What’s a fantastic company and what is a great price?

Let’s say you want to buy a small super market in a great location in central Stockholm from your friend who wants to retire and go live on a small farm. How would you decide to buy it or not?

The things I am gonna talk about here are from the book Rule #1 (affiliate link) by Phil Town.

We will buy a business if it has 4 important “M”s.
1. Meaning
2. Moat
3. Management
4. Margin of safety
Now let’s try to explain each of these in more details.

Meaning

This one is a personal thing. It means you should love the business, believe in it, you are willing to own the whole business and this business alone for a long time, so the survival of your family depends on this business making you money. You will buy it and never want to sell it. Why is this important? Because if you don’t really love the business or don’t really understand it, with the first bump in the road you will try to sell the business (probably with some loss) and lose money along the way (which is against the rule #1 Warren Buffett has. Rule #1: Don’t lose money. Rule #2: Never forget rule #1).

The same goes for stocks too (which is really a small part of a real company and business). As Warren Buffett said: “If you are gonna do dumb things [sell your stock] if the price goes down you should not own stocks”. If you love and understand the company probably you will not do dumb things. Stock price is just what other people think about the business, if you love and know the business you won’t care what others think about it. If you buy your home for 2 million SEK and tomorrow someone calls you and tell you I am buying your home for 1 million SEK you won’t panic sell. You should have the same perspective toward the businesses you own too.

And the other thing is we all have different knowledge about the world around us depending on our day jobs. I am a software engineer so probably I will hear about the news about Apple and Microsoft before you. So it make sense for me to own them. But you who work in a drugstore probably hear Pfizer and AstraZeneca news faster than me, understand their business better and see who is winning more customers, so these make more sense to you. You can make money with all of them.

Moat

Moat is the deep ditch surrounding a castle that protects it from enemy attacks. It behaves the same way for businesses too. It protects the company from losing market share to competitors. It can be some secret formula (Coca-Cola), big user base (Microsoft), loyal customers (Apple), patents (IBM) and so much more. You can see the effects of these moats on the financial statements of the company and by researching (knowing the business helps here).

But where can you find the effect of these moats on financial statements? I would like to see these 4 big numbers be at least 10%.
1. Year over year (YoY) increase in earning per share (EPS)
2. YoY increase in free cash flow (FCF)
3. YoY increase in retained earning (The books says equity but I like retained earning more, they represent different things thou)
4. YoY increase in revenue

I look for 20% or higher net margin too so I know the business has pricing power. The competitors can not put so much pressure on my business that I have to reduce my prices and in result my net margin.

Management

We want our business to be run by a management with honesty, integrity and competence. The first two we can know by researching and listening to quarterly reports the management makes. For the competence part we want to see the business is run efficiently. For that we want to see that the Return on invested capital (ROIC) is at least 10% for many years. And we want to see that company can pay their debt and interest without going more into debt. For that we check to make sure total debt is less than 3 to 4 years of income and FCF.

Margin of safety

Now that we have found a fantastic business for us when can we buy it? If your friend [that we wanted to buy the supermarket from (which makes 1 million SEK per year in net profit)] offers you his business for 1 billion SEK will you buy it? probably not, because it is to expensive and you need to wait 1000 years to make your money back. But if he offers you the business for 1 million SEK you probably won’t think twice about it. You will get your money back the first year and after that you will collect a fat return on your investment. That’s the dream.

Stock market behave the same way as our friend. Benjamin Graham (the father of value investing) came up with a great allegory called Mr.Market. He is a bipolar person that everyday gives you three choices.
1. Buy part of his business with a given price
2. Sell part of his business with a given price
3. Do nothing
Some days he is so excited about future that he will price his business crazy high, we will try to sell the business to him on those days. Some days he is so depressed he will sell his business for pennies on the dollar, those days we will try to buy as much as we can. And most of the days he will price his business with a fair value, those days we will just sit on our hands. Patience is the key here.

Two very good quotes from Warren Buffett and Benjamin Graham that I love about this:
“The stock market is a device for transferring money from the impatient to the patient.”
“In the short run, the market is like a voting machine, but in the long run it is like a weighing machine”

So what do we do? We calculate the fair value of the business and only buy it if the price is 50% of that value. Why? Because our calculations may be wrong. Our calculation is about the future earning and no one knows about the future. So with 50% margin of safety we are protecting ourself from losing money. How do we calculate the fair value you ask? That’s a topic for another day.

Hope you enjoyed this story. See you on the next one.