Brevity. Clarity. Simplicity. Today is not the day for longwinded, muddle-headed, Hegelian-type explanations. This essay contains a number of practical, wealth-enhancing ideas presented in what I hope is a clear, brief, and easily accessible manner.
A great company
A great company is one that is able to invest (ever) increasing amounts of capital (equity + debt) at returns greater than the weighted average cost of that capital. As a rule of thumb, returns on invested capital (equity + debt) greater than 15%, or returns on equity greater than 20%, should fit the bill nicely in South Africa.
Return on capital
The return on capital (abbreviated ROCE or ROIC) is the annual quantum of earnings available for distribution to the debt and equity holders of a company. The debt holders earn interest and the equity holders earn dividends and may or may not experience capital appreciation on their shares.
Cost of capital
Remember the time as a teenager when you asked your parents for money to go to the movies? It wasn’t free was it? You probably had to mow the lawn, wash the car, feed the dog, tidy your room, take out the garbage, help unpack the groceries, be nominated for the Nobel Prize, or all of the above to get access to the movie money. Money is greedy; it wants to be in the hands of those who use it most effectively.
The financial cost of capital is measured in terms of an interest rate and is closely related to the expected risk and return of the planned venture. Woolworths is probably going to get money cheaper than Uncle Bob’s corner shop or Mike’s mechanic outfit.
A great investment
I am confident that there are many ways of making very decent amounts of money from shares. Here I only share some ideas from personal experience.
A great company almost never trades at a fantastic investable price. Most people in the market know the names of the great companies, and consequently these businesses trade at prices that do not lead to above average returns over time. The perfect investment, the sell your car, your house, your pet, your-mother-in-law type of opportunity, happens very rarely, but when it does, you need be wielding an elephant gun. These magical moments of opportunity happen when the collective psychology of the market overwhelms any fundamental reason to expect otherwise. When all you hear and see is emotionality, you should be very rational indeed.
Do not put all your eggs into one basket. In short, that is what diversification is all about. But be careful, not all diversification protects as promised. I would rather have ten great businesses in my portfolio that are economically diversified than multiples of ten where I assume that the shear number of shares that I hold will preserve my capital.
There is no single right strategy for proper diversification. But I would argue that for most people, particularly those who take the time and effort to acquire at least a basic understanding of what they are invested in, a prudent range of shares to hold in their portfolios would be a lot closer to all their eggs in one basket as opposed to having one egg in a hundred baskets. Ten to fifteen shares should be more than sufficient for the investor willing to do his or her homework.
Conclusion: A general state of mind
A great tension exists at the heart of investment practice. To be very good at investing, you need to be immersed in the field. But immersion in the field hides its greatest danger, the fact that you are in the field. You and I use our eyes to see, but how many times a day do we notice our eyes. We buy fancy Hugo Boss or Chanel fragrances to impress our olfactory audiences, but have you noticed that after a few days only the audience is able to enjoy the aroma.
The danger exists that the very person who is supposed to be the most knowledgeable about fundamental investment value will the one who fails to recognise it when it presents itself. For example, mining executives, who presumably know their companies better than most, invested right at the peak, and from the look of it, will be divesting right at the trough of the so-called commodities super cycle.
I think a very effective way of going about seeing the eyes that see, smelling the air that you breathe, or divining the emotionally blinding state of market psychology, is to create distance between you and your regular way of being.
There are many ways to create distance; there is distance by geography, such as a move to Pofadder if Sandton is proving maddening. There is distance by imagination and thought, where you use creativity and analysis to consider the why questions of your profession that you may always have taken for granted. Lastly, there is distance by time, where sometimes the best thing to do is to go for a walk, take a long weekend to recharge, or travel the world by motorcycle. You may laugh, but read “Investment Biker” by Jimmy Rogers and tell me that circling the world on a motorcycle is not at least good for your financial health.