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but one of the supplementaries i often get asked by people is well look these companies are very good companies i think they are um and you know i think they are provably very good companies if we're not talking about some kind of judgmental matter they produce very high returns on capital employed in cash they do it consistently they do it year in year out even at the bottom of economic cycles they can reinvest some of those wonderful returns to grow their value over time etc etc they've been established for a very long time sometimes for over a century and so on and most of them you've heard of you may even have heard of all the companies that we invest in i mean there's only about 70 so i mean it's not exactly an enormous universe so how is it that it's possible to buy these companies that are such good companies but buy them a bit cheaply how does that work and i think there are many explanations for that most of which have got to do with the concepts of economics or behavioral finance which i'll delve into very briefly because i think it's not that sort of meeting where we're going to sit here and do a hypothesis on economics but one of them is i think on average that the way that the market values companies is by a concept called mean reversion strange enough there was an article about it on the back of the financial times uh fund management supplement this morning by a man called edward chancellor from a fund management company called gmo and mean reversion means this if a company's got very high margins and very high returns on capital it will attract competition people will enter the industry competitors will expand the company itself will employ more capital as well and gradually those returns will be driven down towards the average for the market and if a company's got very poor returns on capital very poor margins capital will exit that strategy basically companies will exit because they can't make an adequate return companies will go bust nobody invests in new capital and gradually the returns within that company in that industry will start to gravitate up towards the mean and i think it's a very very good theory um and i think as a way of valuing companies on average i salute it i think it's the sort of uh thing that people should apply i think that the reason that this strategy may one of the reasons why this strategy may be viable uh what is viable and may continue to be viable is i think there are a small group of companies in the world that don't mean revert that have superior margins and superior returns that don't get competed away and that's because they have huge intangible advantages they have brand names patents intellectual property distribution networks installed bases of equipment to which they have a tame market for selling spares and service or all of the above and as a result they're able to fend off competition so that the capital can't enter their markets readily to meet revert and those are the companies that we seek to own so i think there's an economic reason for us being able to buy these companies somewhat cheaply i think there's also a behavioral reason and that is i think as investors as human beings uh we're attracted to insight excitement basically um if you look at investors uh they seem to believe and there's quite a lot of economic theory to support this that in order to make a superior return they have to take a higher risk we're taught that and there's economic theory behind it the efficient markets hypothesis there's plenty of folklore behind it there's no such thing as a free lunch you know if you want to make more money you have to take higher risk unfortunately for about the last 50 years all the statistics tell you the opposite you make most money from the most stable and least volatile shares but still people persist in buying the small companies in the very volatile shares thinking that by assuming that risk they're going to make more money there's no sign of that whatsoever but i think we are innately attracted to it that i think the best way of describing why we do it is the so-called lottery ticket effect you know if you buy a lottery ticket you are definitely not uh basically someone who's done it on the application of statistics because you're overpaying for the odds of the very large win but it's the very large win that attracts you and that's why i think we we are attracted towards these very apparently high return risky companies and that's what gives us our opportunity i think to buy our very good relatively predictable companies at a relatively cheap price and so yeah i often get asked about valuation probably the most amusing questions i get about valuation are from a couple of people i encounter who we talked to at the outset of fun smith or even before we set it up who said a couple of things which always amused me one of them being well i mean your timing's really poor at the moment i mean the economic outlook is bleak you yourself are very bearish about it etc etc you know have a look at it another time that some of the same people say to me well it's only succeeded because of the good timing i mean if you haven't started it then i i sometimes wonder if they ever sort of remember the things they previously said to you and the other one i particularly like is the people who said i really like the strategy and what you're doing um but i do think that this is a bad time at the moment and i think when there's been a significant decline in the market i'll buy some i often think we're up about 50 today from inception if we if we started at 100 and we're now trading at 50 and i said then good news we're down fifty percent want to put some money what do you think the outcome would be so it's wonderful i i don't think sometimes people's self-knowledge in terms of their behavioral characteristics and investing is very good um hopefully ours is very slightly better there we are
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