The tale of Mr. Market, which Benjamin Graham tells in chapter 8 of his classic book The Intelligent Investor, is a parable that puts the ups and downs of the stock market into perspective. In essence, the story depicts the stock market as a congenial but manic-depressive individual who every day offers to buy your shares in the companies you own or to sell you his stocks. You can choose to do either or neither without hurting his feelings, and you can rest assured he'll be back again tomorrow. Most days, he is a fairly rational fellow, but at other times he gets very excited about the prospects for the market and offers to buy or sell at a premium. Sometimes, for no apparent reason (or at least no good reason), Mr. Market gets depressed about business ownership and significantly marks down the price of all companies, regardless of their quality or long-term outlook.
As a disciple of Warren Buffett and his partner Charlie Munger, I always try to keep some cash available for those times when Mr. Market gets depressed and offers to sell me a good business on sale. This is the essence of Buffett's famous quote about being greedy when others are fearful.
Sometimes you're afforded the opportunity to purchase many different securities at compelling prices. During the sell-off in the second week of October, I was anxious to take advantage of Mr. Market's dour outlook. I saw the first significant stock market downturn since 2011 as an opportunity to purchase a wonderful company or two at a fair price or better. The question becomes: What do you buy when most equities are 8% to 12% lower than they were just a few days earlier and there is more opportunity than cash?
Munger and Buffett provide the best mental model for how to think about this situation. When considering purchasing the shares of a company, compare it to one of the very best businesses out there -- one that beats out 98% of existing businesses -- and use that as your standard. In the past, that company was Coca-Cola (NYSE:KO) for Buffett and Munger.
Using this model, I measured potential investment choices against a company I own and am familiar with: MasterCard (NYSE: MA). With a durable competitive advantage, fabulous returns on capital, terrific free cash flow, a long runway for sustained growth, and a reasonable price, MasterCard makes a particularly effective standard. By comparing other stocks to great businesses like MasterCard, you save a great deal of time by ruling out a vast majority of lesser-quality companies and avoid investing in businesses with little long-term growth potential.
MasterCard is what Buffett refers to as a "toll bridge" business. These kinds of companies have wide moats because they have little competition and provide access to an essential service. Just as you might have to pay the operator of a toll bridge in order to cross the river, merchants and banks pay tolls, in the form of fees, to use MasterCard's payment network. The company's returns on invested capital of more than 40% confirms its competitive advantage. Further, the company's free cash flow is significant and growing. According to Morningstar, it was $1.5 billion in 2010 and has grown each year, reaching $3.8 billion last year. Another mark in MasterCard's favor is that it estimates that 85% of the world's financial transactions are still made with cash or check, meaning there is still plenty of opportunity for significant growth. Finally, in October, Mr. Market was offering this fine company for about $70 per share -- a 10% discount to where it traded the previous three months and 15% below where it began the year.
If a firm you're considering buying shares of can't match the business potential of your chosen filter company, than why not just buy more of that golden standard? Let's look at an example.
Blackhawk Network Holdings (NASDAQ:HAWK) is a company I've had my eye on since back in the summer. Like MasterCard, it's in the card and payment business. However, Blackhawk provides prepaid gift cards. It's an industry leader in the prepaid card business, though I'm not convinced it has an economic moat, as it's relatively small and, until recently, was a division of Safeway. If a grocery store can get into the prepaid card business, then it's likely that a large financial-services company could do the same. Or consider Wal-Mart (NYSE:WMT), which sells its own branded prepaid cards and has recently started offering a money transfer service to compete with Western Union (NYSE:WU). Direct competition from Wal-Mart or some established financial-services company could pose a serious threat to Blackhawk. Also, let's not forget that every time a Blackhawk card with a MasterCard logo gets used, MasterCard gets a cut of the fees.
One of the things I like about Blackhawk is their returns on capital. According to Morningstar, over the trailing 12 months, Blackhawk has a return on assets of 6%, return on equity of 26%, and return on invested capital of 18%. Yet despite these great numbers, MasterCard's are better. Over the same time frame MasterCard has posted returns of 28%, 49%, and 40%, respectively. If you look at the data for Blackhawk since 2011, after it was separated from Safeway, the returns have been fantastic but the trend has been negative. MasterCard, on the other hand, has seen its returns on capital increasing each year, and with less leverage.
Finally, let's compare prices. In October, when MasterCard was around $70, it had a price-to-earnings ratio of 24. It was certainly not a Ben Graham-style value stock, but it was much cheaper than its Morningstar-reported average of 32.6 in 2013. Blackhawk, on the other hand, had recently experienced a record high in October, while most other stocks were slumping. It was, and is still today, sporting a P/E ratio of about 35.
Given these comparisons, it's easy to see why I added to my MasterCard holdings rather than buying shares of a new company. One of the beauties of this screening method is that it's not only incredibly useful for deciding where to invest money you currently have, but it's also useful for making decisions about your existing portfolio.
With my account having little additional money available for making new purchases, I screened my portfolio with the MasterCard filter. In evaluating my holdings against MasterCard, I decided I would rather have a larger stake in MasterCard than continue owning Transocean (NYSE:RIG) or Rocky Mountain Chocolate Factory (NASDAQ:RMCF), neither of which compares favorably, especially considering the price offered by Mr. Market. This is not an excuse to make frequent trades; rather, it should be used as a tool to increase the quality of your holdings when exceptional companies trade at fair value or less.
Often, we look for the next great stock in many places other than our current holdings. While the practice of diversification can reduce volatility and lessen the risk of an individual stock, don't let that stop you from buying the very best business when the price is right.
Brian Wells owns shares of Coca-Cola, MasterCard, and Western Union. The Motley Fool recommends Coca-Cola, MasterCard, and Western Union. The Motley Fool owns shares of MasterCard and Transocean and has the following options: long January 2016 $37 calls on Coca-Cola and short January 2016 $37 puts on Coca-Cola. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.