There is a catch-22 when it comes to money – the more money you have, the more problems there are with growing it.
Consider two businesses, Company A (R22.0 billion market capitalization) earns R1.4 billion per year and Company B (R1 billion market capitalization) earns R75 million per year.
To produce a 15% return, Company A must create R210 million with their R1.4 billion in earnings. Company B on the other hand, only needs to increase earnings by R11.25 million.
In other words, to create the same value, Company A needs to sell almost 20 times more product than Company B. Where Company A may have saturated a market to deal with, Company B may only be growing a foothold.
In share investing a ten-bagger is a stock that has appreciated in value 10 times. A ten-bagger is something most stock investors strive for. A single ten-bagger can turn a mediocre portfolio into a spectacular one. For Company B to increase ten-fold would create a R10 billion business with earnings of R750 million. In other words, Company B even after increasing ten-fold, would not be as big as Company A is today. Now, for Company A to become a ten-bagger, it would mean that they would need to become a R220 billion company earning R14 billion per year, bigger than most businesses in South Africa. This company would be enormous.
This doesn’t mean that it is impossible for Company A to produce such a return, only that it is significantly more difficult. With all things the same, the probability of a ten-bagger by investing in Company A is significantly less than with Company B.
Free Cash Flow
An acceptable price is not a specific number as many people believe, but a range of appropriate values. Consider a candy vending machine that generates R1000 a year in free cash flow. If a price of R10,000 is paid, the buyer is expecting to see their money returned in 10 years. If R15,000 is paid, then they are willing to wait 15 years. When free cash flow is being considered as the basis for what to pay, the investor should determine how long they are willing to wait to see their money back. Some investors are willing to wait 15 years and others are only willing to wait 10 years or less.
The biggest mistake that investors make is not recognizing how many years they are willing to wait to see their money returned. During the tech boom of the late 90s in America, many investors paid 60, 80 or 100 times free cash flow; not recognizing that it would take them 2 or 3 generations to see their money back (if at all).
Some even rationalized that a 40% growth rate would shorten their waiting time to an acceptable level. This was shown to be an irrationally exuberant expectation.
By using earnings, a value of the business is determined by considering it as an ongoing entity or as a cash flow generating entity.
I would be more interested in a share when the price is falling. Additions to a companies portfolio are better made during periods of negative returns than positive ones. A purchase is more likely as the ratio of price to earnings falls to 12 or lower.
The book value of a business is its assets minus its liabilities; technically this is also the value of shareholder equity.
Unlike the calculations used to determine the value of a business based on its cash flow over time, book value represents the value of the hard assets (and liabilities) of the business.
The book value of the aforementioned candy vending machine business is the candy vending machine assets minus its liabilities. Assuming an asset value of R10,000 and no liabilities, the candy vending machine business has a book value of R10,000.
If the asset produces R1000 of free cash flow in the first year, the book value of the business going into the second year increases by this amount. That is, the book value of the candy vending machine business increases from R1000 to R1100. In businesses that produces a constant and unchanging amount of free cash flow, the book value or shareholder equity of the business will increase in a linear fashion (e.g. R1000, R1100, R1200, etc.). In businesses that produce increasing amounts of free cash flow, the book value or shareholder equity of the business will increase geometrically (e.g. free cash increases 10% year over year; book value increases from R1000 to R1100 to R1210 to R1331, etc.).
Investing in ultra-large companies is a bad idea for individual investors. To hope that a R100 Billion company will grow earnings at double digits over the course of the next decade (and beyond) is foolish. Unless an investor is looking for a stable flow of dividends, investing in large companies is a waste of time.
Investing in large companies is one of the primary reasons that mutual funds (and mutual fund investors) fare so poorly over the long haul. The combination of paying high fees to buy ultra-large, slow growing businesses ensures poor performance.
A 10-bagger (i.e. a stock that increases 10-fold) can change a poorly performing portfolio into a spectacular success. The odds that a R100 Billion company will increase 10-fold are non-existent.
Smaller companies (i.e. < R5B market capitalization) not only offer superior returns, but their price fluctuates far more dramatically which provides greater opportunities to invest at an attractive price. The best way to ensure satisfactory returns is to invest in “tiny” companies with clean balance sheets and proven growth.
The High Price of Diversification
Another often promoted concept is diversification. Mutual funds and financial planners have pounded this concept into the mind of the public for years.
In 2008/09 market slump businesses on the JSE across every sector were decimated as prices all came down to earth.
Diversification offers no protection from downside risk and virtually guarantees poor results. The great irony here is that my portfolio of about a half a dozen shares has performed better than the wildly diversified market indexes in the last two stock market meltdowns of 1999/2000 & 2008/09.