QUALIPORT
When Investing, Think Like Buffett

By Bruce Jackson (TMFGoogly)
April 5, 2001

The Qualiport's ideal holding period is forever. Reality however dictates that precious few companies have a long-term sustainable competitive advantage such that they are suitable to be held forever. Warren Buffett, the most successful living investor, has found just 4 companies -- Coca-Cola (NYSE: KO), American Express (NYSE: AXP), Washington Post (NYSE: WPO) and Gillette (NYSE: G) -- that fit the bill.

For the long-term investor, a much more realistic holding period is between 3 and 10 years. The Qualiport may end up holding a company like PizzaExpress (LSE: PIZ) for between 3 and 10 years. It has somewhat of a competitive advantage in the UK at least, courtesy of its brand, its critical mass in terms of number of restaurants, and falls into a nice niche being between the budget and expensive ends of the casual dining out market. Competitors are already moving into PizzaExpress' competitive space, proving that the barriers to entry are not insurmountable. But, the competitors -- principally Ask Central (LSE: AKC) -- are yet to reach critical mass, so the jury is still out on whether they will really hurt PizzaExpress.

Sustainable Competitive Advantage

The hardest part about long-term investing is finding companies with a sustainable competitive advantage. It is not a science, and usually comes down to some sort of gut feel. I've written before in this space about how I consider Manchester United (LSE: MNU) to have a long-term sustainable competitive advantage. But that's just my opinion. As to whether that makes it a good investment or not, time will tell.

It is often assumed that the hardest part about long-term investing is valuing companies. However, once you've licked the bit about finding companies with sustainable competitive advantages, the valuation part of the equation is actually quite easy. Just think of it as you do buying a house.

Valuing A House

If you are buying an investment property for cash, there are only a three key points you need to consider.

1. The yield on the initial purchase price.
2. The prospects for capital appreciation or depreciation.
3. The investment return compared to other forms of investment.

Let's use the following as an example.

House cost: £100,000
Rent per week: £200
Assumed occupancy: 45 weeks
Assumed annual costs: £1,000

Point 1

Calculated from the above, the initial annual yield is 8%  -- (45 weeks * £200 - £1,000) ¸ £100,000. This 8% is also the same as the return on equity. Point 1 covered.

Point 2

Lets say you plan to own the house for 25 years. As well as earning rent every year, at the end of 25 years the house will have a residual value, and over such an extended time period this will likely be significantly higher than the initial purchase price. Point 2 covered.

Point 3

Would you make such an investment? In the current economic environment, a nominal return of 8% per annum sounds quite attractive. But what if inflation was running at 6% and interest rates were 9%? Suddenly the property investment isn't looking as attractive. Shares have returned roughly a nominal 12% per annum over the past 80 years. Many would be happier taking what they perceive as the relative certainty of the property investment versus an investment in the stock market. The choice is yours. Point 3 covered.

How would you value the house?

Let's look at the house from a different angle. £100,000 is only an indicative price, and is up for negotiation. Taking into account the risk-free interest rate (in this case the long-term UK bond yield is just short of 5%), you decide you require an annual return on your initial investment of 8%. You predict the long-term inflation rate at 3.5% and assume that house prices in your area will rise at 6% per annum over the next 25 years. That is also the period over which you intend owning the house.

Over 25 years, with net rent (£8,000) going up by the rate of inflation each year (3.5%), you will receive almost £311,000 income over the life of your ownership. Discount that back to the present value using the long bond yield (5%) as your discount factor, and that translates into about £169,000.

In 25 years' time, your house will be worth just over £429,000, based on its value rising at 6% per annum. Discount that back to the present value (again using 5% as the discount factor) and that gives you just short of £127,000 -- (1/(1+5%)) ^ 25 * £429,000.

Based on your assumptions, the present fair value of the house would be about £296,000. Got your cheque book ready?

How much should you pay?

Whoa there girl! If you paid £296,000 for the house, your return over 25 years would only equal the long bond yield, in this case 5%. That's not a great return on your investment.

What then should you pay? The future value of your investment is £740,000 -- £311,000 + £429,000. In order to make a return of 8% over 25 years, your purchase price would be just over £108,000: (1/ (1+8%)) ^ 25 * £740,000.

Voila. Based on your assumptions and your required rate of return, your maximum purchase price would be £108,000. If you could pick it up much cheaper than that, all the better. 

Relating It All Back To Shares and Buffett

Your aim as an investor is to buy great companies at cheap prices. Using the house example above, you would look to buy it for £85,000 or less, being at least 20% below its intrinsic value.

By using the same principles as for the home buying example, you can easily value predictable companies. Be conservative with your assumptions, and think long-term. In most cases, the stock market can only look forward a maximum of 18 months. Your competitive advantage is your ability to look forward 3, 5, 10 and 25 years. Do it now, and you may find the stock market is offering you some opportunities. But beware: long-term valuations only work for companies with long-term sustainable competitive advantages.

Warren Buffett essentially says exactly the same thing in his 2000 letter to shareholders of Berkshire Hathaway (NYSE: BRK.A). Instead of using a house as his example, he went for birds. The letter is a must read for all long-term investors.

At the time of writing, Bruce Jackson owned shares in PizzaExpress, Manchester United and Berkshire Hathaway.