At Frank Capital Management LLC, we invest our clients’ money much differently than the typical investment advisor or financial planner.
In recent years, it has become fashionable for most advisors to spend little time on investment selection. Index funds are the default choice. This makes their job easy: they can determine their clients’ allocations, buy index funds and then move on to other tasks. Basically, set it and forget it. Most advisors spend their days finding new clients, creating financial plans, conducting meetings, and working on estate and tax planning.
This is not our approach. Our clients have entrusted us to care for their money and we invest our own money, including retirement funds, right alongside our clients in the same securities. Therefore, we feel like we should spend the bulk of our time analyzing where their money goes so we can have a high degree of confidence that their assets are in the right place.
It is my view that the investment management industry has lost sight of its purpose and this has led to significant distortions in the stock market. I will elaborate more on this in later posts.
Our investment philosophy, value investing, is all about analyzing stocks from a real-world business perspective, as if you were a businessman looking to buy an entire business.
Here is a highly simplified (but informative) example that shows how the price one pays for a business determines the eventual return.
Suppose there is a local Italian restaurant in your neighborhood that businessman Mike is interested in purchasing.
The restaurant earns $100,000 per year in profits.
Mike approaches the owner, Sal, and he agrees to sell him the restaurant for $1 million.
Therefore, Mike’s return on his investment is 10 percent per year: $100,000/$1,000,000 = 10%
This assumes that the restaurant’s profits are constant at $100,000 per year.
If Mike is successful at running the restaurant and increases the annual profits to $110,000, then the return on his investment increases to:
$110,000/$1,000,000 = 11% per year
This assumes that Mike did not have to spend any money to increase the restaurant’s annual profits from $100,000 to $110,000.
The opposite it true if the annual profits fall. Then Mike’s annual return drops accordingly.
Notice one interesting fact: Mike spent or borrowed $1,000,000 to buy the restaurant. He is making $100,000 per year, but that does not factor in his taxes or any cost for improvements at the restaurant. So, assuming for example, that the profits stay constant, it will take him 10 years just to earn his $1 million back. He hasn’t made a penny, and he’s been working hard for a decade. Of course, if the restaurant continues to generate profits, he now has a business that he can turn around and sell to another buyer. But, there is a real risk that the business will fail or profits will decline. Business is difficult, competition is fierce, and it is very hard to keep an enterprise afloat for a decade or more. Therefore, one view of risk is having a very long payback period on your initial purchase price.
What causes a long payback period? A high purchase price relative to profits.
There are situations where it makes sense to pay a high price relative to current profits, because a business is growing quickly and one has a high degree of confidence that this growth will continue for many years.
But, there are no guarantees. So even a business that looks unassailable can get blindsided by changing technology, shifting customer preferences, or unexpected competition.
Now, consider what would happen if Mike paid $2,000,000 for the restaurant instead of $1,000,000, while the annual profits were still the same at $100,000:
$100,000/$2,000,000 = 5%
Now Mike’s return is only 5% per year. Is that good? Well, it depends. If Mike can invest that money in a corporate bond of a financially stable company and receive 5%, the bond is a much better option because he does not have to do any work and he can collect the interest. Plus, there is much less risk investing in a large, multinational company than a small, local business.
However, if the restaurant is doubling its profits every year, then it might be an excellent investment, even at $2,000,000 and a current 5% return on investment because future profits will be $200,000, $400,000, or even more.
The goal of this exercise is to highlight how the basic arithmetic of investing works. Investing is simply laying out cash today for the hope of receiving more cash in the future. The higher the price pays for a business relative to the yearly stream of profits (all else equal), the lower the return. The lower the price, the higher the return.
So, what does this have to do with stock market investing? The same principles work in practice, whether you are buying a local restaurant or buying a piece of a multinational corporation in the form of a stock that trades on the New York Stock Exchange, NASDAQ, or any international market. If you buy at an intelligent price (i.e. a price rooted in conservative, real-world business values) and the business grows over time, eventually the stock market will recognize that value and you will make money. If the price you pay is too high relative to the company’s earnings, then your investment will likely generate poor returns.
While all this seems elementary, I believe it is extremely overlooked in today’s markets. I will show you why in subsequent posts.