What's good enough for Buffett will do for us!
by David McEvan
"The investor with a portfolio of sound stocks should expect their prices to fluctuate and should neither be concerned by sizeable declines nor become excited by sizeable advances. He should always remember that market quotations are there for his convenience, either to be taken advantage of or to be ignored. He should never buy a stock because it has gone up or sell one because it has gone down. He would not be far wrong if this motto read more simply: Never buy a stock immediately after a substantial rise or sell one immediately after a substantial drop."
This is easy to forget. Unless you need to sell shares to raise cash in the next few weeks, it is not relevant what their price is. Far more important is the financial strength and management quality of the company. A good company will always survive and sometimes even prosper during the inevitable ups and downs of the economy.
Those who do not need to raise cash in the short term should keep in mind the good times that will inevitably return, while taking solace in the dividends good companies churn out year after year. Here is a passage from another book, The Warren Buffett Portfolio, by Robert Hagstrom.
"If we were to ask Buffett what he considers an ideal holding period, he would answer, `Forever' – so long as the company continues to generate above-average economics and management allocates the earnings of the company in a rational manner.
" `Inactivity strikes us as intelligent behaviour,' he explains. `Neither we nor most business managers would dream of feverishly trading highly profitable subsidiaries because a small move in the Federal Reserve's discount rate was predicted or because some Wall Street pundit has reversed his views on the market.' Why, then, should we behave differently with our minority positions in wonderful businesses?"
That is a key point – good investors buy businesses, not shares. All businesses have very profitable years and not so profitable years. The key number to the long-term investor is the return on their capital – shareholders' funds. If a company is generating a return that is better than other investment options such as cash, bonds or property then the investor should be happy to let the money sit there and grow.
Return on capital has nothing to do with the share price on any given day. Instead, it is a measure of how much is earned and poured back into the business – the real formula for success that share prices often fail to depict. It is measured by taking net profit as reported, and dividing that by shareholders' funds as shown in the balance sheet. Buffett has said if that ratio ends up being 15 per cent or higher, you have a real growth investment.
The share price is not that important. Your target should be to find good companies with reliable earnings that generate a return on equity of 15 per cent or more – without the weak balance sheet that can distort that number.
