Buying Good Businesses at Bargain Prices

 

All the passages below are taken from Joel Greenblatt’s book, “The Little Book that Beats the Market,” 2010 Edition.

 

I LOVE MOVIES, and The Karate Kid is one of my favorites. Of course, I would like any art form where eating popcorn and candy are part of the deal. But there is one scene in this particular movie that holds special meaning for me. In it, the old karate master, Mr. Miyagi, is supposed to be teaching his teenage apprentice, Daniel, how to fight. The boy is new at school and being bullied by a group of karate-trained toughs. Daniel hopes learning karate will help him stand up to his tormentors and win the girl of his dreams. But instead of teaching him karate, Mr. Miyagi puts Daniel to work---waxing cars, painting fences, and sanding floors.

 

So after a whirlwind of scenes showing poor Daniel working his fingers to the bone---waxing, painting, and sanding---the youth has finally had enough. He confronts Mr. Miyagi and essentially says, "Why am I wasting my time doing these simple and menial tasks when I should be learning karate?" Mr. Miyagi has Daniel stand up from his sanding duties and starts throwing jabs at the young boy while yelling "Wax on! Wax off!" Daniel deflects each jab with the swirling motions he learned from so many hours waxing cars. Next, Mr. Miyagi throws a punch while yelling "Paint the fence." Once again, Daniel deflects the punch, this time using the up-and-down action of painting a fence. Similarly, Mr. Miyagi's karate kick is then stopped by Daniel's expert floor-sanding ability.

 

In effect, by learning these few simple techniques, Daniel has unwittingly become a karate master. Now in good movies, the viewer participates in something called the willing suspension of disbelief. In other words, we kind of know that Ralph Macchio, the actor who plays Daniel in the movie, couldn't really use that waxing thing to defend himself in a dark alley. In the real world, before he could finish his first coat, Mr. Macchio would probably get smacked in the head and drop like a sack of potatoes. But while caught up in a movie, we're ready and more than willing to believe that Mr. Miyagi's simple methods can truly work wonders.

 

Well, I'm going to have to ask you to do a little suspending of disbelief, too. Not because what you're going to learn doesn't make sense. On the contrary, the two concepts in this chapter are simple and obvious. It's just that these two concepts are so very basic, you'll have a hard time believing that such simple tools can turn you into a stock market master. But pay close attention now, and I promise you won't get a smack in the head later.

 

When we last left Jason, the hero of our story, he had just asked us to chew over an exciting proposal. His proposal was simple: Would we want to buy a piece of his wildly successful chain of gum stores, Jason's Gum Shops? (You want some, you know you want some....) But as much as Jason wanted to sell us a piece of his business, giving him an answer wasn't turning out to be so simple.

 

By looking at the income statement that Jason had provided us, it turned out that Jason's chain of 10 gum shops had earned a total of $1.2 million last year---pretty impressive. Since Jason had divided his business into one million equal shares, we had concluded that each share was therefore entitled to $1.20 in earnings ($1,200,000 divided by 1,000,000 shares). At Jason's asking price of $12 for each share, that meant that based on last year's earnings, Jason's Gum Shops would have given us a 10 percent return for each $12 share purchased ($1.20 divided by $12 = 10 percent).

 

That 10 percent return, calculated by dividing the earnings per share for the year by the share price, is known as the earnings yield. We then compared the earnings yield of 10 percent we could receive from an investment in Jason's business with the 6 percent return we could earn risk free from investing in a 10-year U.S. government bond. We concluded, without too much trouble, that earning 10 percent per year on our investment was better than earning 6 percent. Of course, although that analysis was simple, we identified a bunch of problems.

 

First, Jason's Gum Shops earned that $1.20 per share last year. Next year's earnings might turn out to be a completely different story. If Jason's business earned less than $1.20 next year, we wouldn't earn a 10 percent return on our investment and maybe we would be better off with a sure 6 percent from the government bond. Second, even if Jason's business did earn the $1.20 per share next year, or even more, that's only one year. How do we know, or how would we ever know, how much Jason's Gum Shops would earn in future years? It could be a lot more than $1.20 per share, but it could be a lot less, and our earnings yield could drop significantly below the 6 percent we could have earned risk free from the U.S. government. Lastly, even if we had an opinion about future earnings, how could we ever have any confidence that our predictions would turn out to be right?

 

In short, all of our problems seem to boil down to this: It's hard to predict the future. If we can't predict the future earnings of a business, then it's hard to place a value on that business. If we can't value a business, then even if Mr. Market goes crazy sometimes and offers us unbelievable bargain prices, we won't recognize them. But rather than focusing on all the things that we don't know, let's go over a couple of the things that we do know.

 

As we discussed, Jason's Gum Shops earned $1.20 per share last year. At a price of $12 per share, our earnings yield was therefore $1.20 divided by $12, or 10 percent---easy enough. But what if Jason's Gum Shops earned $2.40 per share last year? What if we could still buy a share for $12? What would the earnings yield be then? Well, $2.40 divided by $12 equals 20 percent. Therefore, if Jason's Gum Shops had earned $2.40 per share last year, at a price of $12 per share, the earnings yield would be 20 percent. If Jason's Gum Shops had earned $3.60 per share last year, at a price of $12 per share, the earnings yield would be 30 percent! But it gets easier.

 

Now follow closely because there are only two main points in this chapter and here comes the question that will determine whether you understand the first. All things being equal, if you could buy a share of Jason's Gum Shops for $12, which of those earnings results would you prefer? Would you prefer that Jason's Gum Shops had earned $1.20 per share last year, $2.40 per share last year, or $3.60 per share last year? In other words, would you prefer that the earnings yield calculated using last year's earnings was 10 percent, 20 percent, or 30 percent? Drumroll, please. If you answered that 30 percent is obviously better than 20 percent and 10 percent, you would be correct! And that's the point---you would rather have a higher earnings yield than a lower one; you would rather the business earn more relative to the price you are paying than less! Wax on!

 

Now that wasn't so hard, but here comes the second point of the chapter, which focuses on something a bit different from the first (otherwise, I would be saying the same thing twice, which would be wasting your time, which is something I would never do unless I put it in parentheses). The first point related to price---how much we receive in earnings relative to our purchase price. In other words, is the purchase price a bargain or not? But beyond price, we might also want to know something about the nature of the business itself. In short, are we buying a good business or a bad business?

 

Of course, there are plenty of ways we could define what makes a business either good or bad. Among other things, we could look at the quality of its products or services, the loyalty of its customers, the value of its brands, the efficiency of its operations, the talent of its management, the strength of its competitors, or the long-term prospects of its business. Obviously, any of these criteria, either alone or in combination, would be helpful in evaluating whether we were purchasing a good or a bad business. All of these assessments would also involve making guesses, estimates, and/or predictions. As we already agreed, that's a pretty hard thing to do.

 

So once again it might make sense to first examine some things that we already know. In fact, let's not make any predictions at all. Instead, let's just look at what happened last year. For instance, what if we found out that it cost Jason $400,000 to build each of his gum stores (including inventory, store displays, etc.) and that each of those stores earned him $200,000 last year. That would mean, at least based on last year's results, that a typical store in the Jason's Gum Shops chain earns $200,000 each year from an initial investment of only $400,000. This works out to a 50 percent yearly return ($200,000 divided by $400,000) on the initial cost of opening a gum store. This result is often referred to as a 50 percent return on capital. Without knowing much else, earning $200,000 each year from a store that costs $400,000 to build sounds like a pretty good business. But here comes the hard part (not really).

 

What if Jason had a friend, Jimbo, who also owned a chain of stores? What if you had a chance to buy a piece of Jimbo's store chain, Just Broccoli? What if it also cost Jimbo $400,000 to open a new store? But what if each of those stores earned only $10,000 last year? Earning $10,000 a year from a store that costs you $400,000 to build works out to a one-year return of only 2.5 percent, or a 2.5 percent return on capital. So here's the tough question: Which business sounds better? Jason's Gum Shops, a business where each store earned $200,000 last year and cost $400,000 to build, or Just Broccoli, a business where each store earned $10,000 last year but also cost $400,000 to build? In other words, which sounds better-a business that earns a 50 percent return on capital or one that earns a 2.5 percent return on capital? Of course, the answer is obvious-and that's the second point! You would rather own a business that earns a high return on capital than one that earns a low return on capital! Wax off (or paint the fence or sand something or whatever)!1

 

But here comes the big finish. Remember how I told you this chapter was going to be hard to believe? That by using just two simple tools you could actually become a "stock market master"? Well, believe it. You are a stock market master.

 

How? Well, as you'll see next chapter, it turns out that if you just stick to buying good companies (ones that have a high return on capital) and to buying those companies only at bargain prices (at prices that give you a high earnings yield), you can end up systematically buying many of the good companies that crazy Mr. Market has decided to literally give away. You can achieve investment returns that beat the pants off even the best investment professionals (including the smartest professional I know). You can beat the returns of top-notch professors and outperform every academic study ever done. In fact, you can more than double the annual returns of the stock market averages!

 

But there's more. You can do it all by yourself. You can do it with low risk. You can do it without making any predictions. You can do it by following a simple formula that uses only the two basic concepts you just learned in this chapter. You can do it for the rest of your life---and you can choose to do it only after you are convinced that it really works.

 

Hard to believe? Well, it's my job to prove it. Your job is to take the time to read and understand that the only reason this simple method actually works is that it makes perfect sense! But first, as always, here comes the summary:

 

1. Paying a bargain price when you purchase a share in a business is a good thing. One way to do this is to purchase a business that earns more relative to the price you are paying rather than less. In other words, a higher earnings yield is better than a lower one.

2. Buying a share of a good business is better than buying a share of a bad business. One way to do this is to purchase a business that can invest its own money at high rates of return rather than purchasing a business that can only invest at lower ones. In other words, businesses that earn a high return on capital are better than businesses that earn a low return on capital.

3. Combining points 1 and 2, buying good businesses at bargain prices is the secret to making lots of money.

 

And most important,

 

4. Don’t give money to guys named Jimbo.

 

Note

  1. In fact, unless Jimbo expects those Just Broccoli stores to earn a lot more in the coming years (a presumption that would obviously involve making predictions about the future), it seems pretty clear that Jimbo's business is so bad he shouldn't even be building Just Broccoli stores. If he has a choice of building a new store for $400,000 that will earn him just 2.5 percent each year on his investment or buying a U.S. government bond that will earn him 6 percent on his investment---risk free---what's the point of even building a store in the first place? By opening Just Broccoli stores, Jimbo is actually throwing money away! (Even though it looks like he is earning 2.5 percent on his investment in a new store, in real­ity he is throwing away the added 3.5 percent he could earn by simply buying a risk-free U.S. government bond!)  [pg 39-49]