Third, the best businesses tend to be relatively less capital intensive and generate significant free cash flow. A well-managed company that provides a high quality value added product or service and possess a significant competitive advantage should be able to fund its required spending from operating cash flows and hopefully generate free cash. Such a business is also less likely to require high capital investment relative to assets. An investor must examine capital required to finance sales growth and the dividend payout. Cash flow is more than just earnings which can be manipulated through accounting. Companies that generate strong free cash flow are able to repay debt, repurchase shares, increase dividends, and finance their growth through expansion and key acquisitions. They are also attractive acquisition candidates. Companies with increasing cash flow characteristics are often able to grow, regardless of economic or market conditions and tend to offer some downside protection during market declines.
Fourth it is essential to pay a reasonably fair price for a superior business and management. Key valuation determinants include a company’s probably long-term growth rate in earning power, the consistency and stability of estimated growth, its profitability, financial condition, projected cash flow, and quality of management. These quantitative and qualitative characteristics should be attractive relative to a peer group of companies and the general market. Although we are willing to pay a multiple premium for a truly superior company, the price/earnings multiple must still be justifiable.
Fifth, while reasonable investors will often differ on what is a fair price, moderately overpaying for a stock should not be too damaging to the portfolio. If our other principles about investing have been satisfied, then the intrinsic value of the enterprise should increase over time and eventually be reflected in the stock price.
Sixth, we are long-term investors. By holding equities for a long period, we considerably increase the probability of generating positive absolute returns while limiting the risk of significant losses over at least three years. Furthermore, it is imperative that a high-tax-bracket individual benefit from compounding and the lower long-term capital gains tax rate to generate a very acceptable after-tax rate of return.
Seventh, the consistency of earnings demonstrates a recurring demand on a predictable basis for a company’s products or services. A company that demonstrates this consistency will most likely have below average vulnerability to a downturn in the economic cycle.
Eigth, we strongly prefer to invest in a comprehendible business because we are much more comfortable with our ability to evaluate its fundamental operating performance and management’s actions. In addition, the earning power of such a business will likely depend on fewer and more analyzable variables.
Ninth, we prefer to invest in a business that experiences gradual rather than rapid change. Similar to investing in an understandable business, we can be more comfortable with our analysis when change occurs gradually. Having said this, we recognize that technology is an inherently complex and rapidly changing industry. Therefore, when investing in this sector, which is a large and fast-growing segment of the global economy, we focus only on companies that are established market leaders.
Finally, we do not define risk in terms of a stock’s relative volatility but as the permanent erosion of a company’s fundamental earning power. When a business proves to be different from what it was previously assessed to be, the stock is much less likely to recover than when normal market volatility occurs. The Portfolio’s philosophy of investing in high-quality companies reduces, but never eliminates, the risk of deterioration in business fundamentals.
With these principles firmly in mind, our goal is to always improve the process of stock selection.