Your Commitment to Business Investing

By Joe Ponzio on April 14, 2008  |  10 comments

Folks — it's great to be back. A lot has happened over the past few weeks; then again, you should not have been surprised by any of it. The airlines are shutting down (you could have seen it coming from a mile away — serious note: my heart goes out to the employees); Bear Stearns has fallen (someone had to — serious note: my heart goes out to the employees...again); GE missed Wall Street's optimistic earnings estimates (with more than 35% of 2007 revenue from GE Money and a sever credit crisis? No way!)

(Oh, and someone stole my identity. Moving on.)

With the markets in a dizzying undulation — not quite ready to plummet, not quite ready to soar — it's common to ask yourself, "Did I make the right decision? When should I reevaluate? If it's going to get worse, should I stand on the sidelines for a while and look for a bottom or the signs of a recovery?"

The question on the table is, "Should I reconsider my purchase of American Eagle Outfitters?" There has been a lot of talk about it in the comments of that post. Let's break it down in pieces, and then use that logic for all investing:

1) A Drop in Cash Flow

AEO saw a drop in cash flow this past fiscal year. A fairly significant drop at that. This is where understanding your business is so critical. Looking at the capital expenditures, we see a significant jump in the last two years — from about $80 or $90 million to about $250 million. This is certainly going to eat into cash; so, what the heck is going on?

AEO is generally not a very capital intensive business. In addition, we know that they are expanding into a new kid's brand. Starting a business — a major launch of a new line — often requires a ton of capital, and that is going to burn cash for a while. It is a step back in hopes of taking a leap forward.

2) A Single Point in Time

After analyzing a company and buying the stock, it is easy to use that purchase date as the "point forward" for all information and analysis. That's a mistake. When valuing a business, we look at multiple four- and five-year timeframes. We can't just throw that out the window once we become the business owner.

I discussed this on August 2, 2007 — When growth slows down. Buffett tells us:

Do not take yearly results too seriously. Instead, focus on four- or five-year averages.

Was (fiscal year) 2008 a tough year for AEO? Or, was 2007 really stellar? There is no way to know for certain, so we must look at the business over various cycles. That "multiple cycle" analysis must carry forward.

3) The Commitment as a Business Owner

When buying a business, you can't focus on quarterly or annual results. You must give your business time to grow; you must let it stumble. Unless you see a BIG RED WARNING SIGN telling you to get the heck out, you have to relax a bit.

There is no magic holding period; still, you can't look at ten years worth of a business, try to predict where it will be in the next five or ten years, and then focus on (and freak out about) quarterly or a single year's performance.

Sometimes your stock will soar before you can buy enough of it; sometimes it will drop significantly and stay low for years. Throw the price out the window, take a step back, and look at your company over various timeframes. (In fact, ignore the price entirely and pretend you were in the board room with nothing more than quarterly and annual reports.)

4) The Portfolio and Annualized Returns, as a Whole

You must recognize that "shooting for 20% and 30% annual returns" means that:

• some of your winners will come very quickly,
• some of your business will go south and you'll lose money,
• sometimes, you'll wish you had everything in workouts,
• sometimes, you'll wish you had everything in long-term businesses.
• other than in workouts, you must look at everything in long timeframes (ie., your portfolio, your returns, your businesses).

At 20% a year, it takes almost four years to double your money. During those four years, anything can happen (and it usually does).

5) An Exercise in Business Investing

Making decisions based on value are not always easy because, at any time, we can see the price and let it skew our perception of value. That is, we can outthink ourselves.

When prices are dropping, most people second-guess their valuations; when prices are on the rise, many people find reasons to increase their valuation to invest further into the winners.

It doesn't work that way.

If you know that price follows value in the long-term, but you are fixating on the short-term, try this little exercise:

1. Pick four or five (or ten, or twenty) companies that have been around for at least twenty years,
2. Don't look at a chart of their past price,
3. Go to the SEC database and pull their quarterly (10Q) and annual (10K) reports for the past ten years,
4. Starting in 1997 or 1998, read the reports and try to figure out the business' value for that year,
5. Repeat for each subsequent year,

Finally, compare your valuations with the past stock price.

Then, remember that you just looked at ten years of history and saw wild price swings on a daily basis, but saw the markets rationally price the businesses over time. Drill that into your head, and then look at your portfolio again.

(If you can't come up with a reasonable valuation for the companies, you (i) are well outside your sphere of competence in those businesses, or (ii) need to spend a little more time understanding the businesses.)

Don't be an optimist. Don't be a pessimist. Be a business owner — a realist. (Optimists and pessimists rarely last long in business.)

Also Filed Under "How to Think About Investing"

• Before You Back Up The Truck On Adobe
• What You Should Be Looking For
• WBBM Noon Business Hour in Chicago
• Your Commitment to Business Investing