Investing is at its best when it is most businesslike. That's what Benjamin Graham taught us. His book, The Intelligent Investor, is considered by many to be the finest on investing ever written. First penned in 1949, it remains in print today, having recently been lovingly updated by Jason Zweig.
One might think that a book considered to be the ne plusultra of investment texts would delve into the hopelessly complex and ephemeral. Instead, Intelligent Investor's stated goal is simple: to help the investor build a framework to invest in bonds and common stocks. That's it. No discussions of oscillators of any kind, no mention of relative strength, and no great insights into structured finance.
My entire investing philosophy switched when I read a single line in Intelligent Investor. It was this: "Obvious prospects for physical growth in a business do not translate into obvious profits for investors."
The translation: If you're looking to invest in companies that have, for example, spectacular growth potential, you have to make sure that this spectacular growth potential is unappreciated. If everyone knows that a company is going to grow at 15%, then that growth will be factored into today's share price. Buying the obvious doesn't necessarily lead you to the promised land.
For most of the 20th century, telecommunications was the growth business. And, yes, AT&T (NYSE:T) and its many offshoots --SBC Communications (NYSE:SBC), BellSouth (NYSE:BLS), et al. -- are many times larger than anything that existed decades ago. And yet, this business has almost never not been a pitfall for investors. Why? Bad economics, for one, and two, the growth that was supposed to develop did just that, but it was already priced into the companies' stocks.
Looking for a comparable example today? Genentech (NYSE:DNA) is growing, and, given its pipeline of patent-protected blockbuster drugs, it has what would best be described as a gigantic moat filled with crocodiles, snapping turtles, pestilence, and foul odor. What's more, the company has blockbuster candidates in every phase of approval, which should keep the company pumping for decades even after generic manufacturers like Teva (NASDAQ:TEVA) are able to manufacture products to compete with today's blockbusters. There's growth and defense. What more could an investor want?
I suggest that every bit of that growth is priced into the stock right now. The price has run up recently, and positive results for nearly every drug with good prospects are already expected. The folks in charge are going to have to do something superhuman to generate value over and above expectations. Will they succeed? The possibility certainly exists. But Genentech needs to achieve far above and beyond expectations to be a good buy right now.
So, this means that we need to focus on the smaller things, right? Value isn't apparent on the surface, so it must be deep down.
Yeah, that's a little too much, sparky
Imagine this conversation at Creampuff Inc.:
John Trahan: (answering phone) Cataloging Department, John speaking.
Shareholder: John Trahan?
John Trahan: That's why my speaking parts start with "John Trahan."
Shareholder: Oh. I can't see the text over the phone.
John Trahan: Can I help you?
Shareholder: The name is Kobayashi.
John Trahan: Funny, you don't sound Japanese.
Shareholder: I'm a shareholder at Creampuff.
John Trahan: Who are you again?
Shareholder: Your boss. I own Creampuff, and you're spending too much time playing Minesweeper instead of doing your job.
John Trahan: You're not my boss. Jim --
Shareholder: Jim Abruzezze? I fired him.
John Trahan: You WHAT?!?
Shareholder: Only one less productive than you. I thought it would send a message.
OK, you get the point. This conversation would never happen. Shareholders are actually not entitled to any and all information they wish to see about the operations of companies they hold. If the rules were different, a rival company could just buy shares in Genentech and then demand to see in complete detail what projects it was working on. This is why boards of directors exist -- to ensure that the owners of a company are being well-served by management.
But there's something else about this conversation that is absurd. It's the thought that a shareholder would possibly know information about a company in this level of detail. It's impossible. And this leads to something that investors should probably face:
Even for companies that you study with lavish devotion, you are clueless as to 99.9% of the goings on. You're forming investing opinions and putting your capital behind them based on a tiny fraction of the known data about any one company.
Does that make you nervous?
Well, don't be, because almost all of the information you don't know is stuff that doesn't really help you analyze the company in the first place. All information is not created equal.
Hidden, yet important
That's the stuff of investing: finding the stuff that is important, yet not fully appreciated. Or, if you're looking to sell shares or short them: that which is important and overappreciated.
I'll give you an example pulled from my research at Motley Fool Hidden Gems. I noted that Fairmont Hotels and Resorts (NYSE:FHR) lost money in the first quarter during a time when the travel economy was improving. This "obvious" point would suggest that Fairmont was suffering from competition, regulation, incompetence, whatever.
And yet ...
The not-so-obvious facts told me that this stock had "winner" written all over it. You see, Fairmont took a huge depreciation expense because its properties are so highly valued. Depreciation is a non-cash expense, which means that even that Fairmont was not profitable, it was cash-flow positive. Moreover, an analysis of the company's portfolio of properties revealed that their real estate value was greater than the market value of the company. In other words, Fairmont is hiding a gold mine as it opts to sell off properties and maintain operating contracts.
I am confident that this recommendation will pay off in a major way for Hidden Gems subscribers. I found it by focusing on the middle ground: stuff that investors don't necessarily know about, but really, really should.
There's a long history among the great investors of doing this very thing. Berkshire Hathaway CEO Warren Buffett has earned greater than 20% compounded annual returns by simply focusing on important things that weren't readily apparent to the broader market. He made a killing by figuring out that Coca-Cola (NYSE:KO) had more value in its brand name than the company had realized. A string of scatterbrained diversifications in the 1970s and early 1980s diluted the ability of the company to realize its value and paralyzed the stock. But Buffett used that time to buy shares, and then he waited for the company to return to its focus: sugary beverages.
How did those investments work out? Well. Very, very well.
Got it in you?
The moral of the story is this: The sweet spot in investing is determining what is important versus what is not, and then determining whether these important things are valued properly. Anyone can do it. Few do.
This very sweet spot is our passion at Hidden Gems. For a limited time, if you subscribe to Hidden Gems, my compadre Tom Gardner will send you a copy of The Motley Fool's Blue Chip Report 2005: 10 Monster Stocks for the Next Decade as a free gift. You'll also enjoy access to everything we've ever recommended or written. Click here to learn more. There is no obligation to subscribe.
This article was originally published on July 12, 2005. It has been updated.
Bill Mann thinks that the whistle completely makes the song "Paradise City." He has no financial position in any company mentioned in this article. SBC Communications is a Motley Fool Stock Advisor recommendation. Coca-Cola is a Motley Fool Inside Value recommendation. The Motley Fool isinvestors writing for investors.
