Real World Investing

When I was a child, I grew up in a small farm town and used to walk to the local public library just off the town square during the weekends to pour through the Value Line Investment Survey. When I found a stock that interested me, I'd pay to have copied on a black and white machine for $0.01 to $0.03 per sheet, take it home, study it, and then open a small safe that I had purchased from an acquaintance of the family. Inside, there were dollar bills (that I had ironed), coins from around the world, and stock tables.

Today, my life is remarkably the same. The difference is, the copy of Value Line is my own, sitting on a mahogany desk, the walls are covered in framed stock certificates and fine art, I'm writing with a fine fountain pen, and the coffee is served to me in a gold-rimmed cup. Yet, the nature of what I do is identical � in fact, I have such a passion for studying companies, that it brings me the same joy now as it did back when I had no net worth of which to speak and was trying to figure out how to make my way in the world.

That is the very essence of what is great about the American dream. My family wasn't wealthy or powerful, and yet because the knowledge was available, upward mobility existed and allowed me to pour my time, efforts, and talents into something that brought me joy (and profits). This was underscored earlier in the week when I was reviewing the Fortune 500 rankings. Charlie Munger has pointed out in the past that it only takes two or three great investments in a lifetime to get very rich (and you only have to get rich once). That means thinking through the problem of what could go wrong and working to make as certain as possible that you are getting full value for your money.

Let me illustrate the point by taking you through some of the stats. My hope is that seeing real-world examples can help you in constructing your own portfolio:

Wal-Mart Stores vs. Chico's

In 1999, shares of Wal-Mart traded at $70.30 and the average annual p/e ratio was 39.1 according to Value Line. That means that it had an earnings yield of only 2.56% - less than the historical rate of inflation! Any fool should have been able to see that it was perfectly asinine to buy shares at that price. True enough, nine years later, the stock traded in the mid-to-low 40's and only recently recovered into the 50's.

In fact, had it not been for the talents of Wal-Mart's brilliant CEO, Lee Scott, and his management team, the value destruction could have been far worse for those who overpaid during the bubble. Why? They have taken net income from $3.5 billion to $12.7 billion in that time, earnings per share have increased from $0.77 to $3.13, and cash dividends have skyrocketed from $0.14 to $0.88 per share. In fact, according to the company's annual report, Wal-Mart's growth alone would have created a Fortune 75 company. It's disappointing to hear market pundits complaining about this type of performance when they are focusing on the ticker and not the underlying business. Results like these at a behemoth that is bigger than some countries are monumentally difficult and deserve praise. Instead, all you hear is people complaining the stock has gone down for almost a decade, not realizing that they were idiots for paying the prices they did.

Yet, at the same time in 1998, a small retail store chain known as Chico's was experiencing tremendous success and traded at only 14x earnings. The stock went from (adjusted for splits) $0.40 per share to the more recent price of $7.15, turning the same $100,000 investment into $1,787,500. Basic elementary logic should have told people that it would be far easier to grow a company that generated $9.1 million in profit at a very fast rate than it would be to grow one earning $3.5 billion. That means that if investors thought Chico's had a bright future, they should have been more than happy to pay 14x earnings for it with its smaller sales and profit base (and thus, higher potential growth) than paying nearly 40x earnings for a giant company. The problem is, how many people took out a calculator and asked themselves what their assumptions in future growth implied and required to accomplish?

You may wonder why I've chosen the figure $100,000 for each investment. Obviously, most people don't have that kind of cash sitting around available for their portfolios. Yet, it's probably an average person working at a factory for a decade or two is going to be able to amass at least that in his or her 401k with decent planning. I wanted a number that therefore was possible and illustrated Ben Graham's idea of thinking of a stock as a piece of a business.

If you were going to start your own metal working firm or retail store, you would probably have to come up with six figures to get it off the ground � fixtures, computers, hiring employees, working capital, etc. Yet, most people don't realize that choosing to buy, say, $100,000 worth of a relatively small mall-based retailer, Hot Topic for instance, you are buying 0.044% of the company. The choice then would become, "would I rather own 100% of my own small business or buy 0.044% of this one?" Those who think like that might very well have a better chance of enjoying satisfactory investment results if they did. Buffett has consistently said he would rather own a small piece of the hope diamond that the entirety of a rhinestone.