The Consumer Is Not Dead

One who is seeking fantastic medium to long term returns in the global financial markets should remember these five words: the consumer is not dead. This can mean a lot of things to a lot of investors as to what sectors or companies are best to allocate capital, but most importantly, this means that despite the current volatility in the Mideast, the continued tapering discussions and talk of an “overvalued” market, the consumer, which accounts for two-thirds of US GDP and trillions of dollars in global spending, will continue to push global growth.

From 2012 to 2014, the rate of change in the annual growth rate in global annual disposable income per household in real terms rose over 250%. Western Europe seems to be on the right track in terms of reducing unemployment and boosting growth, although it is expected to be the region with the lowest rate of growth in real household disposable income in 2014, at 0.3% year-on-year in real terms. This positive, albeit modest, rate of growth will be a much welcomed turnaround for households in the region who saw their real annual disposable income fall every year since 2007.

Looking at emerging markets, the data is even more incredible. In 2010, the emerging markets accounted for $12 trillion in spending. In 2025, they are expected to account for about $30 trillion of spending, or nearly half of global spending. Obviously, the forecasts of consumer spending, income and demographics of this size can vary, but there’s little debate about the direction. According to the McKinsey Global Institute, the ranks of the global consuming class will swell from about 2.4 billion today to 4.2 billion by 2025, when the world’s population is expected to be about 7.9 billion. In other words, for the first time in history more people will belong to the middle class than living in poverty, according to McKinsey.

Latin America and Asia are obvious players to watch. From 1990 to 2007, the number of middle-class households in Latin America has increased from 56 million to 128 million, according to a 2011 analysis by the United Nations Economic Commission for Latin America and the Caribbean. Moreover, research from McKinsey suggests more than 75 percent of China’s urban consumers will have, in purchasing-power-parity terms, the equivalent average income of Brazil and Italy by 2022. Just 4 percent of urban Chinese households were within that level in 2000—but 68 percent were within it in 2012. In the decade ahead, the middle class’ continued expansion will be powered by labor-market and policy initiatives that push wages up, financial reforms that stimulate employment and income growth, and the rising role of private enterprise, which should encourage productivity and help more income accrue to households. Should all this play out as expected, urban-household income will at least double by 2022.

What does this all mean for the investor considering sectors and individual companies?

There isn’t a universal answer to this question, but there are 4 major sectors that are directly affected by consumer incomes and those are the areas that have my attention. Global consumer finance, healthcare (SRCL), consumer non-cyclicals (BUD) and pharmaceuticals will be best positioned over the next decade given these fundamental drivers. In the international pharmaceutical business, developing countries are not called emerging markets. They’re called “pharmerging” markets. Such countries are expected to significantly increase their spending on medicine over the next four years, accounting for about 70% of the projected increase in sales for the leading pharmaceutical companies through 2017.

One of the most important lessons I have learned in the years I have been investing is as follows: given the status quo, a company’s technical history reflects its business model. Look at a company like General Mills (GIS), Colgate-Palmolive (CL) or Church & Dwight (CHD). These companies are in the fast paced consumer non-cyclical space, heavily tied to global household incomes, rising populations and the growth of emerging markets. Despite wars, recessions and bubbles across the globe, the fundamentals for these companies have been intact for the last 40 years and it seems that they will be +20 PE stocks perpetually. These companies’ stock charts are virtually straight lines averaging 12.6%, 13.3% and 36.9% CAGR excluding dividends respectively over the last 10 years, making the recession of 2008-2011 nothing but a blip. If an investor had held just these 3 stocks in their portfolio over the last 35 years, he would’ve beaten the S&P 500 by more than 4000%. What does this mean for the future? I obviously cannot provide an answer to that but needless to say I don’t see a reason why the next 20 years for these companies will be that much different given their business models and industry fundamentals.

Overall, sometimes the most obvious factors provide for the best investment ideas. Continue to look for global mid-cap companies attacking the global consumer for the best long term results.

3 Things To Think About When Investing In Startups

Recently I was out to dinner with a group of friends and one of them said to me: “Hey man I’ve invested in this incredible startup. You should really check it out and consider getting in.” This is a line that I have been hearing with increasing frequency over the last year and it is usually followed by some variation of “I’m so excited” or “they are doing something totally awesome”. As an investor in a tech startup I must admit that I too have fallen victim to such exuberance in the past but now with a bit more experience my attitude to such things has begun to change from one of blind optimism to one of realism or perhaps dare I say it (gasp) skepticism.

Why should we be skeptical when evaluating the merits of investing in a young company? We all know the entrepreneurial success stories that the media reports about ad nauseum; the Ubers, the WhatsApps, the AirBNBs, the Facebooks, the Twitters that went from zero to hero valuations at breakneck speed making their early investors wealthy in the process. In addition, it has become easier than ever for us to invest in such early stage companies through the proliferation of such ventures as well as online crowd funding platforms. In fact, the glamorous tales attached to these stories have become the stuff of legends immortalized by the news media and even Hollywood. Pay attention to the media and you could be led to believe that these golden boys are being minted everyday and thus the last thing you want to do is miss the next boat to adventure, freedom and prosperity. Time to jump aboard….right?

Make no mistake investing in a startup can be very lucrative as returns can go as high as 100 times your initial investment. But you can also lose your entire initial investment. So before you drink the Kool Aid and get into “the game” be aware of the following:

1) Are you ready and willing to lose every penny of your investment?

The bottom line is that making a startup successful is extremely difficult work. Contrary to the small statistical samples of success touted by the media, studies undertaken by Harvard Business School indicate that 3 out of every 4 venture backed start-ups fail to return investor capital. The numbers for tech startups are even worse at a 90% failure rate. Therefore, it is important to remember the precarity of any early success founders use as investor bait. For start-ups things can change very quickly and when things go wrong you probably won’t get any notice. Some common issues to be wary of are: What if the competition launches a new and better product which threatens the early traction the company has attained? (Not to mention that it has never been easier to launch a tech company given the availability of cheap developer tools and platforms.) What if Google or Facebook enter the space? What if another recession hits? What if one of the startup’s anchor clients decide to leave the platform? What if the company has a bad month of sales and can no longer meet expenses?

These very real possibilities beg the question: What kind of investor are you? As Dan Martell one of Canada’s top angel investors would say: “If you don’t have $150,000 you’re willing to put on black in Vegas and roll the dice, then you shouldn’t be angel investing.” To invest in startups requires a very high-risk tolerance and if you are not ready to write off your entire investment then look elsewhere.

Risk mitigation tips:

If you still want to invest I suggest investing no more than 10% of your money in startups and not investing it all in any single startup. Instead, it is quite possible, given the proliferation of online platforms, to invest equally in over 5 ventures enabling one winner to make up for any losers.

2) Are you going to need your money any time soon?

In investing parlance there is a crucial concept called liquidity. What this refers to is the degree to which an asset or security can be bought or sold on the market without affecting its price. In the case of startup shares there will be little or no liquidity and thus if you want to sell your shares you probably can’t or if you can only at a steep discount. Most likely, the only way you can get out is after the company has a liquidity event (IPOs or acquisitions) or exit (someone buys the shares hoping to make a profit during a round of financing).

The crucial takeaway is that these events take time to occur (often 3-5 years and sometimes even 10, if ever). Furthermore, be aware that although most companies die around 20 months after their last round of financing raising $1.3 million, many start-ups limp on for years, out of the public eye but still attached to the intravenous of early investor money. This is tied to the “hypomania” that many entrepreneurs suffer from that can be characterized by immense self-confidence, recklessness and over-optimism.

Risk mitigation tips:

Bone up on your behavioural psychology and spend time evaluating the personality of the founders. What kind of people are they? What kind of exit do they envision and how feasible is it? Also be prepared to lock up your investment for the next 5-7 years.

3) Be honest with yourself about your own business experience and expertise

We simply can’t know everything about everything and to be a successful startup investor it is essential to have a solid understanding of the business that you are investing in. This is the crux of good investing as without a good working knowledge of the performance metrics that matter in the particular industry or market niche within which the startup is operating you are setting out to learn a potentially painful lesson.

Risk mitigation tips:

If you are dead set on investing in a startup, first, try to create a list of what you know. Do you work at an advertising company, an online retailer, a medical technology company or a social media company? You may find that you know more than you think. Do your research and try to connect what you know to a startup that is trying to make something work in an industry you understand. This will help you make better decisions and may also allow you to help the young company grow once you have invested. Finally, if you haven’t the slightest idea about how to value a company I would strongly suggest taking an online course or at least reading a textbook on valuation and corporate finance.

Simply put, investing in a startup can certainly be a rewarding learning experience yet it is important to be prepared and to approach “the next big thing” with a healthy level of skepticism.

How History Can Help You Beat The Market Over The Long Run

In 2001, the Oracle of Omaha made a fantastic speech to the MBA students of the University of Georgia (seen here) and one specific example he gave caught my attention. In 1950, Mr. Buffett bought half an interest in a Sinclair Gas station with a friend who was in the Naval Guard. In the early 1950s the station was not doing well and Mr. Buffett eventually lost his entire investment, which at that time was roughly $2000. However, in his speech Mr. Buffett indicated that the true cost of his investment was not $2000, but rather close to $6 billion (in 2001 dollars).

The Oracle has not made many blunders when it comes to capital allocation but this small example got me thinking about the powers of compounding and the drastic effects of opportunity costs. The most famous example of compounding is Peter Minuit who was the Director of the Dutch colony of New Netherland from 1626 until 1633. History has it that he purchased the island of Manhattan from the Native Americans on May 24, 1626 for goods valued at 60 Dutch guilders, which in the 19th century was estimated to be the equivalent of US$24. The island of Manhattan today is worth roughly $9 trillion which means that his initial investment has compounded at an estimated average rate of return of over 7% per year for the last 388 years.

There are many other real life examples of incredible wealth creation by very smart investors who intuitively understood opportunity costs and the effects compounding. One of the most successful investors is Mr. Theodore R. Johnson who was an employee of the United Parcel Service. Mr. Johnson never made more than $14,000 a year, yet managed to plough every penny of his annual savings into only one stock – UPS. When he reached the age of 90, he shocked his relatives and friends by announcing that his net worth was a little over $70 million. Mr. Johnson also re-invested all dividends earned into UPS stock.

Another brilliant investor is none other than Shelby Cullom Davis. Mr. Davis received his bachelor’s in Russian history at Princeton (1930), his master’s degree at Columbia (1931), and his doctorate in political science at the University of Geneva (1934). He worked many odd jobs and was also a freelance writer and author. Starting at age 38, he took $50,000, provided by his wife Kathyrn, and amassed it into a $900 million portfolio in 47 years. This amounts to an annual compounded rate of return of over 23% during that time span. Mr. Davis always bought on margin (which undoubtedly helped his returns) but what’s incredible about Mr. Davis is that he only invested in one particular industry, which was insurance. Mr. Davis was relentless in his study when searching for insurance stocks. He largely focused on fundamentals before choosing his investments, looking for a solid balance sheet and making sure the insurer did not hold risky assets like junk bonds. He then focused on management quality and made trips to meet with the management team. By the mid-1950’s he held up to 32 insurance companies, and by the end of his life had amassed large stakes in AIG, AFLAC, and Chubb. He even bought a piece of GEICO when it was being left for dead and a young Warren Buffett bought a large stake in the business for pennies on the dollar. Mr. Davis also lived very frugally, often never writing anything down in order to save paper. His extreme frugality helped him to save every penny he could to invest in “compounding machines,” as he called them.

However, my favorite real life example is Ms. Anne Scheiber, who is possibly the greatest investor of all time. Ms. Scheiber lived quietly in her rent-stabilized studio apartment on West 56th Street that was bereft of luxuries: paint was peeling, the furniture was old and dust covered the bookcases. She walked everywhere, often wearing the same attire. She worked for the I.R.S. for 23 years as a tax auditor, leaving the bureau in 1944 with a total savings of $5,000. Ms. Schieber never made more than $4,000 a year, and never received a promotion in her entire career.

Over the next half century, she parlayed that $5,000 into a portfolio of blue-chip stocks that included Coca-Cola, Paramount, Schering-Plough and re-invested all dividends. On January 9th 1995, at the age of 101, that $5,000 portfolio was worth about $22 million and she donated the entire amount to Yeshiva University. One can only imagine how wealthy Ms. Schieber could have been if she had started her investment career much earlier and continued to work while re-investing all of her earnings, but it is safe to assume that the portfolio would be worth more than quadruple the final amount.

How can these history lessons make you a better investor?

There are two important lessons that an investor at any age can learn from these stories. First, the overwhelmingly most important factor for any investor is discipline. As seen with these examples, a substantial amount of wealth is created when human beings refrain from doing moronic things, which in the investment world means constantly buying and selling. Taking the “sit on your ass” approach to investing so famously coined by Charlie Munger creates absolutely incredible results over the long-term. Forget making a quick buck trading volatile options, forget that lucrative pharma stock you think will jump 25% in a day, forget “riding” a sector rotation involving basic materials and cyclical stocks and absolutely forget the new tech company that has no revenue whose stock is jumping 35% because another 10,000 users just joined its social media platform. The opportunity costs are far too great and that quick 50% you made trading TWTR in an out-of-the-money call option expiring in June actually just cost you tens of millions of dollars (or more depending on your age and capital) because you didn't have the ability to take a large position with a tiny bit of leverage in a very high quality business with a substantial ‘moat’.

That leads me to the second lesson which is identifying high quality businesses. All of the investors mentioned above have very concentrated portfolios (Mr. Johnson only had one stock) in which they invested all their capital and rode for a very long period of time.

But what makes a quality business? Let’s start by indicating what industry provides the best returns. According to a study by Patrick O'Shaughnessy, the number one sector that has provided the highest average annual returns since 1963 is Consumer Staples with an average compounding rate of 13.33%. Health Care and Energy are second and third with 12.52% and 11.44% respectively. The worst sector? Technology with 9.75%.

The single best stock over the past fifty years has been Altria (MO) which has a total return of more than 1 million percent in that time frame. That’s a compounding rate of 20.23% per year, every year. If one were to have $1000 of Altria (then Philip Morris) in 1963 that amount would be worth more than $8 million today (that includes dividends and stock splits). Anheuser-Busch, Pepsico, Coca-Cola and Hormel were also near the top of that list according to the study.

Why have consumer staples done so well? Part of the reason is that these companies offer scale and recognizable brands leading to wide ‘moats’. Other reasons include basic inflation, psychology, rising population growth and increasing consumer incomes which are all factors that have been in place for the last 100 years. These trends have been well documented and it is safe to say that they still will be in place for the next fifty years, perhaps growing at a faster rate given the incredible potential of Asia, Africa and Latin America.

So the next time you hear an analyst pitching an iron condor options trade, a broker selling the next hot issue, or your neighbor rushing into a ‘once-in-a-lifetime’ start-up, I would urge you to filter out the noise, stick to your core competency and become a student of history. As Bill Gross once said, “there is no better teacher than history in determining the future… There are answers worth billions of dollars in a $30 history book.”

10 Non-Finance Books That Can Make You a Better Investor

Over the course of our investing lifetimes we will be bombarded with huge volumes of material, the majority of which won't be useful or even retained. In fact, despite all the sophisticated material available on security analysis, business, economics and finance etc. knowing it is no guarantee of success. Instead, when it comes to being a good investor I believe that the first and most important thing you have to know is yourself. These books may help you do that.

1) Hermann Hesse – Siddhartha

In this classic 1922 novel Hermann Hesse describes a man’s spiritual journey of self-discovery through ancient Nepal. In his quest to find enlightenment or Nirvana Siddhartha learns that a universal understanding of life cannot be achieved through teachers as it can’t be taught. Instead, by letting go of his external search he becomes more able to focus on his inner self and being at one with the universe. Beautifully written, the book suggests that to achieve our own version of fulfillment we should have faith in what we have within us rather than relying on the voices around us.

“Seeking nothing, emulating nothing, breathing gently, he moved in an atmosphere of imperishable calm, imperishable light, inviolable peace.”

2) Robin Sharma – The Monk Who Sold His Ferrari: A Fable About Fulfilling Your Dreams & Reaching Your Destiny

This inspirational book is structured around the stereotypical story of a high powered executive who has a heart attack which prompts him to re-evaluate his life, sell all his possessions and move to India in search of a more meaningful existence. Although this story is an unrealistic model for most of us, the author smartly provides 7 great virtues that the enlightened executive learns on his journey. These virtues include: 1) mastering your mind 2) following your purpose 3) practicing kaizen (continuous improvement) 4) living with discipline 5) respecting your time 6) selflessly serving others 7) embracing the present. Each of these virtues is well explained and with a little or in some cases a lot of effort, can be implemented in our own busy lives.

“Success on the outside means nothing unless you also have success within.”

3) Albert Camus – The Stranger

Often cited as an example of Albert Camus’s philosophy of the absurd and of existentialist ideas, this novel describes the before and after story of a French Algerian man who for no apparent reason commits murder. By following society’s attempt to rationalize and explain the killing which was simply an irrational event Camus tempts us to reconsider society’s tendency to think that individual lives, human existence and events always have a rational meaning and order. This is captured by the concept of the “absurd” which relates to humanity’s futile attempt to find rational order where none exists. Instead of depressing us, once we realize that some events simply have no rational meaning, we should instead be able to achieve a certain level of intellectual and spiritual liberation.

“Everything is true, and nothing is true!”

4) Robert Green – 48 Laws of Power

If realists had a book or worship, this would be it. Meticulously researched yet controversial, the book traces the lives of many of the world’s most powerful and influential individuals (with power being defined as “the ability to get people to do what you want them to do”) and suggests that their trajectories have been shaped by the observance of 48 universal laws. For example; Law 3: Conceal your intentions, Law 11: Learn to keep people dependent upon you, Law 35: Master the art of timing etc. Although this book attempts to lay waste to the old adage that good things happen to good people, it is worth reading for anyone interested in improving their strategic intuitions.

“Everyone has a weakness, a gap in the castle wall. That weakness is usually an insecurity, an uncontrollable emotion or need; it can be a small secret pleasure. Either way, once found, it is a thumbscrew you can turn to your advantage.”

5) Daniel Kahneman – Thinking Fast and Slow

In this thought-provoking book, Noble Peace Prize winner Daniel Kahneman takes on the still poorly understood topic of the human mind. He asks us to critically examine the way we think and suggests that our minds regularly contradict themselves, distort reality and mislead us. Essentially, our minds apply two very different systems of thought to any question at hand. The first is a simple and reactive system which reads emotion and handles automatic skills. The second is used when the mind must focus on specific details such as numbers and methodical thinking. Of particular interest is the author’s suggestion that our minds naturally seek causes in random events and push us to distort reality by realigning memories to correspond to new information. With this in mind, the economic theory that human action is guided by reason begins to fall apart yet the upside is that Kahneman offers us insight into how we can teach ourselves to effectively avoid such pitfalls and thus “think better”.

“We are confident when the story we tell ourselves comes easily to mind, with no competing scenario. But ease and coherence do not guarantee that a belief held with confidence is true.”

6) Aristotle - The Basic Works of Aristotle (Edited by Richard McKeon)

Although an exceptionally difficult book to get through as the prose is dense and often quite dry, this book is a must read for those intent on getting a taste of some of the ideas that continue to shape Western thought, religion and science. Aristotle’s ideas about “reversion to the mean” are quite useful as they explain that whenever we observe something abnormal or exceptional there will in time be a return to the norm unless conditions change. In fact, his body of knowledge is so impressive that if this great polymath were still alive today, it would not be preposterous to think that perhaps cancer would be cured, global warming was solved and we all could live in peace.

“It is the mark of an educated mind to be able to entertain a thought without accepting it.”

7) Sun Tzu – The Art of War

Although written with armed combat in mind, this realist classic offers many lessons that are applicable to confrontations we face in our daily lives whether with superiors, inferiors, friends or enemies. Its teachings are also useful when a team must be effectively built in order to achieve a desired outcome. In addition, its constant emphasis on the theme of deception is quite relevant as keeping an enemy guessing and uneasy can pay large dividends in a wide variety of non-physical situations. The idea here is to win battles without ever actually having to pull your sword out of its sheath.

“All warfare is based on deception.”

8) Carl Von Clausewitz – On War

Unlike the more tactical account of war by Sun Tzu, Von Clausewitz book takes a more philosophical look at the subject and expands on the “strategic” aspects of war. Of note are his discussions on the nature of a “military genius” (involving certain key character traits beyond intelligence such as decisiveness and courage) and “friction” (the difference between the ideal performance of a fighting force and their actual performance in real world scenarios).

“It is even better to act quickly and err than to hesitate until the time of action is past.”

9) Bertrand Russell – Skeptical Essays

British philosopher Bertrand Russell’s life story alone is worth considering as his life has been dedicated to advancing knowledge and defending noble values such as pacifism and freedom of thought. In these essays his crystal clear writing suggests that we should cultivate a form of measured skepticism that implores us to revise even our most confirmed beliefs irrespective of the authority upon which they rest.

“The opinions that are held with passion are always those for which no good ground exists; indeed the passion is the measure of the holders lack of rational conviction. Opinions in politics and religion are almost always held passionately.”

10) Richard Feynman – “What do you care what other people think?”

To be a great investor, and maybe even a solid person, four simple but not easy virtues are integral: discipline, skepticism, independence and patience. In this book Nobel Prize Winning physicist Richard Feynman illustrates these virtues by describing his career and the position he often occupied outside the “established” way of thinking.

“It is our responsibility as scientists, knowing the great progress which comes from a satisfactory philosophy of ignorance, the great progress which is the fruit of freedom of thought, to proclaim the value of this freedom; to teach how doubt is not to be feared but welcomed and discussed.”

Have you read any of these? What are your favourite non-finance books that have made an impact on you? I’d love to hear your thoughts in the comments or send me an inbox message.

Nine Questions To Help You Identify A High Quality Business

Today there are so many different types of businesses out there that you may feel lost when it comes to finding a great one. I often get asked: “Where do I even start in finding a good business to invest in?” Finding the right type of business can certainly be a challenging activity, but luckily, there are certain fundamental characteristics that can help you narrow your search. These fundamental characteristics belong to high quality businesses that posses “superior economics” and thus “expanding value”.

What this means is that if you have a business that will continue to grow, eventually the market will lift the price of the company’s stock. But what is a quality business that will continue to grow? The answer lies in nine questions that can help you to identify businesses that will consistently expand their value.

#1 Does the business operate in what looks like an‘oligopoly’?

What you want to identify are brand-name products or services that people or businesses are dependent upon. For example, if you go into a convenience store, bar, pharmacy or grocery store, what are the products that absolutely must be sold in order for the establishment to stay in business? Some items you may notice would be Marlboro cigarettes, Budweiser beer, Hershey chocolate, Arm and Hammer baking soda, Tide detergent, Pampers diapers, Colgate toothpaste and Canada Dry Ginger Ale. On the services side, what are the things people and businesses must use every day to perform key functions? Some examples would be credit cards such as Visa, Mastercard or American Express, railways and transportation such as CP Rail, Union Pacific or Tyson Foods and even basic IT infrastructure that businesses use such as Accenture. The idea here is to identify businesses that have deep competitive advantages and control so much of the market that it would be nearly impossible to compete with them.

However, businesses with these kinds of oligopolistic qualities do not mean they have to be huge. Although, scale in general does follow market capitalization, a deep competitive advantage is much deeper and involves utilizing incredible strategy to fortify market positions. This can help explain, for example, how the $12bn Dr. Pepper Snapple Group has its products on the same shelf in the same stores with similar global distribution as the $186bn Coca-Cola or the $220bn Nestle. An understanding of global strategy and a deep analysis of a business's true edge can help make any potential investor identify the most important factors.

#2 Are the earnings of the business solid and trending upwards?

Despite having distinct oligopolistic qualities, the business may still be poorly governed and thus earnings may be inconsistent. What you are looking for here are annual earnings per share (EPS) that have been and continue to be on a consistent uptrend.

#3 Does the business have a healthy balance sheet?

If the business possesses the aforementioned qualities and an EPS uptrend it will most likely be generating a lot of cash and shouldn’t need much long-term debt. Nevertheless, there is such a thing as good debt as this type of long-term debt is acceptable if it is used to acquire another oligopoly type business.

#4 Does the business consistently earn a high rate of return of shareholders’ equity?

Like the examination of a business’s EPS it is also important to identify whether it consistently earns a high rate of return on shareholders equity (ROE). If the ROE is consistently high it is a signal that the business’s management is skilled at making money from the existing business but is also able to profitably use retained earnings to maximize shareholder returns.

#5 Is the business able to retain earnings?

Not all businesses can generate a surplus of earnings in the operation of their business. Instead, most businesses have to spend most of their earnings on just maintaining inventory and capital expenditures. But the few that can use their retained earnings to acquire new businesses or expand their profitable core operations are the ones you are looking for.

#6 Does the business have to spend a lot to maintain current operations?

So what we want are businesses that can grow, that can retain earnings and that don’t have to spend all their retained earnings on maintaining the status quo. Some businesses have such onerous capital budgeting plans that they end up having little or no money left to maximize shareholder returns. For example if a business makes $2 million a year, and retains every cent, but every other year it has to spend $4 million replacing equipment the business would simply be breaking even. The idea here is to find businesses that rarely require replacement of plant and equipment and have products that never go obsolete and thus don’t need ongoing expensive R&D. Using a very simple example, compare a railroad company such as Kansas City Southern to a car manufacturer such as Ford. Once the railroad infrastructure is in place, no major capital expenditures need to be made whereas in the case of Ford, car manufacturing requires innovation and huge capital expenditures to constantly keep up with the consumer so large sums must be spent simply to stay in business.

#7 Is the business able to reinvest retained earnings and how good of a job does management do this?

The final dimension of the retained earnings puzzle relates to how the business uses its retained earnings. What you are looking for here is a management team that consistently employs retained earnings for an additional high return. The business can use retained earnings to expand currently profitable core operations, acquire profitable cash generating businesses or if it cannot employ its retained earnings at above average rates of return, to buy back shares. Regardless of which of the three strategies the management team employs, a history of profitable use of retained earnings, or a reasonable promise of future profitable use is key.

#8 Can the company adjust prices to inflation?

There are some businesses such as coal companies, gold companies and cattle companies that are tied to fixed dollar investments. With such commodity type businesses the costs of production can increase with inflation while the prices the business can charge for its products decrease due to oversupply or great competition. In other words, the simple economic forces of supply and demand within their relative markets can deem these businesses obsolete. You want to avoid these businesses and instead look for businesses with oligopolistic qualities that can increase their prices to keep up with inflation without causing a decline in demand.

#9 Will the market value of the company increase due to the value added by retained earnings?

At the end of the day, if the business you are considering measures up to the last 8 factors, what you want to see and what you most likely will see, is that as the net worth of the business grows, so does the market’s valuation of the business and hence its stock price. This is the exact opposite of being interested in a stock that has been rising due to speculative pressure. Instead, ignore what the stock price has done in the short term because if you have found a high quality business as outlined above, chances are that in the long term, the market will adjust the stock’s price to mirror the true value of the business.