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you've survived good companies well done right the rest is shorter it's very important and I hope naturalist straight not only what it is we're saying about them but why it's important because I reckon if you I wish I'd kept a diary from my first day in work in 1974 in the financial service industry with two columns each day and then I put a tick in the column when somebody said to me on the one hand is that a cheap stock or not a cheap stock is that a cheap fund or not a cheap phone is it chief market not a cheap market chick in that column and on the other hand when they put one in the other column is it a good company and I know which column where the balance will be Chalmers I don't know exactly cuz I didn't keep the diary but overwhelmingly over the years and still to this day people ask us here but is it cheap it's not the most important question it providing you get the first decision right which is you've got good things whether or not they're cheap is a secondary consideration it's why it's second on our list okay don't take my word for it this is Warren Buffett psychic Charlie Munger I don't know why I picked these particular numbers but there's what he said over the long term it's hard for a stock to earn a much better return than the business which underlies EOS if the business earns 6% on capital over 40 years are no idea why chose six percent or four years but doesn't matter you hold it for that 40 years you're not going to make much different than a 6% return here's the punchline even if you originally buy it at a huge discount all right conversely if a business owns 80% on capital over 20 or 30 years even if you pay an expensive-looking prices the punchline the other way you'll end up with one hell of a result right now mr.
McClure is not speculating on this he's not offering you his suggestion it's mathematically effective right here's two companies and your investing career 40 years seems like a long time but actually most of us given our lifespan now are going to be investors for much longer than 40 years actually even if we start in our 30 say we're going to be investors for much longer than that and these two companies are you've got a very simple choice you've just got our own company our company B for the 40 years that's all it is so you require company a has a return on capital employed of 20% and B has one of 10% to make this in terms of mental arithmetic so you don't have to do complex mental arithmetic neither company pays a dividend so a hundred percent of their post tax returns are invested in their business and they both have the same tax rate so I hope having board for Britain on return on capital employed for the last 20 minutes or so I could convince you that a might be the better investment to select however if only life were that simple and the day when you go to buy them they are differently raging a is trading on four times prevailing on the stock market B is only two times portfolio for those of you and I Alice Book value is the Kappa take it as the capital employed there so for every pound of capital employed in this lovely 20% to owning company you've got to pay for in share price term whereas nothing surprisingly with this one almost 10% you've only got to pay too bit trickier isn't it which one do you want now it gets worse when you come to Sullivan forty years later because you want to invest in bonds and lose money this one is hardly valuation I have no idea why it's occurred it's out of fashion your timing is bad for whatever reason it just take my word for it it's hand it's gone from four pounds for every pound of book value to two pounds this one on the conversely is in fashion at a moment it's doubled its valuation now which one do you want to learn hmm it's still I now believe it or not and we can send you the spreadsheet for anybody wants to see our Selfridge you've actually got enough information here not for the gobbledygook that I talk about return on capital employed price of the book you've got all the data there where if we tell you the share price at the outset we can tell you what you regained at the end of what the compound returns but you've got everything you need there in those few numbers you're terrible timing here but in this very good company would have cut your share price compound annual growth rate to 18% you'd have taken 2% off from what Charlie Munger tells you is the underlying return this one your brilliance or luck I don't know which it is would have got the return up to a whole twelve percent over the long-term it's the return that the company makes on the capital it reinvest which will determine your outcome not whether you buy it cheap and sell it expensive or the other way around here's a real company to illustrate that this is a company that you've heard of I already imagined I would be fairly confident you've used its products it's a consumer product company these are three years actual numbers don't bother looking at the ball I'll just pick out a few here's three years you can see its sales went from 15 billion dollars to 17 nearly 18 to 19 billion dollars and it's a net profit which is somewhere in the income where are we net income went from 900 million dollars to 1.5 billion dollars it's growing at about 8 percent per annum these are not a typical years I bought 20 years up there only because it would be a crowded slide they're very typical of how this company performs to this day I've continued to perform a bit like this and it did before what would you be prepared to pay for this company so now we get back to the chief there or expensive so never mind per share we'll just do it for the whole company so if it makes 1 point 1 billion dollars in net income would you pay a PE a price earnings ratio of 10 so you buy it could I get you all to bound together with me tonight and we'll go and buy this company for 11 billion dollars now I reckon you would alright you might be able to get you in for that yeah how about getting you to pay 20 times earnings so we paid 22 but it does mmm I think now we're just start hearing people go it's a bit expensive isn't it yeah I'm out 30 times 32 not one of you would come with me mark my she knows example the rest of you I've got no confidence at all that I can get you to come along 40 times you would be trying to get to find if you find a short seller for the company basically at that point the proceedings right now this is a company called PepsiCo hmm and I didn't actually lie to you on the previous slide because I'm not like that but I did do something slightly misleading you see the years that I put up I labeled 2014 15 and 16 and actually they're not they are actually 1989-90 1990-91 so they're 25 years ago so I did it to you because we can now tell what happened with our decision that I was trying to get you to mate with me so there's what happened fundamentally the 19 billion dollars of sales became 62 billion in the intervening years because we've got the 2016 results here we could tell you what the 1.1 billion of profits became 6.6 billion dollars of profit so it went up six times the market value went from twenty seven billion dollars two hundred forty six billion dollars you'll get told by the way in relation to our strategy that these companies are more expensive and they've ever been I'll come back to that backs a bit later though they're not actually this company's much more lowly rated now than it was back then some 22 times earnings versus 25 okay how did we get on well if we bought the company for ten times we'd have made fourteen point three percent per annum return because we can tell you what happened share price now over the twenty five years if I got you to pay twenty times we'd have made the 11.1% if I got you to pay thirty times remember none of you were I didn't hear any protests yeah I've been in Terry I didn't hear anything we'd be on nine point three percent okay forty forty times eight point one percent the S&P 500 for the same period with dividends reinvested it was nine point one percent per annum this is the toughest index in the world for fund managers to even equal let alone beat we could have paid thirty two times earnings with PepsiCo and equal than index at most fund managers find impossible to be human beings are really bad at working out the effect of differential compound growth rates over long periods of time we don't realize quite what happens when companies compound their earnings in the way of his company's compound we're very very bad at judging the outcome we could have paid thirty two times earnings for PepsiCo back there at the 1991 I'm an equal the index could about thirty times of beating the index basically now I know a valid question is yeah but is this the same as nanjing neither one i've got a clue but I do know this every time you make an investment decision now you're making judgment and about the future and I think this is a lot more predictable than your airline stock or your oil and gas stock or your bank and so on that's a real live example here's another real live example this is the S&P 500 and this is about market timing and valuation now let's imagine you were very very clever lived a very long time and started very early and what you did was you bought the sp500 it is low in the 20th century and sold it at its high in valuation terms you would have been buying it in 1917 the lowest valuation S&P was a day America into World War one when the price earnings ratio was five point three and you'd have sold it just at the peak of the dot-com boom in 1909 when it's 34 times ignore the charts just just look at the numbers perhaps for a moment you would have made a compound any return of eleven point six percent per annum by buying it it's lower valuation selling it is high in valuation well done that's pretty good return not bad but we can break down what comes from your cleverness with the timing and the valuation and what comes from the companies just reinvesting by the following method if you put into a calculator if you've got a Hewlett Packard 12c like me the old industry standard you can work out what you've made from this because you can put in minus 5.3 present value 30 for future value the number of years in here which is 82 years old 82 yeah and press the button it will tell you that 2.3 percent of that 11.6 came from your cleverness 80 percent of the return came from the companies just reinvesting and compounding in value now this is 500 average companies this is not a particularly good company with a 29 percent return eighty percent of the return is an example of perrito's law 80 percent of the result comes from 20 percent of the actions 80 percent of this came from the companies investing in not you doing anything and if you do it with a good company this is our friends Unilever again for 20 years and you do the same calculation if you brought it in 95 on 16.8 times sold it in 2016 or 21 times what I've done obviously you've made a ten point nine percent return over that period if you do the same calculation you'd find one point one percent of this came from the uplift in value ninety percent of it comes from the company over the long term it's what the company does it makes money not what you do we still having said all that so I've said if Charlie Munger says is what the company does not not your your valuation that gets you there I've given you the theoretical company a and B I'll get with you the PepsiCo example and I've talked about comparing what happens with the index and Unilever having settled that we do try not to overpay because I mean you would be mad to go out there and deliberately overpay so we do every day in real time compare a thing called the free cash flow yield so the free cash flows that our companies generate after paying for everything except the dividend so we divide that by their market value to get a yield now but let's our cash flow belongs to us the shell risk and we compare that free cash flow now and in about four or five years time come we can see is it growing remember we like growth with each other our investable universe of stocks that we follow that we will be prepared or owned with the market with bonds and with any other yardstick and we try every day to make sure that we were invested in the companies which have good that we would own which give the best combination of value so having said that it's not that important we don't ignore it I said earlier you'll be told that this is the stretch is all about consumer staples and that they're more expensive ever be this is just a price earnings ratio chart for the 20 years there for the consumer staples ticker it's not our biggest sector of investment so stretchy definitely the super staples per say and you'll see in the P terms there they're movin 22 I think I do a bit further doubts it's not a recent Charlie Brown about here now as you can see they were much more highly rated in the 1990s basically no they're not more expensive they've ever been and bear in mind the Fed Funds rate was about it was about 6% there basically during that period so the actual underlying valuation rate was much much higher when they were much more highly rated they haven't been a particular help actually if you look at this our fund over the over the last five years in terms of compound returns and here's some sectors you've seen if you get down here consumer staples have actually been a net retractor from our performance over time they haven't performed as well as our fund has performed over time so it's not all about them then finally do nothing this is a complex table I apologize for that but this is our portfolio turnover rate you can see the highest is thirteen point four percent per annum that is strikingly load by industry standards I'll come on to that in a moment here's what it's been over the last half a dozen years you can see two percent five percent its negative in three years which is a piece of gobbledygook I'm afraid and when we are calculating this turnover we don't do it on a way that we would like we're given a formula and what the formula does is it looks at our buying and selling so obviously we've got that number and then it nets against there any net inflows into the fund it's a net cash inflows so when we've had big cash inflows which have exceeded our dealing we end up with a negative turnover which is absolute nonsense I mean I open here none of us know what that really means here's a better help here's our dealing costs okay and you can see our dealing costs there's the actual numbers but here's them as a percentage of the assets so last year we spent point zero one eighth of a percent on dealing so we spent less than two hundreds of a percent on dealing okay I'll show you some other people as an example in a moment you know we're talking about a 17 billion fund here those numbers would be a black armband a for the broking industry basically i which is not our problem but it would be if everybody ran money like this because they won't
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