Getting Started In Value Investing

Chapter 4: Are Great Companies Great Investments? Stick with the Champs
• Many investors are seduced by the thought of finding the newest company in an exciting
growth industry like Microsoft or Google
• They often ignore popular established businesses that have consistently produced strong
revenue and earnings for decades like Johnson & Johnson
• The three most common excuses for avoiding great established companies are as follows:
• Great companies are too efficiently priced
• Investors assume that because great companies are so widely followed by
large investors they trade very close to their underlying business value
• Looking for the 10 bagger
• Investors are intrigued with finding small companies with very little profit
that have potential for exponential growth
• In most cases the anticipated growth does not occur
• Established companies are already too large to have this kind of growth
potential
• The financials get no respect
• Coca-Cola, founded in 1886, generated $5.5 billion in free cash flow in 2006
but commanded only a price to earnings (P/E) ratio of 21. While Electronic
Arts, a software game maker (founded in 1982), generated $473 million in
free cash flow in 2006, it commanded a P/E of 87!
• The author sites a study titled “A Great Company Can Be a Great Investment” by Jeff
Anderson and Gary Smith
• In the study the authors bought the 10 most respected companies listed in Fortune
magazine every year and held them until the list comes out the next year
• Over the 22-year period the Fortune portfolio produced 17.7% annual returns
compared to 13.0% for the S&P 500
• The longest period of underperformance against the S&P 500 was two years
• Great companies provide excellent products and services to customers and if they are
purchased at reasonable valuation levels will produce superior investment results
• Many investors make the mistake of selling their entire portfolio every single year
• Warren Buffett believes that an investor should assume that they will only get 20
investments over the course of their life and act accordingly
• Early in his career Buffett practiced what he now calls “cigar butt” investing which means
buying a mediocre business at a low valuation and waiting for it to rise in value
• The author defines a “cigar butt” opportunity as a company trading at very cheap price with
little or no debt
• In most cases they are selling at cheap prices for valid reasons related to the declining
fortune of the company or the industry it is in
• Charlie Munger convinced Buffett that investing in great companies at reasonable valuations
is a better alternative because they have the potential to increase earnings in the future
• Buffett ultimately concluded that “cigar butt” investing is a mistake because the company
has already seen its best days and after the stock reaches fair value it must be sold
immediately
• Another benefit of investing in great companies at fair prices with a history of profitability is
that the investor knows they can overcome business cycles because they have done so in the
past
• “Cola went public in 1919; the stock sold for $40 per share. The Chandler family bought the
whole business for $2,000 back in the late 1880s. So now it goes public in 1919, $40 per share.
One year later it is selling for $19 per share. It has gone down 50% in one year. You might think
it is some kind of disaster and you might think sugar prices increased and the bottlers were
rebellious. And a whole bunch of things. You can always find reasons that weren’t the ideal
moment to buy it. Years later you would have seen the Great Depression, WW II and sugar
 rationing and thermonuclear weapons and the whole thing—there is always a reason. But in
the end if you had bought one share at $40 per share and reinvested the dividends, it would be
worth $4 million now (author’s note: 2006 value-$5.6 million). That factor so overrides
anything else. If you are right about the business you will make a lot of money. The timing part
of it is a very tricky thing so I don’t worry about any given event if I got a wonderful business
what it does next year or something of the sort.” - Warren Buffett speaking with MBA students
at Florida State University
• The author states that there are very few companies with consistent operating earnings,
high returns on equity and marginal amounts of debt
• He believes that investors should focus primarily on this small universe of companies
• Since they only become available at attractive valuations infrequently investors must load up
on them when the opportunity arrives
• “We have tried occasionally to buy toads at bargain prices with results that have been
chronicled in past reports. Clearly our kisses fell flat. We have done well with a couple of
princes—but they were princes when purchased. At least our kisses didn’t turn them into toads.
And, finally, we have occasionally been quite successful in purchasing fractional interests in
easily-identifiable princes at toad-like prices.” - Warren Buffett
• It is not only difficult to find great companies at attractive prices, but it also takes discipline
to stick with those companies over long periods of time
• “Investing is where you find a few great companies and then sit on your ass.” – Charlie Munger
• An added benefit to holding great companies for the long term is that it reduces your tax
obligations because capital gains are only paid upon sale of the stock
• Key Points
• If you think of investments as lottery tickets, you will also be willing to pay too much
for stocks. There’s a chance you’ll profit, but it’s a long shot.
• You will always do better staying with proven winners, those boring but consistent
companies. Fast-profit stock tips are exciting, but you will be better off rich and
bored.
• Take Buffett’s advice: Invest like you have a punch card with only 20 punches. You
will then invest in only your best ideas. Stick to quality companies and hold them for
the long term. The big money is made by sitting not trading.