Buy the Book: Thomas Phelps studied past companies in existence from 1932 to 1971 that grew at least 100 times in size to see what they had in common. He shares the key characteristics found in compounding machines as well as the key traits investors need to invest for the long run.
The Notes
- Market history is filled with examples of companies that returned over 100x on an initial investment. The difficulty is in finding and holding on to those companies over many years.
- Most investors are too eager to sell a good position with a small profit rather than hold on for a larger gain.
- Paul Garrett’s Criteria for “Fast Growing Companies”:
- It must be small.
- It must be relatively unknown. Popular stocks come with a premium price that pays for too much future growth.
- It must have a unique product or service that does a job better, cheaper, or faster with the possibility of a long-term increase in sales.
- It must have a strong, research-minded management.
- Buy right and hold on.
- Lesson from Selling IBM too early:
- “Stay with your most successful stock investments as long as the companies are increasing their earnings.”
- “Never forget that people whose self-interest is diametrically opposed to your own are trying to persuade you to act every day. Who is talking often means more than what is said. Try to identify people whose interests correspond with yours.”
- “Bull market highs are made when the outlook for still higher prices is most broadly convincing. Conversely bear market lows are made when the likelihood of still lower prices seems overwhelming to the preponderance of reasonable, well-informed moneyed men. Since bull and bear markets are to a considerable extent manifestations of changes in mass psychology it is fatuous for anyone to believe that he can persuade a representative group of investors to sell stocks when that mass psychology is bullish, or to buy stocks when it is bearish.”
- “Few investors, private or professional, seek the big game. They focus on chances to make five points here and ten points there. They rush to buy on information that the next quarter’s earnings will show a good increase, or to sell because they hear that profit gains have slackened.”
- “The only thing worse than making an investment mistake is refusing to admit it and correct it. Usually the faster an error is rectified the less it costs.”
- “The big risk in correcting errors in the stock market is that stocks look best to so many of us when their prices are highest, and worst when their prices are lowest. Almost irresistibly we are tempted to shoot where the rabbit was, to do now what hindsight shows would have been the right thing to do yesterday, last year, or even five or ten years ago.”
- “Never if you can help it take an investment action for a non-investment reason.”
- Lesser Thought About Risks:
- Inflation risk re: “safe” cash holdings.
- Risk of not buying (or not buying enough to have a meaningful impact on overall returns).
- Risk of selling too soon.
- “Good assets are potential earning power. Since most people focus on earnings you can acquire assets at bargain prices once in a while because the companies owning them are operating at a loss and there is no sign of a change for the better.”
- “Wall Street has its fads and fashions just as Paris does. A stock that is not in vogue may do a great job for its owners without attracting much speculative attention.”
- “It is almost a truism that nothing kills a money-making opportunity faster than its widespread popularity.”
- Stock prices, on average, grow at the same rate earnings grow, assuming the P/E ratio stays constant. But P/E ratios rarely stay constant. A rising multiple can mean investors overpay for future earnings growth. A falling multiple can mean investors underpay for future earnings growth.
- “Growth stocks are highly attractive if they continue to grow as fast as or faster than they have been growing, and if buyers continue to expect them to continue to grow as fast or faster, and if the rate at which future earnings and dividends must be discounted does not increase materially… No intelligent investment decision is possible without considering all three ‘ifs.'”
- “All anyone can buy in the stock market at any time is the unknown future. The past is not for sale.”
- Over 360 stocks met the criteria of growing over 100x in 1971. Many investors owned those stocks from the outset. Few, if not all, held on long enough to earn those returns. It takes a particular level of foresight, patience, and stubbornness to stick with a company and its adverse swings in its stock price.
- On Projecting Future Growth:
- “In human relations, as in nature there seems to be a law against limitless growth. Beyond a point, people simply won’t tolerate any more…”
- “When you pay in advance for the earnings of a stock to triple or quadruple, as you do when you buy it at three or four times the price-earnings ratio of the Dow-Jones Industrial Average, you should foresee not only the growth you are paying for but further above average growth beyond that. This means that you must evaluate the competitive status of the company not as it is today but as it will be six to eight years from now, when it is three or four times bigger.”
- On Other People’s Forecasts:
- Not worth much. If you do pay attention to it, look at the reasons or underlying assumptions for the forecast.
- No one knows for certain what the future holds.
- “In investing we deal always with probabilities and possibilities, never with certainties. It follows as night the day that in investing the odds are all important.”
- The art of weighing risk and reward is recognizing when a risk is not a real risk or the risk is not nearly as great as the market anticipates.
- Finding the Odds:
- Chance of gain relative to the chance of loss.
- “Meaningful opportunity-risk ratios relate the prospective gain and the probability of achieving it to the prospective loss and the risk that it will materialize.”
- “The wise investor tries to make even money bets when the odds are heavily in his favor.”
- Assumptions:
- The value of any security is the discounted present worth of all future payments.
- A dollar of income from one fully taxable source is worth as much as a dollar from any other fully taxable source.
- It follows that when investors pay more for a dollar of income from one source than they need to pay to get an equivalent dollar of income from another source they are expressing implicitly the opinion that the income stream from the first source will rise faster or dry up more slowly than the income stream from the second source. Otherwise what they do makes no sense.
- “Investors don’t pay different prices for the same thing. When they seem to be doing so they are paying like prices for different anticipations.” — Robert G. Wiese
- Stock prices change based on whether things turn out better or worse than expected.
- Great stock price rises are due to some combination of rising earnings and rising multiples. The same is true of great price declines — a combination of falling earnings and falling multiples. Multiples rise and fall due to widespread shifts in investor sentiment.
- Psychological Factor in Stock Prices:
- “What goes up on a rise in investor expectations can go down on a fall in those expectations. Both can occur without any change in reported earnings.”
- “It is rare for seasoned stocks to have price-earnings ratios much over four times the Dow’s. Hence when a stock sells at 60 times earnings while the Dow is selling at 15 times earnings, the prospective buyer is on notice (a) that his optimism about the stock’s future is widely shared, and (b) that the chances of a further rise in the price of the stock due to a further rise in its relative price-earnings ratio are slim.”
- On Market Trends:
- “It is really not as important, short term, to know what sales and earnings are going to be five and ten years hence as to know what other investors are going to think they will be. In general the longer a trend continues the more people can be found willing to risk their savings on the proposition that it will continue longer still. As a practical matter then we probably should assume that old trends will persist longer than new trends simply because, whether they do or not, more investors will be inclined to assume that they will.”
- “The great mistake made by the public is paying attention to prices instead of to values.” — The ABC of Stock Speculation
- “It is only fair to say that the public rarely sees value until it is most markedly demonstrated to them, and the demonstration comes generally at a pretty high price. It is easier for them, as experience shows, to believe a stock is cheap when it is relatively dear, than to believe it is cheap when it is more than cheap.” — The ABC of Stock Speculation
- Corporate Management:
- Ethical Side:
- Consider the ethics of the people behind a company. Are they there to enrich themselves or enrich shareholders?
- Is the company trying to make the world a better place? Is their sole goal to make a profit?
- Avoid investing with someone who offers something for nothing or has a past history of fraud. Never invest with someone you do not trust.
- Unethical leaders tend to hire similarly inclined people that rot the culture of the company for years.
- “It is unwise to look for a quick turnaround in any organization whose management has demonstrated a lack of moral principle.”
- Diligence, integrity, and a host of other virtues are competitive advantages.
- Egonomics: making every decision on the basis of what it will do for your ego. The true egonimist is always selfish.
- Is the CEO an egonomist? Does s/he promote themselves rather than the company?
- Do they pump money into pet projects that earn a below-average return on invested capital?
- Does invested capital increase annually with no improvement in market share?
- Does reinvesting retained earnings produce a lower profit than if you had invested that money yourself?
- Do they prioritize the company headquarters over sales and earnings? Companies that build monuments to their past are complacent about the future.
- “Business is not an established thing. It is a movement, a progress. Its past means nothing — tomorrow is all that counts. It must not be anchored to old ideas, convictions or standards — or to pride. The biggest problem in business is not to grow old.” — Monuments Rarely Pay Dividends
- A CEO that takes credit for every success without praising their workers is bound to lose workers that aren’t recognized for their achievements.
- Ethical Side:
- “Inflation is the cruelest tax.”
- “Many people have been ruined by debt. Many others have made their fortunes with borrowed money. What makes the difference is simply whether the time bought is used profitably.”
- “When any rule, formula, or program becomes a substitute for thought rather than an aid to thinking, it is dangerous and should be discarded.”
- 4 Ways Stocks Have Produced a 100-to-1 Record:
- Advance primarily due to recovery from extremely depressed prices at bottom of greatest bear market in American history. Special panic or distress situations at other times belong in this group too.
- Advance primarily due to change in supply-demand ratio for a basic commodity, reflected in a sharply higher commodity price.
- Advance primarily due to great leverage in capital structure in long periods of expanding business and inflation.
- Advance primarily due to the arithmetical result of reinvesting earnings at substantially higher than average rates of return on invested capital.
- Rate of Return Needed to 100x:
- 35 years — 14%
- 30 years — 16.6%
- 25 years — 20%
- 20 years — 26%
- 15 years — 36%
- “Long-term capital growth is tied to long-term earnings growth. The only way an investor can get more growth than that is to catch swings in stock market sentiment from optimism to pessimism and back again. If he misjudges those swings he may get a great deal less in capital growth than in earnings growth.”
- People talk more about their winners than their losers. It presents a lopsided perspective of their success.
- Betting against the end of the world, and being wrong, means no one will be around to collect. The best time to invest is “when the world is ending” because things either can only get better or nothing will matter.
- What to Look For:
- Great companies worth owning for the long run reveal themselves in their fundamentals over many years.
- The authors used examples to break companies down by invested capital per share, book value per share, earnings per share, reinvested earnings per share, dividends per share, sales per share, return on invested capital, return on equity, return on book value, and sales per invested capital. Gradual improvement or consistently high rates are shown over many years (10+) in companies that have grown 100x.
- Specifically:
- Reinvesting earnings at a constant or rising rate of return on invested capital. Return on invested capital is above average.
- Buying other companies via stock at a lower multiple than the acquired company’s stock.
- Increasing sales without increasing invested capital.
- Watch out for rising earnings/sales due to rising debt as it carries more risk.
- The key is to focus more on a company’s earning power instead of its stock price.
- “Earning power is a competitive strength. It is reflected in above-average rates of return on invested capital, above-average profit margins on sales, above-average rates of sales growth.”
- Sales to invested capital (sales per dollar invested) — “sometimes gives an early warning of increasing competitive pressures.”
- Recording year-by-year sales growth, profit margins, return on book value, return on invested capital, sales to invested capital, book value per share will reveal changing trends within the company.
- A 10-year record is preferred to see trends.
- Competitive Advantage:
- “No business is so good that it cannot be spoiled if too many get into it. It is vitally important the high rate of return be protected by a “gate” making entry into the business difficult if not impossible. Such gates may be patents, incessant innovation based on superior research and invention, ownership of uniquely advantageous sources of raw material, exceptionally well-established brand names… Just make sure the “gate” is strong and high.”
- 2 Questions:
- How strong is the company’s competitive advantage? Can other companies easily compete for market share?
- How good are the prospects for continued sales growth?
- “Real growth is as simple and certain as arithmetic if the book value of a stock is increased by retained earnings while the rate of return on invested capital remains constant.”
- Importance of buying at low multiples: “If the price of each dollar of earnings rise to 14 times its starting point, the earnings themselves need rise only a little more than seven-fold to produce a stock price advance of one hundredfold.”
- “Anyone who can hold on in the face of all the advice and temptations to make sure of a profit demonstrates a quality of mind quite out of the ordinary.”
- “When you buy a stock with a superior profit margin, an above-average rate of return on invested capital, and sales that are growing faster than the industry’s or the country as whole, you have time on your side.”
- “Good judgment comes from experience. And experience comes from bad judgment.”
- Many investors don’t understand the difference between activity and results. Investing is one of a few pursuits where doing more often leaves you with less.
- Should You Pick Stocks:
- Do my education, training, and contacts in finance and industry equip me to do an above-average job of investing my own money, or would I be playing the other fellow’s game?
- Am I prepared to do the vast amount of screening necessary to find a stock with 100-to-1 potential? Or do I want to concentrate on my business, profession, or hobby and let someone else do the work?
- Am I strong enough financially and emotionally to risk a major investment in one, or even two or three, stock I have chosen myself? Or will I lose faith in my judgment the first time the market goes down, as it often does even in the case of stocks which ultimately advance 100 for 1? Can I walk alone when the going gets rough?
- What if despite all my efforts to buy right I end up buying wrong? Have I the facilities and the know-how to watch the stock, or stocks, of my choice, and its competitors, closely enough to discover my error before all is lost? Do I know the difference between the courage of conviction and mullish balking at admitting and correcting errors?
- Investment Questions:
- Should expectations be realized, how much does it increase the value of the asset?
- How long will it take?
- What is the present value of the expected increase?
- How much of the expected increase is already priced in?
- Is there a large enough difference between the current price and the expected value to be profitable if you’re right and offer a margin of safety if you’re wrong?
- “Since no one can foretell the future with certainty, it makes sense to try to buy when the seller bears the brunt of possible adverse developments and to sell when the buyer is willing to transmute our hopes for the future into present cash.”
- “Stock trading is more a study in psychology than in finance or economics. It sometimes seems to appeal most to those least qualified by temperament to succeed at it.”
- Why most investors fail:
- “To buy right requires vision and courage — faith that is evidence of things not seen, things not susceptible of mathematical proof.”
- “To realize 100 for one requires patience, extraordinary tenacity — the will to hold on.”
