1 CIGAR BUTTS & MOATS A"Phoenix"Capital"Research"Publica5on" How To Make a Fortune With Value Investing 2013 Phoenix Capital Research, OmniSans Publish, LLC. All Rights Reserved. Protected by copyright laws of the United States and international treaties. This newsletter may only be used pursuant to the subscription agreement and any reproduction, copying, or redistribution (electronic or otherwise, including on the world wide web), in whole or in part, is strictly prohibited without the express written permission of OmniSans Publishing, LLC. All Rights Reserved.
Disclaimer: The information contained on this newsletter is for marketing purposes only. Nothing contained in this newsletter is intended to be, nor shall it be construed as, investment advice by Phoenix Capital Research or any of its affiliates, nor is it to be relied upon in making any investment or other decision. Neither the information nor any opinion expressed on this newsletter constitutes and offer to buy or sell any security or instrument or participate in any particular trading strategy. The information in the newsletter is not a complete description of the securities, markets or developments discussed. Information and opinions regarding individual securities do not mean that a security is recommended or suitable for a particular investor. Prior to making any investment decision, you are advised to consult with your broker, investment advisor or other appropriate tax or financial professional to determine the suitability of any investment. Opinions and estimates expressed on this newsletter constitute Phoenix Capital Research's judgment as of the date appearing on the opinion or estimate and are subject to change without notice. This information may not reflect events occurring after the date or time of publication. Phoenix Capital Research is not obligated to continue to offer information or opinions regarding any security, instrument or service. Information has been obtained from sources considered reliable, but its accuracy and completeness are not guaranteed. Phoenix Capital Research and its officers, directors, employees, agents and/or affiliates may have executed, or may in the future execute, transactions in any of the securities or derivatives of any securities discussed on this newsletter. Past performance is not necessarily a guide to future performance and is no guarantee of future results. Securities products are not FDIC insured, are not guaranteed by any bank and involve investment risk, including possible loss of entire value. Phoenix Capital Research, OmniSans Publishing LLC and Graham Summers shall not be responsible or have any liability for investment decisions based upon, or the results obtained from, the information provided. Phoenix Capital Research is not responsible for the content of other newsletters to which this one may be linked and reserves the right to remove such links. OmniSans Publishing LLC and the Phoenix Capital Research Logo are registered trademarks of Phoenix Capital Research. OmniSans Publishing LLC - PO BOX 6369, Charlottesville, VA 22906
How to Make a Fortune With Value Investing Welcome Cigar Butts and Moats. The purpose of this newsletter will be to help you accumulate wealth through the careful allocation of capital in high performing, investments that we ll hold for months if not years. Our investment strategies will be heavy influenced by the thinking of Benjamin Graham and his legendary student, Warren Buffett, with a focus on investments that are either undervalued or which offer tremendous compounding potential. Before we get started, I want to lay out some of the central principles of successful value investing. In This Report Two critical approaches to value investing. Benjamin Graham s Cigar Butts or looking for just one more puff. Warren Buffet s quest for economic moats. How to make a fortune in long-term value investing. First and foremost, you need to know that few if any investors actually beat the market in the long- term. The reason for this is that most of the investment strategies employed by investors (professional or amateur) simply do not make money in the long run. I know this runs counter to the claims of the entire financial services industry. But it is factually correct. In 2012, the S&P 500 roared up 16% including dividends. During that period, less than 40% of fund managers beat the market. Most investors could have simply invested in an index fund, paid less in fees, and done better. 3
If you spread out performance over the last two years (2011 and 2012) the results are even worsen with only 10% of funds beating the market. If we stretch back even further, the results are even more dismal. For the ten years ended 1Q 2013, a mere 0.4% of mutual funds have beaten the market. 0.4%, as in less than half of one percent of funds. These are investment professionals, folks whose jobs depend on producing gains, who cannot beat the market for any significant period. The reason this fact is not better known is because the mutual fund industry usually closes its losing funds or merges them with other, better performing funds. As a result, the mutual fund industry in general experiences a tremendous survivor bias. But the cold hard fact what I told you earlier: less than half of one percent of fund managers outperform the market over a ten- year period. So how does one beat the market? Cigar butts and moats. Cigar butts was a term used by the father of value investing, Benjamin Graham, to describe investing in companies that trade at significant discounts to their underlying values. Graham likened these companies to old, used cigar butts that had been discarded, but which had just one more puff left in them. Like discarded cigar butts, these investments were essentially free : investors had discarded them based on the perception that they had no value. However, many of these cigar butts do in fact have on last puff in them. And for a shrewd investor like Benjamin Graham, that last puff was the profit potential obtained by acquiring these companies at prices below their intrinsic value (below the value of the companies assets plus cash, minus its liabilities). Graham used a lot of diversification, investing in hundreds of cigar butts to produce average annual gains of 20%, far outpacing the S&P 500 s 12.2% per year over the same time period. So when I say that you can amass a fortune by investing in Cigar Butts, I m not being facetious. For this reason, cigar butts, or deeply undervalued companies, will be a focus of this newsletter. And like Benjamin Graham, we ll only be holding these companies in the short- term: until they reach their intrinsic value. The other term, moats is in reference to the investments Warren Buffett, a student of Ben Graham and arguably the greatest living investor, seeks out Buffett amassed his enormous fortune through a systematic investment philosophy consisting of a few key ideas: 4
1) Buy companies with moats around them meaning that they have a competitive advantage that stops competitors from breaking into their market share. 2) Stay within your circle of competence : if something is outside your knowledge or something you don t really understand, avoid it no matter how great it sounds. 3) Focus on companies that have economic goodwill meaning they have an intangible quality (such as a brand) that permits them to raise prices on their products without driving consumers to a competitor. 4) It s better to buy a great business at a fair price, rather than a fair business at a great price. 5) If you can find a company that meets these criteria, buy it and hold for the long- term to allow it to compound as much as possible (Buffett once said his favorite holding period was forever ). Note the key differences between Benjamin Graham s strategies (buy lots of undervalued companies at cheap prices and hold them until they meet their intrinsic value) and Buffett s (buy a small number of companies at decent prices as long as they have a unique position in the market and then hold them for the long- term). To consider how moat investing works in the real world, let s consider McDonalds (MCD). For starters, MCD has a moat. MCD was launched in 1940. Burger King was launched in 1953. Wendy s was launched in 1969. Despite these competitors moving into its space, MCD has thrived, growing to become the largest hamburger based business in the world: its 2012 revenues were $27 billion compared to Burger King s $1.9 billion and Wendy s $2.5 billion. Today, MCD has over 34,000 restaurants based in 199 countries employing 1.8 million people. Obviously the company is able to defend its market share from competitors. That s an economic moat. MCD s core business, selling hamburgers and sodas, is easily within most investors core competencies. That is, it s not hard to understand the business of making and selling burgers. However, do not let the simplicity of the concept (selling burgers) fool you. MCD is an incredibly well run organization. The McDonalds brothers who created the first restaurants implemented an assembly line approach to producing hamburgers and milk shakes, systematizing the process until they were producing a vastly superior product at a faster pace than their competitors. The end result was that they rapidly took market share. Ray Kroc who bought the business from the McDonalds and built it into a global powerhouse, took this approach even further. 5
Under his watch, every aspect of MCD s business was quantified down to the smallest detail. For example, a MCD beef patty must have fat content below 19%, weigh roughly 1.6 ounces, and be 3.875 inches in diameter. This methodology was applied to every aspect of MCD s business from how it prepared fries (they only use #1 Idaho russet potatoes cut to be 7/32 inches thick with at least 21% minimum solids) to the training of franchise owners (they have to attend a week long training at McDonalds facility Hamburger University where they learn management skills, quality control and countless performance metrics). As a result of this systematization as well as clever marketing, MCD has developed tremendous economic goodwill that has allowed it to become the #1 fast food restaurant on the planet. Between this and the company s focus on producing returns to shareholders, those who invested in MCD and held for the long- term have dramatically outperformed the market and built literal fortunes. Indeed, had you in McDonalds in 1986, you would have outperformed the S&P 500 by a simply enormous margin (see Figure 1 below). Not only that but you would have crushed every asset manager on planet earth with very Figure 1: MCD shares demonstrate the power of moat investing 6
few exceptions. in the long- term. Regarding returns to shareholders, MCD has paid dividends every year for 37 years and has increased its dividend at least once per year. Dividends per share have increased from $0.11 in 1986 to $2.87 in 2012. Those who invested in MCD shares in 1986 are receiving a yield of nearly 30% per year on their initial investment today just from dividends alone. MCD is so focused on producing returns for shareholders that the company has bought back 23% of its shares outstanding in the last ten years. So even investors who bought in 2000 have experienced a synthetic yield of roughly 5% per year. However, the most dramatic returns produced by moat investing are evident through the power of compounding as illustrated by MCD s Dividend Re- Investment Plan or DRIP (a plan through which cash dividend payouts were automatically used to buy more MCD shares). If you had invested in MCD s DRIP program in 1988, you would have turned $1,000 into over $23,000 by the end of 2012. This is not by adding to your positions, this is the result of one single $1000 purchase of MCD stock. This example of moat investing is precisely the kind of wealth generating investment that has made Warren Buffett a billionaire. Cigar Boats and Moats. Focus on these two strategies, and you will produce literal fortune 7