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alex bird was a punter and one of the greatest better of the horse racing back in old times when technology was not too great the photo finishes were filmed and took few hours before the crowd got to know who won in the meantime all the punters would place their bets that which of the horses would have won you will be surprised to know that alex bird for the next 20 years made 500 consecutive winning bets on photo finishes bird noticed that when horses crossed the line together the horse on the far side often appeared to have won what he had figured out was parallax he discovered a simple technique to exploit this by standing as near to the winning post as possible closing one eye and creating an imaginary line across the track at finishing line he could tell which horse had actually won so how did bird got the winner right the answer is that he already knew who the winner was even before the results were out terry sped the ceo of one of the successful and the largest funds of uk the fundsmith and the author of this book has the same approach to investing his funds since inception from 2010 until now has delivered an annual return of 19.3 per annum which is phenomenal in the mutual fund industry and that too over a period of 10 years just when people make investing more so complicated his fund has delivered an outstanding performance by just buying the companies which are already winners rather than predicting which could be the winners let's dive deep into terry smith's approach to investing and learn how to make money by only investing in the best companies of the world this is the better investor helping you achieve your financial goals and freedom through organizing your finance stock market investing and learning from billionaires and these are top 5 lessons from the book investing for growth how to make money by only investing in best companies of the world written by terry smith lesson number one experience matters the most the average age of the 20 companies in the portfolio of fundsmith is north of 100 years obviously there are new age companies like facebook owned by him in his fund but then there are also nestle which is 128 years old colgate palmolive which is more than 200 years old only one can imagine how many economic recessions elections wars and uncertain times companies like these would have seen if nothing since then could kill these then in all probability their longevity is unquestionable we all know that warren buffet says the recipe to create wealth is to buy good companies and hold them forever but the question here is to select the company that can exist forever surely floppy disk and cd-rom industry were once a very high growth industry by even investing in the leader then and had you have thought to hold it forever you would have left with no money moser bear filed for bankruptcy in 2018 and it should be no surprise thus it is prudent that to hold the stock of a company forever it has to last forever and if you would want to place your bet that which company will last forever then it is the best way to place your bet on the company that has already been in business and operated for a long long and very long time if it would have been fragile it would have not existed if you would have to place your bet that out of gold and any of your alternative cryptocurrency which would still be valuable hundred years from now most bets will go on gold because it has been around for many thousand years now and if all the worst times in humanity could not make it redundant then it is most likely that in future 2 it will be around this is called lindy effect according to which in case of non-perishable items the probability of a thing to exist increases in the future the more it has existed till now same is true for businesses so if you want to look that which business will be around for next 50 years firstly look back and see that which are the ones that have already been around for last 50 years lesson number two return on capital employed we all have been bombasted by the phrase that by only good companies but what is the definition of a good company warren buffet wrote in his letters to shareholder that the single most test of the quality of a company is the return it generates on the capital invested which is nothing but return on capital employed the formula for which is operating profit divided by assets minus short-term liabilities well you don't have to do the mathematics and just like any other financial ratio it is also available easily on google as a thumb rule return on capital employed of 10 is poor 12 to 15 is average 15 to 20 is good and more than 20 is considered excellent erie says that a good quality company must have the history of maintaining good return on capital employed consistently for a long period of time charlie bunga the right hand man of warren buffet said over the long term it's hard for a stock to earn a much better return than the business which underlies it earns if the business earns 6 percent on capital over 40 years and you hold it for that 40 years you're not going to make much different than a 6 percent return even if you originally bought it at a huge discount which means to say that if you aim to achieve returns of 20 per annum in your long term investing career of say 30 years you must be invested in business that has return on capital employed of 20 percent on an average for these 30 years let's understand this with the help of example itc the erstwhile imperial tobacco company which is also now mcg and hotels giant in last 20 years the itc has maintained its return on capital employed between 20 to 30 percent and if you see its stock price has appreciated from 12 rupees in 2001 to current price of 220 rupees which is the compounded annual return of 16 per annum and if you consider the dividends given taking in account of bonus share and share splits which themselves account for 11 per annum if you combine both the returns by the appreciation of stock price and the dividend received the returns comes out to be 16 plus 11 which is 27 per annum which is in line with its average return on capital employed in this time thus if you are investing for long term then the returns that you will get will be more or less in line with the average return that the business itself generates therefore consistency of the past return on capital employed must be an important metric in your investment selection lesson number three cash is king it has been reiterated n number of times not just by me on this channel but by many great investors that the profit that a company generates and shows us an income statement can be very different from the actual cash that increments in the company's bank account for this reason we must not just be happy that the profits have been growing however we must correlate it with the operating cash flow operating cash flow is the actual cash that the company has made from its operations which can now be used for investing or reinvesting or repaying loan etc the ratio of the net profit of the company and the operating cash flow of the company is called cash conversion ratio the higher it is the better a high cash conversion ratio means more of the net profit of the company is being realized as cash the best quality companies generally have cash conversion ratio of more than 90 percent some even have it more than 100 percent suppose you sold a shoe for the price of hundred dollars and it took you forty dollars to make the show then your profit comes out to be sixty dollars but take a case that the customer buys it on emi of fifty dollars a year and agrees to make the payment in two years then in that case the profit in the income statement will still be shown as 60 dollars but the operating cash flow that is the cash that got added in the company's bank will just be 50 dollars which is the cash given by customer minus forty dollars which is the cash used in making the shoe that is ten dollars if we calculate the cash conversion ratio then it comes out to be ten dollars divided by sixty dollars which is sixteen percent now suppose you'll go to mcdonald's and they sell you five-year membership for five hundred dollars to eat as much burgers as you can suppose you ate for 100 in the first year and the cost of raw material for mcdonald's was forty dollars then the profit to the mcdonald's in the income statement will be hundred dollars minus forty dollars which is sixty dollars however the operating cash flow will be five hundred dollars which is the money paid by the customers minus forty dollars which is the cash used as raw material for making the burgers so the cash that goes in the bank will be five hundred dollars minus forty dollars which is for sixty dollars and the cash conversion ratio will be four sixty dollars divided by sixty dollars which was our net profit which comes out to be 766 percent cash conversion ratio of more than 100 generally means that the customers are actually paying for the product in advance not always but most of the times so before becoming happy that the profits of the company is rising year after year please take a look at the cash flow statement and see that whether the operating cash flows are also increasing similarly and that how much of the profit is actually getting converted into actual cash lesson number four do not try to time the market if you have found such a company mentioned above which is highly experienced has consistent history of good return on capital employed has good cash conversion ratio and the one that is growing its revenues and profits consistently then if you wait on the sidelines for the right time to invest then you will only be left with regret perfect timing is nothing but luck how can someone know that this is the market top and this is the market bottom trying to get out of these companies when they become overvalued and get in when they become undervalued is immaterial in such companies even if it was possible especially seeing the investor horizon to be more than 30 years this is the chart of colgate palmolive one of the oldest company of the world founded in 1806 which is a leader in making toothpaste toiletries and pet food can you spot the day when 9 11 happened looking at the chart or the day u.s inflation rate rose by the fed in 2000 when was the us iraq war threat looming on sure you can do that but you will definitely need a microscope to find out when did that happen here is another chart of nike the famous shoe brand which was founded in 1964.
if you see today when were the opportunities of the market timing in these companies 30 to 40 years back in 1980s and 1990s you can definitely not tell when they were thus the longer your holding period as an investor in such type of companies the more immaterial the timing becomes if such companies are available at fair valuation then waiting for them to become cheaper can be a big mistake even if these companies when bought at an expensive valuation have rewarded the shareholders there may be a little under performance in the short term but in the long run of 30 years or more it will make no difference with respect to the amount of time you will spend on forecasting the correct time to enter and exit the stock if you are investing in cyclicals or cigar butts as advocated by benjamin graham who is known as the father of value investing or even how warren buffet did in his early race then in that case buying cheap becomes extremely important and so does selling out at the correct time well if you do not know what i am speaking of you can check out my past video which is on intelligent investor a book written by benjamin graham himself this is a chart of a cyclical steel company you can see that even if you hold it since long back you would have not made any money but the way to go for these type of companies as discussed earlier is to just stick to them forever this warren buffet wasn't lying when he said time is a friend of good companies lesson number five keep a cap at costs costs can easily eat away your returns if you invest in a mutual fund then these come in the form of expense ratio or also called as the management fees which can be one to three percent per annum on top of that there is performance fees in some of the funds if you think that these are minuscule then let me explain you suppose you had invested in the stock of berkshire hathaway the company of the world's greatest investor warren buffet 30 years back which is compounded at an annual rate of twenty point three percent per annum then your one million dollar would have turned into 237 million dollars however suppose berkshire hathaway was a mutual fund and mr buffett charged you two percent management fees then after 30 years you would be left with 143 million dollars which is almost 100 million dollar less thus if you are an investor in a mutual fund be skeptic about the expense ratio or the management fees that you're paying well you would as well say that this fees is only because we stayed invested for 30 years with mutual fund you think you're smart and will exit after one year then the costs only increase because when you will withdraw your investments you will have to bear a charge called exit load which is again one to two percent not only that there is a processing fee also that you need to pay to your mutual fund once you exit not only that the gains you realize after selling your mutual fund are subject to income tax which is ten percent if you sell after one year and twenty percent if you sell in less than one year or different depending on different countries even if you are directly buying stocks then frequent trading also makes you pay brokerage to your broker on both buy and sell orders other than that there is a tax called stt which needs to be paid immaterial or whether you're buying or selling a share this is a side of the income tax that you'll have to pay thus if you're a long-term investor and invest in stocks directly then it is in your best interest to choose quality companies of the likes already discussed and just keep holding on to them till time immemorial avoiding the urge to buy something new by hearing some tip and news on television in a long scheme of things these hidden fees can eat up your hard earned returns to those of you who would want to invest in a mutual fund please look for the one that has the lowest expense ratio in not just my opinion but in the opinion of the most of the great investors a no-nothing investor is best investing in an index fund these have the least expense ratio of 0.1 to 0.2 percent and staying put with them without redeeming for a very long period of time say 20 to 30 years is the best way to go for a no-nothing investor let's have a quick recap one of the simplest mantra for wealth creation is to buy stocks of good companies and hold it forever but for that we need to find out not just good companies but companies that will be around for a long time this quality of anti-fragility can be seen in the companies that have been around for many decades if all the economic booms burst elections and wars couldn't disrupt the business then most likely nothing will in future the single most important metric to judge the quality of the company is the return that it generates on the capital it invests called the return on capital employed in a long run it is almost impossible for a company to return to its shareholders more than the return the underlying business generates look for companies that have maintained their roce more than 15 to 20 percent consistently for a very long time the profits we see in income statement most of the times are not realized as cash thus it is prudent for an investor to look at the operating cash flow and then compare it with the profits that the company shows in the income statement the ratio of operating cash flow to the net profit is called cash conversion ratio the higher the better when you're investing universe in is in these high quality companies that have been around for a long time then doing the tricks to time the market may prove futile even if you get a little advantage in short term in long term it proves out to be more or less immaterial comparing the effort you will have to put in to get the forecast right each and every time which is impossible the additional unseen cost can easily eat away your returns always calculate your returns after paying taxes and many other fees it is in the interest of an investor to churn and revolve stocks as minimum as possible this will help you minimize fees and tax on the transaction which in the long run can take away more than half of your gains that's it guys if you liked the video please like share and subscribe do check out my last video on the summary of value investing and behavioral finance written by parag parikh i will come again soon with a summary of another investing book until then cheers guys
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