Written June, 2018 by James M. Esler
The securities markets are not for those with an easy stomach. It is also not for the aggressive gambler. At least, gambling is not what they were intended for. Early history says that companies in Western Europe wanted to raise money and those wealthy people around town could buy into the company so it could survive (or make it across the Atlantic Ocean). And if the business did survive, those investors would be entitled to future earnings (pro-rata). I’m sure they were paid out directly those days (ie dividends). Gambling short term is not a distinguished way to invest. That’s not investing, matter of fact.
Thus, a true investment pays you back profits that will eventually pay you back the price you originally paid, through dividends and retained earnings. Of course, the earnings must be discounted. So if a business is trading at a high price/earnings ratio, it should largely be out of favor simply because investors won’t get paid back for a very long time. This is where speculation is very prevalent when there are very high price to earnings ratio.
The goal of a business is to earn consistently. If it can, it will forever stay in business. However, it is difficult for this to happen, based on competitors trying to destroy the competitive advantages, the management may do poorly, Margins can deteriorate. If a company believes that it can earn more than its investors, it can retain the earnings. If the company can’t, it should dissolve (mostly).
A business owner should only look at results and NOT MARKET PRICE. So too, should the investor. If the results still indicate that the company is a going concern (will be in business for the long term), Retained earnings and/or dividends will ultimately build the value of the company higher. This is such a simple idea, but is 100% accurate. If you pay goodwill, it becomes harder to make an absolute profit on the company, since in order to do so, 100% of the goodwill must be recouped from earnings and dividends. Once you buy a company, you shouldn’t care about the market price – you should only worry that 1) the company is earning money at a rate beyond the risk free bond rate (over 10% is ideal) and 2) the earnings will continue. For growth companies, you may pay more, but the price [should be] a combination of current book value and the potential for higher, or consistent earnings. Higher earnings can come from both higher revenues and also improving margins. Both of these can be accomplished by higher revenues and by reducing expenses. When valuing a company, the goal is to determine if revenues can grow to a point that the earnings will clear up the good will (if there is any) and finally return economic profits to the owners. Margin improvement can also lead to clearing up the good will and consistently earning profits.
An activist investor believes there is a problem with management. Management is not allowing for good margins or higher revenues (typically the former). Thus, when an active investor joins a company, owners may regard this favorably, if that person has the appropriate skill set. However, if the activist investor believes the company is troubled, they may push for liquidation of assets, which is much more difficult to earn a profit ultimately. Often, the activist investor believes there is some sort of value that the current management does not see. This can be in cost cutting, merger potential (synergies), or entering a complementary new line of business. Or the investor just wants to buy assets from the business (ie PP&E) for a discount to resell and leave the business out of it. This is the best strategy if there could be potential impairment to the business’s value due to intangible assets (brand names, patents, etc.)
Price is what you pay, value is what you get. Once you buy a company, you shouldn’t care about the price again until you are ready to sell.
The business owner, must then be wealthy enough not to need to sell the business. However, they should sell the business if they believe they will not get a return on their investment over time (ie the company cannot consistently deliver profits). The return on the investment comes from the clearing up of any goodwill (ie price minus tangible book). If the investor is too busy, or is not particularly good at valuing businesses, they should employ investment advisors.
Analytical example: If current management is doing a lot of m&A, the investor should determine if the m&a will provide potential for higher, more consistent long term earnings. If not, the management is doing a poor job using current potential earnings. Asset impairments are a giant red flag.
Diversification takes all of the earnings of many companies and brings them altogether. This is a much safer, more consistent way to ensure you will have long term, consistent profits. In order to beat such a group, you must buy a business that will display to investors that it can out-earn the index.. and very sustainably. In order to determine if the company will have consistent earnings long term, you must understand completely what their product is, what competition they have, what potential they have, and if they have management that can properly deploy capital.
There should theoretically be no difference between public and private securities markets. If one was to invest in a private security, they would not expect to sell it so quickly. Often, private equity firms have 3-5 year lockups for this very reason – they want to allow the business to increase in value over this time. There may be short term stumbles, but if you are to buy a company that is below value, you must hold on to it until they provide proof of consistent earnings. Using an investment manager, you should be able to bounce back quicker than by owning an index for the very same reasons outlined above.
A simple allegory to explain: in life, investment-oriented folks find the best way to make a living. It mostly boils down to looking for competitive income (ie salary), with long-term growth potential. This person will avoid careers that will absolutely end soon (such as a dodo bird breeder) and also those that don’t pay enough for their skills (being underpaid). In many industries (including investments), long term employment is becoming increasingly difficult to sustain. A key theme of the above illustration is adaptation. A manager of the company should always try best to maintain competition by adapting.