The best-performing four percent of listed companies explain the net gain for the entire U.S. stock market since 1926, as other stocks collectively matched Treasury bills. And “four out of every seven common stocks” returned less than one-month Treasuries. Markets do well, but the average stock does not.
When analyzing individual companies, there is a disconnect between our expectations and this base rate of performance. Consider how investors value companies. We are trained to think about intrinsic value as the present value of the company’s future cash flows. This is of course technically correct. But it bumps up against reality. I find it useful to think of companies as organisms. They operate in an ecosystem and they are subject to both a life cycle and natural selection. Some are resilient and adaptable, but most perish rather quickly. Eventually, they will be replaced by an entity better adjusted to the changing environment. Public companies have typically achieved reasonable size and are often mature, if not in decline, already.
But when projecting cash flows, investors collectively fall into a mental trap of optimism. Unless a business is already in terminal decline, people rarely model the free cash flow to taper off. Instead, businesses that should be expected to fail over time are being collectively valued as if they were going to experience perpetual growth alongside the economy.
The second issue with discounted cash flows is that public shareholders are last in line to receive them.
One way to think about an investment in a public company is as a combination of two bets: a bet on the company’s future and a bet that shareholders will get their share of said future despite a lack of control. Another way to think about the investment is as a bet against competition, innovation, unions, other industry players trying to capture more of the value chain, and management’s greed or lack of integrity. Shareholders forget that capitalism, in the form of competitors, innovators, and insiders, is happy to eat their lunch.
I believe this leaves the non-controlling public shareholder investor with three options (it’s a different game for controlling investors): Be a long-term ‘business investor’. Identify a group of wonderful businesses that will compound long-term and are shareholder friendly and priced attractively as investments. Trade securities. Whether your timeframe is a few seconds or a few years, you trade the security as opposed to becoming a long-term partner in the business. People make a lot of money long and short as companies go through their life cycles, but value investors of the Buffett and Munger school can get uneasy with this notion. It can feel a little stigmatized. But once you realize that most companies are not attractive long-term investments, this approach to the market seems perfectly rational. That said, if trading is a losing game on average, it brings us to the last option: Opt out of the game. Stop trying to pick long-term winners or trading the bag of future losers. Invest in an index that, over time, allocates more to the winners and cuts the losers. Accept that at any point in time you are buying some great companies above their fair value as well as some awful companies that are about to go under. It’s just a cost of doing business
We don’t have to do many things that work. One or two things every now and then that work really well. That’s the beauty of this business. [But] you can’t have a big disaster. That is what we try to avoid. We do not ever want to lose a significant percentage of Berkshire’s net worth. Buffett in 2011
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