FISCALLY FIT
The Warren Buffet way
SHYAM P.
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Stock picking for above-average, long-term returns begins with identifying good companies to invest in.
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Many aspiring investors think that buying stocks blindly based on “recommendations” from others who claim to be “experts” either in a newspaper, magazine, T.V or brokerage report, is “stock picking”. If you have st
ill not learnt a lesson despite having lost a significant amount of money already by following this technique, then reading ahead is probably too much effort that is not worth it anyway.
For the others that want to really learn how to choose stocks on their own and are willing to do a little homework before plunking down hard earned money, who could be a better teacher than Warren Buffet, the most successful investor in the world with a 40-year track record of picking stocks (and buying companies) that have generated average returns of 20 per cent p.a? His approach to investing is one of the few out there that can be termed as “simple” (not to say that it is ‘simplistic’ by any means, else everyone who follows him would have become billionaires!). But, there are many who started with a few thousands worth of Berkshire Hathaway (the company run by Warren Buffet) shares that are now worth many millions. Wouldn’t it be great if you too could learn his approach and apply it to investing on your own? Actually as lofty as the goal may seem, all the tools required for practising it are readily available and supplied by Buffet himself. Yes! I am talking about the letters written by Warren Buffet to his company’s shareholders every year, dating back to the 1970s. They can all be downloaded free of charge from www.berkshirehathaway.com
. (Psst! I happen to have some of the earlier letters that are not posted on the website, in case you are interested). These letters lay out pretty much everything that an investor needs to know including what mistakes to avoid — by learning from Buffet’s own mistakes, which have been thoroughly analyzed by none other than Buffet himself.
Buffet philosophy
Buffet’s investment philosophy is based on “Buying good companies at bargain prices”. How do you identify a good company? Is it the one with the highest sales growth? Highest profit growth? Highest profit margin (i.e. profit per rupee of sales)? Largest market share? What is “the” most important parameter that helps gauge how good a business is? Before I introduce what I like to call “the God ratio”, let me ask you a question. What do you ask for before you put your money in a fixed deposit? It is probably “What is the interest rate offered?” i.e., “What is the return that you are going to get?” right? Well, businesses can also be benchmarked based on the returns they generate.
Assume you have inherited Rs.1 crore, you have an opportunity to either start a business using the capital or invest the amount in a fixed deposit. You have two business ideas — one is a restaurant and other is an ice-cream parlour. After detailed research, here are your findings. The restaurant business is expected to generate Rs. 10 lakhs profit per annum. The ice cream parlour, on the other hand, is expected to generate a profit of Rs 15 lakhs per annum. The third option is to invest your money in a fixed deposit that will pay you an interest of 9 per cent p.a. Which option would you pick? Obviously the ice-cream parlour, right? Why? Because it offers the highest return-on-capital i.e. 15 lakhs/1 crore (15 per cent). This is higher than the 10 per cent offered by the restaurant business and also higher than the 9 per cent that you would get from the FD option. According to Buffet, it is this ratio, the “return-on-capital” (“the God ratio”) that sets apart a good business from a poor one.
Fast forward into the future: your ice cream parlour is in its fifth year of operation but unfortunately you have never been able to generate more than Rs 10 lakhs per annum profit (i.e. 10 per cent return-on-capital). You have tried everything you could but you just can’t seem to get the business to produce a higher return-on-capital. You look up the fixed deposit rates — they remain at 9 per cent. What would you do? If you were a rational businessman, you would rather sell the enterprise, park you money in FD and relax, while still earning almost the same profit!
To summarise, it doesn’t pay to be in a business, if the business can’t earn, in terms of return-on-capital, a rate that is higher than what you could otherwise earn by just parking your funds and receiving interest at almost zero risk. So you may ask, what is the ideal return-on-capital for a business? 15 per cent? 20 per cent? or 30 per cent?
Actually, I don’t know! It depends on your level of risk aversion. After all, businesses carry a higher risk than FD. So it is fair to expect a higher return. My opinion is, the return-on-capital from a good business needs to be greater than 20 per cent p.a.
Not many listed companies in our country have a track record of earning more than 20 per cent return-on-capital. But still they continue expanding, by hiring more people, opening more branches, spreading abroad, acquiring companies larger than themselves using debt and just growing mindlessly, sometimes even faster than their competitors that earn higher returns on capital. How are they able to do this? The answer is…by raising more and money from the public or from other investors who are too enamoured with the “growth story”. But is such a growth that depends mainly on raising more capital but produces low returns on the capital, sustainable? Probably not. Even if it does, it is never going to produce above-average long-term returns to the shareholders. Because, over the long term, return on your investment in a company’s shares depends on the return-on-capital that the company generates for itself.
Companies that “consistently” achieve a high return-on-capital can be considered to be “fitter”, as they are likely to have long-term advantages of some kind. This advantage protects them from competition and helps them continue to earn above-average profit by using relatively less capital. If you are a long-term investor who wants to buy and hold stocks, it is these companies that you want to own shares of. Having said that, you need to note that there is a gap between a good company and a good investment — it is called “price” i.e., the price at which you buy the shares of the company. In my forthcoming articles, I will discuss simple techniques to compute the return-on-capital for a company and to arrive at a bargain price for acquiring shares of companies that have a track record of “consistently” generating high return-on-capital. This combination of buying above-average companies at below average prices will help you to reap above-average return on your investment for many years to come.
This is a fortnightly column on money and life. You can contact the author at: shyamscolumn@gmail.com or www.shyamscolumn.com.
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