The Magic of Predictability
Many people are talking about Twitter and how its business will evolve in the coming years – the one thing most observers agree on is that its future is hard to predict.
Why does this matter? Because predictability is at the heart of successful investing.
The goal of stock market investing is to buy shares in a company and sell them for a higher price in the future. You can do this only if you have an idea of the true value of a company at the time you buy its shares. To estimate the value of a company, you must predict its future financial prospects.
There are many high quality companies that you can count on to grow at a relatively predictable level for several decades. Their long term financial prospects can, therefore, be estimated reasonably accurately, making them easier to value.
Surprisingly, such companies are often undervalued by the stock market because most investors focus on what a company’s share price might do in the next year or so, rather than taking the long term view.
A business is only worth the money that you can take out of it over time. Consequently, the economic value of a business is simply the present value of the cash flow that it will produce during the rest of its existence. Over the long term a company’s share price will approximate its economic value.
Many people fail to recognize that most of a company’s economic value (usually more than 75%) is based on cash flow that the company will produce more than five years from now. Therefore, investors not looking beyond the next five years are largely speculating about how a company’s share price will perform and often undervalue the shares of predictable businesses with long term potential.
Consider Warren Buffett’s company, Berkshire Hathaway in early 2000. At that time, it was valued at just over the cost of its underlying assets. This was despite a very highly regarded management team and businesses with obvious, steady long term prospects.
Why? Because it was the height of the high tech bubble and investors were focused (speculating) on potential near term returns from high tech shares -somewhat like today. As a result, the shares of many relatively predictable, less exciting companies, like Berkshire Hathaway, were undervalued.
On March 10, 2000 the NASDAQ Index (the bellwether for the US tech market) peaked before crashing. That was the precise day that Berkshire Hathaway’s shares bottomed, at a price that they have not been close to since.
Investing is a probabilistic exercise in which you should simply be trying to tilt the odds in your favour. Investing in companies with relatively predictable growth profiles can help you do so.
Predictability not only increases your chances of estimating accurately the economic value of a company, it also leads you to companies that you can feel comfortable owning for many years. Owning shares for the long run has the benefit of deferring tax on capital gains. This allows your capital to compound tax free.
If you purchase a share for $10, it grows at 10% each year and you own it for 20 years, at the end of 20 years it will be worth approximately $67 before tax and $54 after you sell it and pay capital gains tax. Alternatively, if, at the end of each year, you sell the share you own, pay the capital gains tax and then reinvest in another share that also grows at 10%, your investment will be worth only about $43 after tax at the end of 20 years. In this case, the advantage of buying and holding leads to 25% more capital after tax.
To find predictable companies, steer away from sectors where there is a risk of obsolescence (eg. high tech) or performance is dependent on the price of a commodity (eg. mining, oil & gas).
A good place to start is with companies that have consistent historical growth and profitability, as well as defensible competitive positions. For example, the consumer staples sector includes some of the most predictable companies in North America, such as Brown-Forman, McCormick and Walmart.
Short-sighted investors may always see such companies as fully valued. But long term investors who own these businesses will be sleeping soundly at night, dreaming of compounding returns, and knowing that the companies they own will likely still be growing many years down the road.
A version of this edition of The Long View was published in the Globe & Mail on December 27th, 2013.