How to Produce Outsized Long-Term Returns from the Perspective of Value Investing

I’m going to let you in on a little secret: Wall Street doesn’t look out beyond 1 year.  That’s it.  Just 1… Wall Street is part of the brokerage industry and all that the brokerage industry cares about is making sure: 1) you remain invested in their expensive products, and 2) you continually churn your investments so they collect large commissions.  They want you chasing returns and buying the hot fad of the year.  Think about it – every Wall Street analyst’s ratings report comes with a Buy/Sell recommendation and a 12 month (i.e. 1 year) price projection.  And every ratings change is accompanied with a statement saying why they’re upgrading or downgrading the company and it’s always along the lines of “we see revenue accelerating this year…” or “we don’t see any catalysts this year to drive the stock higher….” It’s all about the next 12 months and that’s it.  But that’s OK, as long as you understand how the industry works, because that shortsightedness creates discrepancies that long-term investors are able to capitalize on.  Plus, most of these “analysts” are sheep that can’t think for themselves.  They simply follow the stock price and upgrade AFTER it has gone up, assuming the company must be “doing well this year” so I should have a “Buy” recommendation on the stock.  Or they downgrade AFTER the stock has fallen.  Because of this, I typically use ratings changes as a contrarian indicator and do the opposite of what Wall Street recommends.

Now that we’re all on the same page regarding Wall Street, let’s get on to the valuable stuff.  Please note that the charts and examples below are hypothetical and for illustrative purposes to convey a concept.

I think everyone’s goal for their “growth” investments is to produce outstanding long-term returns; the type of returns that really crush the stock market’s long-term average annual rate of approximately 10%.  In order to do so, you need to find and invest in companies that are able to grow the intrinsic value of the actual business at high rates of return.  For example, if you hope to earn returns in the ballpark of 15% per year, you need to invest in companies that are growing/generating returns of at least 15%.  Here’s a chart that illustrates the long-term growth of 15% per year compounded for 20 years:

As you can see, $1 invested would grow to $16.37 after 20 years.  So we can say that Step #1 is to find companies led by excellent management teams that have a proven track record of historically being able to generate returns above 15% as well as believing they will continue to do so based on the industry and company’s position within it.  Some metrics to look at might include Return on Equity (ROE), Return on Invested Capital (ROIC), etc.  In short, a company that generates an ROE of less than 10% will not earn you long-term returns in the neighborhood of 15% per year over a long time horizon.  You might be able to buy stock in a low returning company on a big dip and catch a quick 20% bounce, but that’s a trade, not a long-term investment that offers the benefits of compounding.

Once we find our high quality company, the next step is to look at the current cost of buying shares, as represented by the price of the stock in the market.  Here’s what happens with most stocks over time:

As you can see, there are multiple “up and down” periods over the course of 20 years, where sometimes the stock is trading above the intrinsic value of the underlying company (when investors are really excited about the company’s prospects) and sometimes below intrinsic value (when investors are panicking).  Given enough time though, the stock should converge with and produce returns similar to the intrinsic value.  We can call these periods of time when the stock is not trading at “fair value” to be either “overvalued” or “undervalued,” relative to the intrinsic value of the company.

Now this brings us to an important point – the price you pay for an investment determines your future return.  In other words, if you pay too much by purchasing an overvalued stock, your return will be less than the underlying growth of the intrinsic value.  If you hold it long enough, you should still be bailed out because it’s a great company, but your average annual return will always trail the growth of the underlying company.  In the chart below, our hypothetical investor got caught up in the excitement of a rising stock market and paid too much by buying at the top of the recent range.  Moving forward over the next 9 years his average annual return is “only” 11.2%.  Still pretty darn good, but not 15%.

The flipside of this would be an astute investor that patiently waited for “the market” to get emotional and throw out the stock of all sorts of great companies (i.e. high return companies growing at rates of 15% or higher) down to the point that you’re able to buy the stock at a discount to the company’s intrinsic value.  In the chart below, our hypothetical investor would earn an average annual return of 24.5% over the next 6 years as the price of the stock played “catch up” and converged with the intrinsic value of the company.  The longer this investor held the stock, the more her average annual return would approach 15% but would always remain above 15% (assuming the company can continue to produce returns and grow at 15%).

In summary, the best way to earn outsized long-term returns is by investing in companies that are able to produce high rates of return internally, buy the stock as cheap as possible (relative to its intrinsic value) and hold on to allow the benefits of compounding to do its thing.  It sounds a lot easier than it actually is for two reasons: 1) the world is always changing so it’s very difficult to know if the company can sustain high returns, and 2) we humans are very emotional and impatient because in today’s fast-paced world we demand instant gratification.

Here are the key metrics I look for when assessing companies as potential “growth” investments:

• High return metrics: Return on Equity (ROE), Return on Invested Capital (ROIC), etc.
• Consistent growth and *sustainability* of the business model – does the company have a unique “moat” around the business to protect it and ensure years to come of high returns. The importance of this cannot be understated.  Thinking about this factor in terms of the constantly changing world is the hardest part and most time should be spent here.
• Substantial Free Cash Flow generation (cash leftover each year after the cost of maintaining/growing the business – think of this as disposable income)
• Quality and experience of management
  • How well do they know the industry?
  • How long have they been in the business?
  • Do they have a long-term plan and are they executing on it with focus?
  • Are compensation policies aligned with shareholders?
• Capital allocation policies
  • What is the CEO doing with the Free Cash Flow each year?
  • If management is retaining earnings instead of paying them out as dividends, how efficiently are they reinvesting that money? What growth are they generating on the amount retained?
• Little or no debt on the balance sheet – I hate debt. Most companies misuse debt (waste the money on low-return activities) but leave the company saddled with years of interest payments and eventually repayment of the loan.  More money used for debt payments each year is less money available (free cash flow) for stock investors.  Companies with a lot of debt are in bed with their lenders (i.e. the bondholders), not shareholders.
• Valuation – largely based on the amount of Free Cash Flow generated relative to the market value of the company (Enterprise Value)

Here is a real life example looking at Starbucks (SBUX).  I think Starbucks is one of the most impressive companies I have ever seen in terms of execution, growth, high rates of return on capital, etc.  The stock has been on a fantastic run the past few years but it’s to the point that I feel it’s “overvalued” and just waiting for something to knock it back down to reality.  Here are the annual returns of the stock the past 6 years:

That’s a compounded average annual return of 33.2%!  I don’t care how well they’re executing, the company has not been growing at that pace and cannot post future growth at that pace simply given its size.  I don’t even need to look at the current valuation.  That string of returns alone is enough to tell me that the stock is probably trading above intrinsic value (i.e. “overvalued”).  Therefore, I’d be willing to bet that at some point in the future you can buy stock in Starbucks at a cheaper price/valuation than today.

Hopefully this provides a framework for thinking about investing in stocks for the long-term that allows you to start thinking like a contrarian investor.   That is, cautious when others are excited and greedy, and aggressive when others are panicking.  Just something to keep in mind during these volatile days in the market.  Thanks for following!

-Nick