality businesses because they will be more likely to survive to actually deliver the forecasted cash flows. Buffett’s criteria for high-quality businesses include the following:
- They have a good return on capital without a lot of debt.
- They are understandable.
- They see their profits in cash flow.
- They have strong franchises and, therefore, freedom to price.
- They don’t take a genius to run.
- Their earnings are predictable.
- The management is owner-oriented.
Great companies can convert profits into significant cash flow that can be used to reinvest in the business, pay dividends, or pay down debt. However, the key to being a great investor is buying high-quality companies at cheap prices. Great companies rarely trade at cheap valuations because most investors can see the quality of the underlying business. Usually, the only time that these great companies trade at cheap valuations is during a market crash. The only other exception is if the business faces a temporary business risk but is eventually able to recover. The best example of this type of crisis would be Nestle, when Indian regulators found excessive amounts of lead in samples of Maggi noodles. The company’s share price tanked upon the initial ban being implemented but Maggi’s market share in the instant noodle segment eventually recovered along with Nestle’s share price. You have to be able to invest during times of uncertainty if you really want to become a Titan.
How to Become a Titan
Russell Napier, an former Global Macro Strategist at CLSA and an excellent economic historian, wrote the following:
“I have read all the biographies of the great American capitalists of the 19th century and about how they made their money. All of them are slightly different, but one thing they all have in common is that they were able to mobilize cash to buy things when they were cheap…We are waiting for one more deflation scare to pass, very probably driven by a crisis in the Western sovereign debt markets. When this occurs, investors need to watch the cyclically adjusted P/E and Q ratio. It seems likely in the next five years, equities could become very cheap indeed on those measures. Then would be the time to become the new Mellon, Carnegie, or Rockefeller and buy high-quality corporations when they are very cheap.”
The preceding quote hasn’t aged well because the deflationary bust that he was predicting never materialized thanks to the actions of central banks globally. However, Napier’s advice on becoming the next Mellon, Carnegie or Rockefeller is spot on. You need to handle the vicissitudes of the market with sangfroid. The recent Covid-19 led market crash is an excellent example of how staying calm and not reacting was the right response instead of panic selling at the bottom.
In order to be a titan of the investment world, you’ll need to focus on the following things: intrinsic value, high-quality companies, and cheap valuation levels. I can’t promise that you’ll become the next Mellon, Carnegie, or Rockefeller but I can guarantee that by following my advice you’ll definitely increase the odds in your favor.
As I mentioned in my recent article (Is This the Buying Opportunity of Our Lifetime), the current crisis is not a lifetime buying opportunity. However, the recent market correction has definitely resulted in a few attractive investment opportunities. I’ve taken advantage of a few of these opportunities in my personal portfolio. Although I’m no longer publishing the Value Investing India Report Premium Access Service, I’m in the process of launching a “follow my portfolio” service that will allow you to replicate my portfolio and give you insights into my current holdings. Please sign up for our email list to stay informed about the launch of this new service.