Principle #1 - Always use a Business Approach.
We are buying fractional shares of a business, not wiggles on a chart, volume studies or hot tips of the day.
We approach the purchase of a stock as if we were entering into a business transaction. Therefore, we look at a business as an ongoing concern. If the business is not in a good industry, if sellers are asking too much, or if the business plan and process do not make any sense, then we don't buy the company.
In any business transaction, it is important to understand what you are buying is worth. This provides a basis for us to establish what is a bargain and what is not. It is the difference between investing and speculating. As investors, we must determine the intrinsic value, or Private Market Value (PMV) of the company. This is the ultimate price that sophisticated, willing, and informed buyers and sellers would agree upon. It is the same process investment bankers use in their decision-making process when participating in the acquisition of companies.
To arrive at the company's Private Market Value, we look at it from every angle and appraise the company seven different ways. One of the most informative appraisal methods looks at the company's free cash flow. Free cash flow is the money the company earns after all expenses, including taxes. This money could be paid out as a dividend, or the company may choose to reinvest it back into the company.
Once you understand the free cash flow of a company, you can then establish a purchase price that reflects a desired rate of return. Let's explore this by using a simplified real estate analogy. If the cash flow on a rental house is $10,000 per year and your investment is $100,000, you will have a 10% per year return on your investment. On the other hand, if your cash flow is $10,000 and your investment is only $50,000, you get a 20% return. The same principal is applied when investing in companies.
In addition to evaluating financial statements of the companies in which we invest, our goal is to contact each individual company approximately every 3 to 5 weeks. We also talk to competitors, vendors, suppliers, and board members, much like an investigative reporter would do to get the complete story. It is very important to secure a qualitative assessment of both the management and the board of directors as part of the evaluation process.
Here's another real estate analogy. If you were looking for a new home, you would want to research the neighborhood, schools, proximity to work and services, crime statistics, taxes, and the condition of the home. It would also be important to study the current market prices of comparable homes that are listed for sale, as well as those that have recently sold. Furthermore, it would be necessary to get a home appraisal, inspection, and survey. If you would do this kind of research and study to find your new home, why would you put forth any less time, effort or research when looking to invest your life's savings in a company?
At Century Management, we buy and sell companies based on investment discipline, not popular opinion.
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