?Wisdom, is knowing the truth and how to apply it in any given situation?

?To be rational is to reason and act commensurable with natural numbers?

Today I am going to try and answer one simple question. What is a rational price to pay for a business? It depends. Whenever somebody starts an answer with that statement I immediately think that they don?t know the answer. However, in this case it really does depend on the particular individual and the returns he/she is looking for. Also, it depends whether financial returns are the main priority for that person. For example, when Caesar invested heavily in building The Mansions of the Gods in the Armorican Forest, his main goal was not to earn a respectable return on investment for Rome?s coffers. No, it was primarily to rid himself of his long-lasting problem with a little Gaulish Village under the able leadership of Chief Vitalstitistix. You may not have heard about the village or its chief, but you should know the two local heroes, Asterix and Obelix. Anyway, the point is that there are a number of reasons why people invest in certain companies. One of which is to earn an adequate return on investment. For the purposes of this mail I will assume that the primary reason for investing is to earn an adequate return.

What an adequate return constitutes also varies from person to person. That is why I started my answer with ?it depends?. Personally, I wish to earn a return of 15% plus per annum in US dollars. The return you desire is important because it will determine the rational price you can pay for a business. Let?s assume everybody is looking for a return of 15%. When examining businesses, CASH IS KING! It is important that we understand all businesses to be cash machines and that we examine their ability to generate cash. Machine A will produce $15 one year from now and will continue do so every year, ad infinitum. I can pay $100 for Machine A today and my expectations of a 15% yearly return will be met. However, in equities (as in business) cash flows are not that predictable. It is critical to understand that in a 15% world $100 five years from now is worth only $49.70 today. $100 ten years into the future has a present value of only $24.70. This serves as a simple illustration of how the timing of future cash flows affects the price that you pay in the present. The further cash flows are into the future the less you must pay for them. Also, the further they are into the future, the less certain it is that they will actually occur. This is why I try and find companies that have a high initial yield. Yield in this case means the after-tax cash earnings divided by the price you pay for the company. To calculate cash earnings one starts with the operating earnings of the business. You then subtract the money you had to invest in working capital, capital expenditure, interest and taxes. Using a retailer as an example, you simply take your profits, buy more stock or get more on credit from your suppliers, pay for the upkeep of the building, pay the bank and pay the tax man. What you have left is your cash earnings.

Take a recent purchase of mine, JJB Sports Plc, as an example. The company earned a cash yield of 9.8% in its first half of the year. With historical first half earnings less than 40% of full year earnings, I can look forward to an initial yield of at least 20%. However, earnings in the second half could be half of those earned last year. Guess what, even if that?s the case I will still earn 15% in Pounds Sterling. I would be very surprised if this was the case, as the company should at least sustain its first half earnings.

Underlying all of this is the ?margin of safety?. If I buy in at a price that gives me a high initial cash yield I?m in a pretty comfortable position when things start to go wrong. And we know that things have a habit of going awry. However, if things go right I am really styling. There are negatives to JJB ? some are serious - but overall there is still a very good chance that JJB will grow in future.

PizzaExpress Plc is an unfortunate example of the exact opposite. The price I paid (?494m) put my initial historical full year cash yield at 5.4% in Pounds Sterling. I am still comfortably above the 3% I can earn at the bank, but more or less equal to UK treasuries. Despite all its problems, the company should still outperform UK treasuries. However, it is unlikely that I will ever see my required 15%. I have no margin of safety. I did not leave room for error?and things did go wrong. So, the share price took a dive over the last year. Recently I had a face-off with Hugh Osmond. Hugh Osmond is a rich, resourceful and clever man. He wants to buy PizzaExpress, but was only willing to bid ?250m for it. His historical full year yield would have been 10.6% and that is a much better point of departure than my 5.4%. If I?d started from that position I would have had a fighting chance to eventually see my 15% return.

I said in a previous news mail that in investment, ?to be rational? is ?to be wise?. Companies always face various difficulties in achieving their operational and financial goals. It is my speciality as an investor to determine the likelihood that a company will achieve its goals. Only if it achieves those goals will I be able to achieve my investment goals. It is important that I enter the fray with a realistic chance of making my goals. It is a lot easier to shoot for a goal of 15% starting from a position of 20%, rather than 5.4%. It?s not rocket science, is it? However, we like to make things difficult for ourselves, don?t we? We have to be rational in our thought process and then it is as important to actually translate ideas into investment actions. It doesn?t help much to think one way, but act another.

Opportunities will avail themselves. One just has to be patient. Whether the Dow is at 36,000 or the Dow is at 5,000, it doesn?t matter. If there is 15% on the table, take it. When you start at 15% with a company that has a reasonable prospect of growth you can weather the odd recession, war in Iraq or takeover attempt. However, at 5.6% you dread a recession, a war on Iraq and even a resourceful gentleman like Hugh Osmond.

Coming back to our friends in the province of Armorica (this was around 50 B.C.). Caesar thought he could change them by surrounding them with a Roman city. He thought the Roman influence would eventually Romanise them. Unfortunately for Caesar, the Gauls proved that there are some things in life that you cannot change. We have to realise that in investment things never change. Don?t try and fight the rules, rather work with them. Never, ever say that ?This time things are different?. It has been said that those are the most dangerous words in investment. Give yourself a fighting chance and only pay a rational price. As a rule of thumb, I look for an initial yield of 10%-15%, depending on the realistic growth prospects. You can go lower, as Buffett did when he invested at an initial yield of just over 5% when he bought Coca Cola. However, there are very few Coca Colas out there and, unfortunately for me, PizzaExpress is not one of them.

Go get ?em Dogmatix!

Whatever you are up to, I hope it is profitable and ethical!

Mr. B

mail_mrb@yahoo.com

Posted: 2002/11/25 07:53 View Archive