Swallow Farms Capital Management’s Guiding Principles are significantly influenced from studying and excerpting Warren Buffett’s annual “Letter to Shareholders” and Benjamin Graham’s Security Analysis and The Intelligent Investor.
We use a fundamental approach to selecting individual securities. We screen for companies with above average returns on the capital employed in their businesses. We then review their financial statements to determine whether we’re interested in further study. We avoid businesses that rely on inventing new technology, have low returns on capital employed, use substantial leverage or have a history of ill advised acquisitions. We seek businesses that we can easily understand fundamentally, that are not subject to substantial, dramatic change, that earn above average returns on capital employed, and that can continue to do so in the future. We have identified and monitor many such businesses and now patiently wait for opportunistic entry points to become their business partner as shareholders.
Exceptional businesses achieve above average returns on capital employed while using limited debt. The very best possess the ability to increase prices rather easily (even when product demand is flat and capacity is not fully utilized) without fear of significant loss of either market share or unit volume, and have an ability to accommodate large dollar volume increases in business (often produced by inflation rather than real growth), with only minor increases in additional investment of capital. An economic franchise arises from a product or service that 1) is needed or desired, 2) is thought by its customers to have no close substitute and 3) is not subject to price regulation. Existence of all three will be evidenced by a company’s ability to regularly price its product or service aggressively and thereby earn high returns on capital. Franchises with these characteristics can stand a bit of poor management and survive while average businesses cannot.
Characteristics of a Bad Business
- Slow capital turnover
- Low margin on sales
- Excess productive capacity
- Product or service is undifferentiated in any customer-important way, such as performance, appearance, service, support, etc.
The Case for Equity Investment
The economic case for equity investment is that, in aggregate, additional earnings above passive investment returns – interest on fixed-income securities – will be derived through the employment of managerial and entrepreneurial skills in conjunction with that equity capital. We prefer to invest in companies whose managements understand the process of value creation for shareholders. In our experience, far more company managements offer shareholders the promise of value creation than deliver on that promise. A good managerial record (measured by economic returns) is far more a function of what business boat you’re in, rather than how effectively you row. The primary test of managerial economic performance is a high rate of return on capital employed (assuming no undue leverage). When management with a reputation for brilliance tackles a business with a reputation for poor fundamental economics, it is usually the reputation of the business that remains intact.
Retained Earnings and Equity Growth
Most companies retain earnings to fund their growth opportunities. These retained earnings are no different than the retained interest on a saving account. A dormant (unmanaged) savings account that started with $1000 and retained (reinvested) all interest would report “record earnings” each quarter when interest was paid. Similarly, most corporations retain some or all of their earnings each quarter to fund their growth opportunities. In a stable interest rate environment, this retention of earnings has the “potential” to help grow earnings substantially, similar to reinvested interest in a savings account.
The key to any company’s stock performance over the longer term is the productive reinvestment of retained earnings in the business. A company that earns 10% on equity and retains all earnings for growth will have increased their equity capital base by over 100% in ten years. In cases where reinvested capital is put to productive uses, share values tend to flourish. As a practical matter, a business should retain earnings only when there is a reasonable prospect, preferably based on historical evidence, that for every dollar retained by the corporation, at least one dollar of market value will be created for owners. This will happen only if the capital retained earns at least as much as rates generally available to investors elsewhere. The undistributed (retained) earnings of exceptional businesses should produce significant value for shareholders over time. If they don’t, a mistake has been made as to the company management we elected to join, the future economics of the business, or the price we have paid.
The value to all owners of the retained earnings of a business enterprise is determined by the effectiveness with which those earnings are used and not by the size of one’s ownership percentage.
Like virginity, a stable price level seems capable of maintenance, but not of restoration. Inflation is the enemy of the low return, capital intense business and holders of fixed income contracts.
Accounting numbers are the beginning, not the end, of business valuation. Book value is an accounting concept, recording the accumulated financial input from both contributed capital and retained earnings. Intrinsic business value is an economic concept, estimating the future cash output discounted to present value. Book value tells you what has been put in; intrinsic business value estimates what can be taken out.
The market, like the Lord, helps those who help themselves. But, unlike the Lord, the market does not forgive those who know not what they do. For the investor, a too-high purchase price for the stock of an excellent company can undo the effects of a subsequent decade of favorable business developments.
A Word about Stock Liquidity and Stock Splits
Managements often speak about wanting “liquidity” in their shares. In order for this to occur, there must be turnover (sellers) in their shares. I’m not sure why managements would want a constantly changing shareholder base, but that’s what’s implied. Warren Buffett once said that stock splits benefit accountants and printers. If you own 1% of a terrific business, it matters not that it’s represented by one share or one thousand. What is important is how your pro-rata portion of the business performs. Investors who make investments for non value reasons such an upcoming stock split frequently sell for poorly considered, non value reasons as well.
Fear and Greed
Occasionally there are outbreaks of two contagious diseases, fear and greed. The timing of the epidemics is unpredictable, as are the market aberrations produced by them, in terms of duration and degree. We never try to predict the arrival or departure of either disease. We have no great insights into economic growth or the next move in the market. Our goal is more modest; we attempt to be fearful when others are greedy and greedy only when others are fearful. Rewards to business owners over time must reflect the performance of the businesses themselves, despite any manic or exuberant interim valuations. Investors can succeed by coupling good business judgment with an ability to insulate their thoughts and behavior from the contagious emotions that swirl about the marketplace. In the short run, the market can act as an emotional voting machine but in the long run, it will act as a weighing machine in reflecting each company’s business results.
Efficient Market Theory
Markets are frequently efficient, but not always efficient. The difference is night and day. Investors cannot obtain superior profits by committing to one specific investment category or style. They can earn them only by carefully evaluating facts and continuously exercising discipline.
What the wise do in the beginning, the foolish do in the end. Wall Street’s enthusiasm for an idea is proportional to the revenue it will produce, not its merit.
If your actions are sensible, you are very likely to get good results; in most cases leverage just moves things along faster. If you’re smart enough, you don’t need leverage; if you’re not smart enough, you surely don’t need leverage.
In making equity selections we try to define with extraordinary realism, our area of competence and act decisively on all matters within it, while ignoring even the most enticing propositions falling outside that area of competence. What counts for most people in investing is not how much they know, but how realistically they define what they don’t know. Investors need to do very few things right as long as they avoid big mistakes.
We hope to attain good results by both good business judgment and continuing to insulate our thoughts and behavior from the contagious emotions swirling around on Wall Street. We want to be careful in evaluating facts and continuously exercise discipline. Our goal is to buy outstanding businesses at sensible prices, not mediocre businesses at bargain prices. Silk purses are best made of silk; using sows’ ears, the result is often unpleasant.
Severe change and exceptional business results usually don’t mix. Many investors behave as if just the opposite is true, conferring the highest P/E ratios on exotic-sounding businesses that hold out the promise of feverish change. That prospect lets investors fantasize about future profitability, rather than face today’s business realities. For such investor-dreamers, any blind date is preferable to one with the girl next door, no matter how desirable she may be. Value is destroyed, not created, by any business that loses money over its lifetime, no matter how high its interim market value may be.
Experience indicates that the best business returns are usually achieved by companies that are doing something quite similar today to what they were doing five or ten years ago. This is no argument for managerial complacency. Businesses always have opportunities to improve service, product lines, management techniques and the like, and such opportunities should be seized. But a business that constantly encounters major change also encounters many chances for major error. We feel it’s better to be approximately right than precisely wrong. Furthermore, economic terrain that is forever shifting violently is ground on which it is difficult to build a fortress-like business franchise. Such a franchise is usually the key to sustained high returns.
Growth is always a component in the calculation of value, constituting a variable whose importance can range from negligible to enormous and whose impact can be negative as well as positive. In addition, we think the very term “value investing” is redundant. What is “investing” if it not the act of seeking value at least sufficient to justify the amount paid? Business growth per se tells us little about value. Growth benefits investors only when the business in point can invest at incremental returns that are enticing – in other words, only when each dollar used to finance growth creates over a dollar of long-term value. In the case of the low-return business requiring incremental funds, growth hurts the investor.
The value of any stock, bond, or business is determined by the cash inflows and outflows – discounted an appropriate interest rate – that can be expected to occur during the remaining life of the asset.
The dictionary defines risk as the possibility of loss or injury. Academics define risk as the relative volatility of a stock or portfolio of stocks.
We try to price rather than time purchases. I would rather be certain of a good result than hopeful of a great one. If you are not willing to put a stock in our portfolio for ten years, don’t even think about owning it for ten minutes.