The Floating University

Transcript Page 2

You also want businesses that are not particularly sensitive to outside factors, so-called extrinsic factors that you can’t control.  So if a business will be affected dramatically if the price of a particular commodity goes up or if interest rates move up and down or if currency prices change.  You want a company that is fairly immune to what is going on in the world and I'll use my Coca Cola example.  I mean if you think about Coca Cola it’s a product that has been around probably 120 years.  Over that period of time there have been multiple world wars.  There has been all kinds of you know, development of nuclear weapons, all kinds of unfortunate events and tragedies and so on and so forth, but each year the company pretty much makes a little bit more money than they made before and they’re going to be around and you can be confident based on the history that this is a business that is going to be around almost regardless of whether interest rates are at 14%, whether the US dollar is not worth very much or the price of gold is up or down.  Those are the kind of companies you want to invest in, in the long term, businesses that are extremely immune to the events that are going on in the world.

Another criteria, if you think back to our lemonade stand company, as we grew we had to buy more and more lemonade stands.  Now those lemonade stands only cost $300 each, but imagine a business where every time you grew you had to build a new factory to produce more and more product and those factories were really expensive.  Well that company might generate a lot of cash from the business, but in order to grow you’re going to have to just reinvest more and more cash into the business.  The best businesses are the ones where they don’t require a lot of capital to be reinvested in the company.  They generate lots of cash that you can use to pay dividends to your shareholders or you can invest in new high-return, attractive projects.  

So the key here is low capital intensity, so let’s talk about a low capital intensity business.  Maybe the best way to think about a low capital intensity business is to think about a high capital intensity business.  If you think about the auto industry before you produce your first car you have to build a huge factory.  You’ve got buy a lot of machine tools.  You have to make an enormous investment before you can send your first car out the door and those machine tools wear out over time and as you make more and more cars you have to invest more and more in the factories, so it’s a business that historically has not been very attractive for the owners of the business.  If you looked at the price of General Motors’ stock 50 years ago it actually hasn’t changed meaningfully even up until the last several years before it went bankrupt.  If you ignored the most recent period up through the bankruptcy of GM very few people made money investing in GM over a 40 or 50 year period of time and the reason for that is that GM constantly had to reinvest every dollar that they generated to build better and better factories so they can be competitive.  

If you compare that to Coca Cola while Coca Cola there are bottling companies around the world a lot of those bottling companies aren’t even owned by Coca Cola.  What they’re really doing is they’re selling a formula and in exchange for that formula they get a royalty on every dollar that is spent on Coca Cola.  Those are the better businesses. 

Another good example might be American Express.  If you think about the American Express card when you take your American Express card and you buy something American Express card gets a few percent of every dollar that you spend.  So you put up the capital and they get a several percentage point return on that.  They get 3% of so of what you spent.  So businesses where you own a royalty on other people’s capital are the best businesses in the world to invest in.

I guess the last point I would make is that if you’re going to invest in public companies it’s probably safest to invest in businesses that are not controlled.  A controlled company is kind of like our lemonade stand business that we took public.  The problem with a controlled company unless the controlling shareholder is someone you completely trust, unless there is someone that has a great track record for taking care of so-called minority investors, the non-controlling shareholders it can be a risk of proposition to invest in that business because you’re at the whim of the controlling shareholder and even if the controlling shareholder today is someone that you feel comfortable with there is no assurance that in the future they might sell control to someone else who is not going to be as supportive of the shareholders of the business.  So it’s not that you just—you can simply have a profitable business and a business that has done well.  You have to make sure that the management and the people that control the business think about you as an owner and are going to protect your interests.  So these are some of the key criteria to think about.

The Psychology of Investing and Mutual Funds

Now when are you ready to start investing money?  My guess is you’re a student.  You probably have student loans.  Perhaps you even have some credit card debt.  You’re going to graduate.  You’re going to get a job.  So you don’t want to jump right in and while you have a lot of debt outstanding start investing in the stock market.  The stock market is a place to invest when you’ve got a good—you have money you can put away that you won’t need for 5 years, maybe 10 years.  So if you’re paying relatively high interest rates on your credit cards you definitely want to pay off your credit cards first before you think about investing in the stock market.

You student loans are probably lower cost than your credit cards, but again here my best advice would be if your student loans are costing you six or seven percent well if you pay them off it’s as if you earned a guaranteed six or seven percent return and you’re just better off getting rid of your credit card debt and even your student loan debt before you commit a lot of material amount of money to the stock market.
So what do you do with your money while you’re waiting to invest?  The answer is you pay down your debt and you want to have—even once you’ve paid off your credit card debts, perhaps you paid down your student loans, you want to have enough money in the bank so that even if you were to lose your job tomorrow you’ve got a good 6 months, maybe even 12 months of money set aside.  So these are some pretty high standards and obviously therefore these make it harder to start investing earlier, but the safest course of action in order to be a successful investor is be as—have as little debt as possible.  Be comfortable having some money in the bank, so if you lose your job tomorrow you can live until to find your next opportunity and once you’ve achieved those goals then put aside money that you don’t need to touch.  If you can do that then you can be a successful investor. 

So let’s talk a little bit about the psychology of investing, so we’ve talked about some of the technical factors, how to think about what a business is worth.  You want to buy a business at a reasonable price.  You want to buy a business that is going to exist forever, that has barriers to entry, where it’s going to be difficult for people to compete with you, but all those things are important, but even—and a lot of investors follow those principles.  The problem is that when they put them into practice and there is a panic in the world and the stock market is heading down every day and they’re watching the value of their IRA or their investment account decline the natural tendency is sort of to do the opposite of what makes sense.  Generally it makes sense to be a buyer when everyone else is selling and probably be a seller when everyone else is buying, but just human tendencies, the tendency of the natural lemming-like tendency when everyone else is selling you want to be doing the same thing encourages you as an investor to make mistakes, so a lot of people sold into the crash of ’87 when in fact they should have been a buyer in that kind of environment.  

So that’s why I talked before a little bit about why it’s very important to be comfortable.  You want to be financially comfortable.  If you have student loans you want to have a manageable amount of debt.  You probably don’t want to be paying any—you don’t want to have any revolving credit card debt outstanding.  You want to have some money in the bank because if you’re comfortable then the money that you’re risking in the stock market is not going to affect your lifestyle in the short term.  As long as you don’t need that money tomorrow you can afford to deal with the fluctuations of the stock market and the fluctuations, depending on who you are can have a big impact on you.  People tend to feel rich when the stocks are going up.  They tend to feel poor when the stocks are going down and the reality is the stock market in the short term is what Ben Graham or even Warren Buffet called a voting machine.  Really stock prices reflect what people think in the very short term.  If affects the supply and demand for investors, buying and selling stocks in the short term.  Over the long term however, stocks tend to reflect the value of the businesses they own.  So if you’re buying businesses at attractive prices and you’re owning them over long periods of time and those businesses are growing in value you’re going to make money over a long period of time as long as you’re not forced to sell at any one period of time.

To be a successful investor you have to be able to avoid some natural human tendencies to follow the herd.  When the stock market is going down every day you’re natural tendency is to want to sell.  When the stock market is actually going up every day your natural tendency is to want to buy, so in bubbles you probably should be a seller.  In busts you should probably be a buyer and you have to have that kind of a discipline.  You have to have a stomach to withstand the volatility of the stock markets.  

The key way to have a stomach to withstand the volatility of the stock market is to be secure yourself.  You’ve got to feel comfortable that you’ve got enough money in the bank that you don’t need what you have invested unless—for many years.  That’s a key factor.  

Number two, you have to recognize that the stock market in the short term is what we call a voting machine.  It really represents the whims of people in the short term.  Stock prices are affected by many things, by events going on in the world that really have nothing to do with the value of certain companies that you’re investing in, so you’ve got to just accept the fact that what you own can go down meaningfully in value after you buy it.  That doesn’t necessarily mean you’ve made an investment mistake.  It’s just the nature of the volatility of the stock market.

How do you get comfortable?  Well the way you get comfortable with the volatility is you do a lot of the work yourself.  You don’t just buy a stock because you like the name of the company.  You do your own research.  You get a good understanding of the business.  You make sure it’s a business that you understand.  You make sure the price you’re paying is reasonable relative to the earnings of the company and we talked before a little bit about earnings and how to look at a value of a business by putting a multiple on earnings.  A more sophisticated way to think about a business is to—the value of anything is actually the amount of cash you can take out of it over a very long period of time and people do build models to predict how much cash a business will generate over a long period.  That is probably something a little bit more complicated than we’re going to get into for the purpose of this lecture, but maybe another way to think about it would be helpful.

So when you by a bond and you get an interest rate, so today the 10 year Treasury pays about 3%.  You’re earning 3% on your investment.  When you buy a stock that’s trading at a multiple of its profits or a so-called PE ratio or a price to earnings ratio let’s say of 10 times it’s very similar to a bond.  In fact, if you flip over the PE ratio, you put the E on top, what the business is earning and you put the price that you’re paying for the stock on the bottom it’s what the earnings are per share over the price you get what’s called an earnings yield and you can compare that earnings yield to for example the 10 year Treasury, so a company trading at a 10 PE is actually trading at a 10% earning yield, so you can actually think about stocks or buying equity in a business as very similar to buying an interest in a bond.  The difference is in the bond you know what the coupon is going to be.  You know that 3% interest rate every year for the next 10 years.  With stock you don’t know what the coupon is going to be.  The coupon in the stock is how much profit it earns and you can try to project that profit based on the history of the business and what the prospects are, but that profit is going to move up and down every year.  Now hopefully the long term trend is up and so the way I think about the decision between buying a bond or buying a stock is I want to make sure that the earnings yield, that earnings per share over the price I'm paying for the stock is higher than what I could get owning a Treasury and that earnings yield is something that’s going to grow over a long period of time.

Now if you had a business that was growing at a very, very high rate very often—or growing its profits at a very high rate, very often people are prepared to pay a pretty high multiple of those profits.  Why, because they expect that earnings yield to grow, so if you had a business you might even pay—it might be cheap some day to buy a business at 30 times its profits or a 3% or a 3.3% earnings yield if you think that 3.3% is going to grow at a high rate and eventually get meaningfully higher to a 5, a 6, a 7, a 8 or 10 percent rate.  Those kinds of investments are much riskier.  The higher the multiple generally the higher the risk you take because you’re betting more on the future of the business.  You’re betting more on the future profitability.

So my basic piece of advice in recommending the MacDonald’s and the Coca Cola’s of the world are to find businesses that where you’re going in yield your earnings yield is high enough that you don’t need to be right about a very high rate of growth into the future in order to earn attractive rate of return.  

Okay, so the few key success factors for being an investor in the stock market are one, do the homework yourself.  Make sure you understand the companies that you’re investing in.  Two, invest money that you won’t need for many years and three, limit the amount of—don’t borrow money certainly to invest in the stock market and limit that amount of leverage, if any, that you have as an investor.

Okay, so after this brief 40 minute lecture I wouldn’t just jump in immediately and start investing in the stock market.  You have some work to do.  There is some books you can read and we’re going to provide you with a list of recommended books at the end of the lecture that will help you learn more about investing.  Almost everything you need to know about investing you can actually read in a book.  I learned the business from reading books as opposed to reading books and the experience associated with starting small and investing in the stock market.

Let’s say this is just not for you.  I don’t want to invest, buy individual stocks.  It just seems too risky.  I don’t have the time to do my own research.  What are your alternatives?  Well you alternatives are to outsource your investing to others.  You can hire a money manager or you can hire a group of money managers and there are a couple of different alternatives for a startup investor.  The most common alternative is mutual fund companies.  So what is a mutual fund? 

A mutual fund is I guess technically it’s a corporation, but where you buy stock in this corporation and the manager selects a portfolio of stocks.  So what they do is they pool together capital, money from a large group of investors.  So say they raise a billion dollars and they take that money and they invest in a diversified collection of securities.  Now the benefit of this approach is that with a tiny amount of money, even less than $1,000 you can buy into a diversified portfolio managed by a professional manager who is compensated to do a good job for you investing in the market.  So mutual funds are a good potential area for investment.  The problem is there are probably 7, 8,000, maybe 10,000 different mutual funds and some are fantastic and some are not particularly good, so you need to do research to find a good mutual fund manager in the same way that you need to find individual stocks, so it’s not just the easy thing of just invest in mutual funds.

So here are a few key success factors in identifying a mutual fund or a money manager of any kind to select.  Number one, you want someone who has an investment strategy that makes sense to you; you understand what they do and how they do it.  They’re not appealing to your insecurity by using complicated words and expressions that you don’t understand.  If they can’t explain to you in two minutes what they do and how they do it and why it makes sense then it’s a strategy you shouldn’t invest in.  Number two and this is not necessarily in this order.  This probably should be number one, is you want someone with a reputation for integrity.  Again if you’re starting out you probably want to invest in some of—a mutual fund that is sponsored by some of the larger mutual fund complexes as opposed to a tiny little mutual fund that is privately—by a mutual fund company that you’ve never heard of.  There is some benefit in the larger institutions that have—you can be more confident that they’re not going to steal your money.  You want someone, an approach where the investor invests money on the basis of value.  Now this sounds kind of obvious, but value investing has a very long term track record and there are other kinds of investing including technical investing where people are betting on stocks based on price movements, but I highly recommend against those kind of approaches.  So you want someone making investments where they’re buying companies based on their belief that the prospects of the business will be good and that the price paid relative to what the business is worth represents a significant discount. 

You want to invest with someone that a long term track record and I would say 5 years is the absolute minimum and ideally you want someone who has 10, 15, 20 years of experience investing in the markets because there is a lot that you can learn being a long term investor in the market.  You want someone who has a consistent approach, where they haven’t changed what they do materially year by year, that they have a stated strategy that they’ve kept to thick and thin that has enabled them to earn an attractive return over their lifetime as an investor and I always say in some way most importantly you want someone who is investing the substantial majority of their own money alongside yours.  Obviously it shouldn’t be that they’re investing your money.  This is what they do for you, but for their money they do something meaningfully different.  You want someone whose interests are aligned with yours.  If it’s a mutual fund you want them to have a lot of money in their own mutual fund.  If it’s a hedge fund, which is a privately sold fund for investors who have higher net worth you want a manager who is investing alongside you as well.  

I have a strong aversion to strategies that require the use of leverage, so in the same way you want to invest in companies that use very little debt you want to invest in investment strategies that you very little leverage.  If you can avoid leverage and invest in high quality businesses or invest with high quality managers it’s hard to lose a lot of money versus the use of leverage.  Lots of money can be lost.

Now in the same way when you’re building a portfolio of stocks where you don’t want to put all of your eggs in one basket and you want a reasonable degree of diversification and the more sophisticated, the more work you do, the higher the quality the business is you invest in the more concentrated your portfolio can be, but I would say for an individual investor you want to own at least 10 and probably 15 and as many as 20 different securities.  Many people would consider that to be a relatively highly concentrated portfolio.  In our view you want to own the best 10 or 15 businesses you can find and if you invest in low leverage, high quality companies that’s a comfortable degree of diversification.  If you invest with money managers you probably don’t want to put all your eggs in one basket there either and here you probably want to have two or three different, perhaps four different alternative, mutual funds or money managers, so again there you have some degree of diversification in your holdings.

Finance in Our Lives

So we spent the hour.  We started with a little lemonade stand company and the purpose of that was to give you some of the basics on how to think about a business, where the profits comes from, what revenues are, what expenses are, what a balance sheet is, what an income statement is, how to think about what a business is worth, how to think about what the difference between what a good business is versus a bad business, how debt offered is generally higher, actually lower risk, but lower return, how equity investors or investors who buy the stock or the ownership of a business have the potential to earn more or lose more and we use that background as a way to think about-

We use that as the—just as the basics to get someone of the vocabulary to think about investing and we talked about investing in the stock market.  We talked about ways to think about how to select investments, how to deal with some of the psychological issues of investing.  We covered a fair amount of ground in a relatively short period of time. 

Now I entitled the lecture Everything you Need to Know about Finance and Investing in Less Than an Hour.  Well it really isn’t everything you need to know.  It’s really just an introduction and hopefully I didn’t mislead you, induce you to watch this for an hour, but there is a lot more that can be learned and there is wonderful books that can teach you on the topic, so I think what is interesting about investing whether you choose this as a fulltime career or not if you’re going to be successful in your career you’re going to make some money and how you invest that money is going to make a big difference in the quality of life that you have and perhaps that your children have or the kind of house you’re able to buy or the retirement that you’re going to be able to enjoy and we talked about the difference between a 10% return and a 15 and a 20% return over a very long lifetime and what impact that has in terms of how much wealth you create over the period, so investing is going to be important to you whether you like it or not and learning more about investing is going to have a big impact on your quality of life if money is something that you need in order to meet some of your goals.  

So I recommend this as an area worthy of exploration and the more you learn about investing the more—these same concepts while they’re useful in deciding how to invest your portfolio they’re also useful to you in thinking about decisions like buying a home, making decisions in your line of work, if you’re a lawyer whether to hire additional people, these kinds of calculations and thought processes are helpful and they’re helpful in life and I recommend that you learn more.  So take a look at the reading list and good luck.