Forum Topics Long term investing--following my north star
Chagsy
2 months ago

Excellent work @Solvetheriddle

I am trying to follow a similar path after years of practice. @Strawman pointed out the Philip Morris fly in the ointment example. In a timely piece Morningstar also covered this example and used the following quote “The long-term return on a stock depends not on the actual growth of its earnings, but on the difference between its actual earnings growth and the growth that investors expected.” They go on to discuss "reverse monopolies" link and being a contrarian.

That doesnt change anything you have said, but does reinforce that the high ROE growth stocks at any price, is not the answer, we still have to find those at reasonable prices. Secondly, whilst I do not consider myself a trader, I am quite happy to invest in low ROE stocks when they are very cheap and exit some 2-3 years later when fully valued. I realise your graph is over ten years and represents a buy and hold approach, which is not something I would consider for this group.

Thank you for the time and effort put into that (and all your other) work. Much appreciated

C

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Solvetheriddle
2 months ago

@Chagsy thanks i appreciate your and everyone's views. a few points on the above

figuratively, I see intrinsic value being more or less a flat line from left to right for the cost of capital companies, while for those companies that can continue to add assets above their cost of capital, intrinsic value moves in an upward path from bottom left to top right. The slope depends on the extent of assets deployed and spreads earned. of course share prices, at any time, can be above or below intrinsic value in both cases. as Buffet says time is to the benefit of the good business, increasing intrinsic value in this case. nothing is easy or simple in investing, thats why we are all here and no plan has a 100% track record- it would be arbed away.

i will look into MO case i must have missed that, although there are always outliers in very general investment process.

re Morning Star, probably speaks to the first para--ie are share prices incorporating too much or too little (above or below intrinsic value). it also reminds me of a quote from one of my old bosses, when I said all we needed to do was pick outcomes that vary from consensus, and he said yes, but how do you do that consistently without inside information? he was right, that was 2004.

thanks for the reply and all the best in 2024


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Solvetheriddle
2 months ago

LONG TERM INVESTING—My North Star

First up this post is about LT investing not speculating or trading. Secondly, as I have stated before, my share portfolio is significant in terms of my net wealth and by far represents my largest asset. The upshot of this is that I must get it right and that means being aware of where I sit on the risk/return spectrum. IMO that means focusing on quality growth names as they can offer the best LT returns if acquired well. Since it is a lull before results season, I thought I would look at long-term returns for a group of quality /growth stocks and compare them to a bunch of what I call go-nowhere stocks, being those stocks that in the LT return around their cost of capital. Is my North Star worthwhile?

Thirdly, if I had the data, time and computer firepower I would do an extensive quant-style study but I don’t, so in this case I have taken a big shortcut but have no incentive to doctor the numbers, far from it.

What I have done I pick a dozen stocks that (sort of) sit comfortably in each group. Then look at SP returns over 10 years. Look at the RoE’s and come to some conclusions. Then I comment on issues with the sample and what can go wrong with the execution.

For the stocks I chose for each sample, I tried to spread the sectoral concentration. Secondly, I also tried to exclude the huge winners or losers in each category. Each stock must have been listed for 10 years or very close.

For the quality growth stocks I choose, CSL, RMD, ALL, TNE, CAR, REA, JHX, DMP, CHC, BRG, AUB, and JBH. I left out the exciting WAAX stocks, WTC, XRO, ALU and also PME. The reason for this is that I think 10 years ago these companies would not have had the record to be quality growth but were on their way there, so inclusion would have biased the results too much. I could have gone mad in health but only included two and tried to spread the rest across various sectors. This was done not to bias the sample. The average Roe for this group is 26% (range 12-35%) but that is a hodge podge of varying duration but includes at least the last 5 years for all.

For the “go nowhere” stocks I again tried to spread the sector selection but found a lot of finance and property so tried to cap them. Secondly, I did not include some of the big disasters such as HLS, SGR, IFL and AMP. The stocks I decided on are all institutional-grade holdings and would be a part of many insto portfolios especially 10 years ago. Those stocks are, WBC, ANZ, SUN, SGP, ABC, BAP, GUD, ORG, ORI, PPT, IPL and LLC. I have been kind including BAP, since it was mainly regarded as a growth stock for much of the last 10 years and its inclusion notably assists returns. The ROE for this group is about 7% but probably around 8% if the Org losses are excluded. 8% puts them right around the usual cost of capital. The range was 5-11%, quite tight.

For each group, I then indexed the 10-year share prices and made an equally weighted index of each, growth and go nowhere. The two charts are below.

cea8092885517e2c3e556b879b2671048fc585.png

Over the 10 years, the growth stocks returned 15% pa before dividends and the “go nowhere” stocks returned 1%. Adding approximate dividends of 1% for growth and 4% for “go nowhere” brings them slightly closer but not much. The usual cycle in economics is regarded as 5 years but I have doubled this to reduce macro noise on these results, such as the big move up and then down post-C19 in growth stocks

Conclusions

What are we looking at here?

To me, this speaks to the difference between growth and value investing. Both are valuation-based but quite different. The LT value of the stock is equity*spread above cost of capital*change in equity deployed. In other words, real value comes from adding assets that return above the cost of capital. For companies that return the cost of capital, book value is their LT valuation, it doesn’t matter what assets they add or subtract, if they don’t change the returns no value is added. That is seen by grouping the stocks and looking at the long term. Generating returns from these styles of stocks is then reliant on buying at a discount to book or attempting to trade the cyclical trends that push earnings above CoC. The big returns are made when you can successfully pick a cost of capital returner that sustainably moves to a positive spread type of business. They do occur but rarely and usually entail a changed business. Value investing is based on the company doing stuff it has done before whereas in growth investing the company must do something extra, and keep compounding.

For growth stocks, the valuation is based on accurately assessing the spread over the cost of capital and the growth in equity. In other words, how much (volume) and at what rates (spread) can the company deploy capital? That is a bit more complicated than value investing.

Usually, a reasonable guess can be made at spread and growth scenarios and with an appropriate margin of safety when buying these stocks a pleasing return can be generated at relatively low risk.

What can go wrong?

The critical assumptions here are knowing what drives the positive spread above the cost of capital and how large the opportunity is for these stocks. The world is a dynamic place and sustainable advantages can disappear and the result can be frightful for returns of growth stocks. An example was A2 milk. A2 was a growth company that had built a reasonably long record of attractive returns, so could be regarded as a quality growth stock. What was probably not appreciated by the market was that despite a lot of theories for how its returns were made, in hindsight, they were based on a low-cost distribution model with the help of some good branding that produced great returns. When that low-cost model disappeared so did A2’s differentiation. Either its spread or growth or both were now threatened. I am not trying to get into a discussion on the ins and outs of A2 but to point out that all business models have an Achilles heel and knowing that, or discovering it quickly, is very important in growth investing as you are usually paying up.

In summary, this short study is an affirmation that the theory does measure up over the long term and evens out over a bunch of stocks. The real message to me is the investing approach for “no growth” and growth stocks are quite different, but knowing your companies in detail, especially their weaknesses is critical. Let the compounding take place but have an idea of what is driving it and a broad idea of what it is worth.

Hope that is of interest to some.

disc I hold 9/12 high roe, none of the low roe at this stage.

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Strawman
2 months ago

Loved this @Solvetheriddle

Reminded me of what Buffett said in his 1992 shareholder letter:

The best business to own is one that over an extended period can employ large amounts of incremental capital at very high rates of return.

The worst business to own is one that must, or will, do the opposite — that is, consistently employ ever-greater amounts of capital at very low rates of return.


Also, I'm increasingly convinced that growth, at least to some degree, is essential for any business to be a good investment. Yes there are some exceptions to the rule but only when the price paid is low enough and management modest enough to avoid reinvestment into waning enterprises.

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Rick
2 months ago

I love this @Solvetheriddle! This is how I’ve been gradually shaping our real life portfolio as opportunities present themselves over the last year. Last week I sold most of our WBC shares and invested the proceeds into IEL. Over 2023 I sold a number of other lower growth, lower ROE businesses to build significant holdings in higher growth, higher ROE businesses such as CSL, RMD, NCK, LOV and LYL. My aim is to establish a well diversified portfolio of growth businesses with ROE consistently above 20% with strong balance sheets. I’m not in a hurry as there always seems to be another opportunity just around the corner.

Cheers,

Rick

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Solvetheriddle
2 months ago

@Strawman Thanks Andrew, if i could send one piece of investing advice back to my 25yo self it would be the above. the great man had it nailed early, if only i could execute like him lol

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GazD
2 months ago

Thanks for taking the time to put this down @Solvetheriddle. It’s this kind of insight and consideration that I value in my subscription to Strawman. Fantastic work.

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shearman
2 months ago

Great post @Solvetheriddle

Mirrors my conclusions as well.

However I still find myself looking for and chasing small 'potential' quality growth stocks before they are really proven - when I should probably just increase my holdings in proven winners. More successful has been buying more low-growth (5-10% cagr) medium quality (ROE=10-15) stocks when the prices are very attractive.

One additional benefit of focusing on quality growth stocks - is that now and again you have the opportunity to pickup some at a significant discount.

Either because the whole market goes on sale for a whole (e.g. Covid, GFC) or becomes pessimistic about individual stocks for a period e,g. RMD

This can add 5-10% additional CAGR over 5 year periods


Recently Ive been using sharesight to look at the impact of returns from individual purchases (i.e. use a test portfolio and enter an individual purchase to see the return) - and to see how returns based on strategies differ

This has led me to the conclusions that there are different strategies I need to employ based on the quality/profile of the stocks.

Ive classified my holdings based on investment strategy and now it looks like this:

  • Wealth Winners - Provide high quality growth stocks (ROE > 20, EPS Growth > 10%) - Buy when prices/PE are right (10-15% undervalued) - Hold nearly forever or until reclassified
  • Potential Wealth Winners - Could be a WW - but not enough history but looks promising - Maintain a modest holding until proven
  • Steady Growth (5-10% rev CAGR), ROE 10 to 15 - Buy when 15-20% undervalued - Sell down when overvalued or position too large
  • Speculative Growth - Rev Growth > 15% - likely loss making micro/small cap - Increase holdings as thesis plays out (keep positions small)
  • Turn Around - Fallen WW or Steady Growth - Buy at significant discount and hold until revalued or reclassified


Whats interesting is looking at my returns by strategy over last 10 years (using Sharesight) - current and sold positions

  • Wealth Winners - 29.34%
  • Potential Wealth Winners - 11.58%
  • Steady Growth - 9.45%
  • Speculative Growth - 2.29%
  • Turn Around - 0.15%


If I run this over different periods (3, 5, 10 years) I get different numbers

But the relative returns for the different strategies are very consistent.

What Im trying to do now is

  • Maximise capital into Wealth Winners
  • Refine my strategies within each classification - and then Ill likely drop those that I cant make work (i.e. Turn Around & Speculative Growth)






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Solvetheriddle
2 months ago

@shearman imo what you are doing is very sensible and can be executed. The Position sizing adjusted for risk is important as well. Focusing on your strengths can change returns a lot.

I did a similar study around 1994 that put stocks in buckets and identified what I was good at and not. i just focussed on what i was good at for the next 10 years.

the results were (as i recall) 1985-2003 0%, then when the strategy changed to be more focused from 1994-2004 generated 20% pa. That cant be all luck.

staying the course is harder than it first appears. good luck to you in 2024!

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Wini
2 months ago

Brilliant @Solvetheriddle!

"The LT value of the stock is equity*spread above cost of capital*change in equity deployed."

This is it, and the most important part is the last part, the delta in equity deployed and its return relative to whole base.

I wrote a blog post in a former life about using the return on incremental equity calculation given that it is the equity we are shareholders are most often contributing to the business:

https://oracleag.com.au/blog/2020/09/07/thinking-incrementally/

Amazingly it hasn't been scrubbed from the internet yet and despite some editing to maximise SEO I think I get the message across decently well.

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Solvetheriddle
2 months ago

@Wini thanks Wini, may the markets treat you well! if my universe was only micros, which of course it is not, my portfolio would look a lot like yours is my conclusion

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Chagsy
7 days ago

I thought I would re-visit this topic - as I am trying harder to identify companies in this category that do not currently have a fully priced premium attached to them.

To add some more weight to the graphs @Solvetheriddle published, I thought I would reproduce a table from a recent presentation I watched from Morningstar about moats.

It basically shows the same result:

0cd5e510f2410c3def0a901bc40d24de558124.png

Here is a list of Morningstar's Wide moat companies (note they only analyse ASX 300 companies I believe):

The big 4 banks, ASX ltd, Auckland International airport AIA, Brambles BXB, Cochlear COH, Computershare CPU, Deterra Royalties DRR, Endeavour Group EDV, Fineos FCL, James Hardie JHX, PEXA group, PXA, REA group, Technology one TNE, The Lottery Group TLC, Transurban TCL, Wesfarmers WES.

Filtering for ROE the best performers are DRR, TNE, JHX, WES, BXB, CPU in descending order, and including only those with a trailing ROE over 20%

(You will note a certain number of these are in @Solvetheriddle 's portfolio - and I'm sure a lot of other peoples too)

Of these only the following appear cheap (and not by coincidence have the lowest ROE) and I have divided these companies into two groups: "fallen angels" and "compounders of the future"

Having identified fallen angels that have decent moats the difficult bit is working out whether the current poor performance is likely to change in the medium term

Currently my fallen angels list is:

ASX - probably not going to lose its regulatory monopoly, short term painful re-structuring, medium- long term will likely generate high returns. Big question is if companies continue to list on ASX, or slowly it gets hollowed out by international take-overs.

AIA - took on a lot of debt during COVID so impaired profitability short term. Medium term will return to high returns

EDV - not sure why this is so cheap, probably because of gaming/hotels exposure?

Th future compounders list:

PXA - building out digital real estate settlement infrastructure in the UK to replicate its near monopoly in Australia

FCL - building out and selling software for Life accident and Health insurance companies, still a few years from profitability.

I have also added to my watch list the following "fallen angel" narrow moat companies:

SKC - short term painful fines and re-opening of hotels/restaurants etc, recovering from COVID induced hit: short-medium term recovery to better returns, but long term should be very strong. Unless they do a Crown.

DMP - actually not that cheap, but if worldwide domination eventuates will be kicking myself



Or maybe just buy a Quality/Moat ETF instead and save yourself all the hard work.


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@Chagsy good work, yes this is my wheelhouse, I own PXA and DMP as my comeback plays--with varying levels of conviction. lol. In fact i am not too sure PXA mgt is up to the execution task, but that is another story.

as you say if you accurately identify a quality company that can consistently add assets above its cost of capital there are two main risks, one is well overpaying, and the other is not recognising soon enough when the secret sauce disappears, that can be very painful because you continue to buy into a deteriorating situation.

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