William Ackman: Everything You Need to Know About Finance and Investing in Under an Hour | Big Think
May 02, 2020Hi, I'm Bill Ackman. I'm the CEO of Pershing Square Capital Management and I'm here today to talk to you about
everything
youneed
toknow
aboutfinance
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. I'll do it in anhour
and you'll be ready to go. . How to Start and Grow a Business So, let's get started. Let's do business together. We are going to start a company and a lemonade stand and now I have no money today so I will have to raise money from investors to launch the business. So how am I going to do that? Well, I'm going to form a corporation.That is a small presentation that you make before the State and give a name to a business. We'll call it Bill's Lemonade Stand and we'll raise money from outside investors. We
need
some money to start, so we will start our business with 1000 shares. We just hit that number and are going to sell 500 more shares for $1 each to an investor. The investor is going to contribute $500. Let's put the name and the idea. We are going to have 1,000 shares. He will have 500 shares. For his $500, he will own one-third of the business. So how much is our business worth at the beginning?More Interesting Facts About,
william ackman everything you need to know about finance and investing in under an hour big think...
Well, it's worth $1,500. We have $500 in the bank plus $1000 because I came up with the idea for the company. Now I'm going to need a little more than $500, so what am I going to do? I'm going to borrow some money. I'm going to borrow from a friend and he's going to lend me $250 and we're going to pay him interest of 10% per year on that loan. Now, why do we borrow money instead of simply selling more shares? Well, by borrowing money we keep a larger share of the stock, so if the business is successful we will end up with a larger percentage of the profits.
Now let's see what the business looks like on a sheet of paper. We're going to look at something called a balance sheet and a balance sheet tells you where the company is, what its assets are, what its liabilities are and what its net worth or shareholders' equity is. If you take their assets, in this case we have raised $500. We also have what is called goodwill because we have said the business: in exchange for the $500, the person who contributed the money only got a third of the business. The other two thirds are our property to start the company.
That's $1,000 of goodwill for the company. We borrowed $250. We're going to owe $250. That is a responsibility. So we have $500 in cash from the sale of stock, $250 from raising debt and we owe a loan of $250 and we have a corporation that has, as you will see in the graph, shareholders' equity of $1,500, so that is our starting point . Now let's keep moving. What do we need to do to start our company? We need a lemonade stand. That's going to cost us around $300. This is called fixed assets. Unlike lemon, sugar or water, this is something like a building that you buy and build.
It wears out over time, but it is a fixed asset. And then you need some inventory. What do you need to make lemonade? You need sugar. You need water. You need lemons. You need cups. You need small containers and maybe some napkins and you need enough supplies to, say, have 50 gallons of lemonade at the start of our business. Now with 50 gallons we get about 800 cups of lemonade and we are ready to go. Let's take a new look at the balance sheet. So now we have spent $500 on supplies. We only have $250 left in the bank, but our fixed assets are now $300.
That's our lemonade stand. Our inventory is $200. Those are the supplies and things, the lemons that we need to make the lemonade. Goodwill has not changed by 1000, so our total assets are $1750 and we still owe $250 to the person who lent us the money. Shareholders' equity hasn't changed, so we haven't made any money. All we have done is take cash and convert it into other assets that we will need to be successful in our lemon stand business. So let's make some assumptions about how our business will fare over time. Let's assume that we will sell 800 cups of lemonade a year.
It's not a particularly ambitious assumption, but we have to assume that the lemonade business is fairly seasonal. Most lemonade sales will occur during the summer. Let's assume that we can sell each cup for $1 and it will cost us about $530 a year to staff our lemonade stand. So now let's take a look at the income statement, then the income statement talks about profitability, the income that the business generated, what the expenses are and what is left over for the owner of the company. So we have a lemonade stand. We are selling 800 cups of lemonade at our booth.
We're charging $1, so we generate about $800 a year in revenue and spend $200 on inventory. Here is a line item called COGS. That means cost of goods sold. We have depreciation because our lemonade stand wears out a little bit over time and wears out in five years, so it depreciates in five years. We have our labor expense for people to serve lemonade and collect money from customers and we make a profit. We have an EBIT, that is, earnings before interest and taxes, of $10. That's kind of a pre-tax profit for the business. We don't make a lot of money because you take that $10 pre-tax profit and compare it to our income.
This is a margin of around 1.3%. That's not a particularly high profit. Now we have to pay interest on our debts and we have a loss of $15 and then we don't have any taxes, but at the end of the day we still lose money. So the question is: is this a particularly good deal? Well, we are losing money and our cash basically decreases over time. Is this a business we want to stay in? Now the cash flow statement takes the income statement and calculates what happens to the cash in the company's cash, so that when you contribute $750, some money goes to pay for a lemonade stand.
You lose some money selling the product and at the end of the day we started with $750 and now we only have $500. Let's look at the balance. What has happened? Our cash has gone from 750 to 500. Our fixed assets have gone from 300 to 240. That means our lemonade stand is starting to wear out. The goodwill has not changed. We still owe $250 and our shareholders' equity is now down to $1,490, so that was the 1,500 we started with minus the $10 we lost over the course of the year. So should we continue
investing
in the business? We lost money in the first year.Is it time to give up? Well, let's
think
about it. Let's make some projections about what the company will be like in the coming years. Let's say we take all the cash the business generates and use it to buy more lemonade stands so we can grow. Let's assume that we are not going to take money out of the company and we are not going to pay dividends. We will keep all the money in the company and reinvest it. Let's assume that as we build our brand, we can charge a little more each year, so we'll increase our prices by about a nickel, five cents more for each cup of lemonade each year and then let's assume that we can sell 5% more than glasses per stall per year.So we've built in growth assumptions. Now let's take a look at the company. So if you take a look at this graph, you'll see that in the first year we started with a lemonade stand. We add one a year and then by year five we get to seven because we have a big expansion plan. Our price per cup goes up five cents a year and our revenue goes from $800 and starts growing pretty quickly and the growth is coming from increasing prices for cups of lemonade and also opening more stands. So by year five we have almost $8,000 in revenue.
Our costs are relatively constant, which is lemonade and sugar. That's about $1,702. We have depreciation as more and more supports begin to wear out over time. We have labor expenses, but by the fifth year the business is going quite well. We went from a margin of 1.3% to more than 28%. The business is now up to par. We are starting to cover some of our costs. We are growing up. We are still paying $25 a year in interest on our loan and have profits before taxes, after interest of $2,300 at the end of year 5. So we invested $500 in the business. We borrowed 250 and by the fifth year we are making a profit of $2,300.
That sounds pretty good. Now we have to pay taxes to the government. That's about 35% and we generate net income or in other words earnings of $1,500 by year five and about a dollar per share. So if you
think
about this, our friend contributed $500 to buy 500 shares. He paid a dollar and after five years, if our business goes as we hope, he is actually earning a dollar in profit sharing. Sounds like a good deal. What has been the growth then? The growth has been quite spectacular over the period and that is what has allowed us to become a successful business.Now, these are just projections, but if they are reasonable projections, this could be a business that we want to start or invest in. Now let's look at the cash flow statement. So, as the business becomes more and more profitable, we generate more and more cash and the cash accumulates in the company. We went from $500 of cash in the company to over $2,000 of cash during the period. The balance sheet, again, the beginning balance sheet had shareholders' equity of $1,490, but as the business becomes more profitable, profits increase cash. They add to the company's assets. Our liabilities have not changed and the business continues to generate value over time.
So again at the end of the fifth year we have $4,000 of equity and that's almost three times more than when we started. Good versus Bad Business Now, is this a good business or a bad business? How do we think if it is good or bad? One thing to think about is what kind of profits we are making compared to the amount of money that was invested in the company. This is a business that we valued at $1,500 when we started. Someone put up $500 for a third of the company. We gave it a value of $1,500. At the end of year five, you'll make over $1,500 in profits, which is a more than 100% return on the money we invested in the company.
In reality, it is a quite high number. We spend...let's talk about return on capital. We have spent $2,100 in capital to build lemonade stands and earned $2,336 in the fifth year on the capital we invested. That's more than 100% return on capital. This is a very attractive return. Profits have grown at a very fast rate, 155% annually. This is really a growing company and our profitability has gone from 1.3% to 28.6% in year five and that sounds pretty attractive and it is. So let's look at the person who made the loan. Well, that person contributed $250 and the business has been profitable.
We have been able to pay them their interest of 10% per year, $25 a year, and they are happy because they contributed $250. They earn a 10% return on their loan and the business is worth over $250. We have more than that in cash. As a result, they are in a safe position, but have only made 10% of their money. Now let's compare that to the equity investor, the person who bought the company's shares. That person made a dollar per share in the fifth year versus a dollar per share investment, so he is earning more than 100% or around 100% return on his investment versus only 10% for the lender. .
So who got the best deal? Well, obviously the stock investor. Now, why is the stock investor entitled to earn much more than the lender? The answer is that they took more risks. If the business fails, the lender is entitled to the first $250 of value that comes from liquidating the business, so if he sells the lemonade stands and only gets $250, the lender gets all the money back from him. You are safe. They earned their 10% return while the business was running. They got their $250 back, but the equity investor, the person who bought the shares, is out because he goes after the lender.
So what is the difference between debt and equity? Debt tends to be a safer investment because it has a first claim on a company's assets and comes in many different forms. You've heard about home mortgage debt. This is a loan secured by a home, but you could have mortgage debt on a building for a business. There is senior debt. There is junior debt. There is mezzanine debt. There is convertible debt, but ultimately,
everything
is debt. It comes in different orders of priority in a company and the rate it charges is inversely related to its security, so the better the security and the lower the risk, the lower the interest rate you are entitled to receive.The younger the loan, the higher the interest rate you'll be eligible to receive, but you can avoid the complexity. All you need to think about is that debt comes first. It is a safer loan, but your opportunity to make a profit is limited. Now, heritage also has its different forms. There is something called preferred stock or sharespreferred. There are common stocks or common shares, and again, stocks and shares are basically synonyms. They are options, but they are not really worth talking about today. The important point is that the equity keeps everything that is left after the debt is paid off, which is why it is called a residual claim.
Now, the nice thing about the residual claim is that the value of the business increases if you no longer owe anything to your lender, but all of that value goes to the shareholder. So the question is why was the lender willing to accept only a 10% return when the capital earned a much higher rate of return and the answer is that when the business started there was no way of
know
ing whether it would be successful or not and The lender made a bet that if the business failed they could sell the lemonade stand. It costs $300 to do it.They would have lemons, lemonade. Even if they sold it at a much lower price than the dollar they originally projected, the lender felt pretty confident that he would get his money back, while the shareholder is really taking on a risk. They were betting on the profitability of the company and ran the risk that if it failed they would lose their entire investment, so they were entitled to a higher return or had the potential to have a higher return if the business was successful. So let's talk about risk. There are many different ways people think about risk, but the one we think is the most important: Many people talk about risk in the stock market as the risk that stock prices will go up and down every day.
We don't think that's the risk you should focus on. The risk you need to focus on is, if you invest in a business, what are the chances that you will lose your money, that there will be a permanent loss. When you're thinking about investing your own money, when you're thinking about one investment versus another, don't worry so much about whether the price goes up or down a lot in the short term. What matters is, ultimately, that when you get your money back you will get a return on your investment. How do you think about risk? Well, one way to think about risk is to compare it to other alternatives, so you could buy government bonds and government bonds are considered the lowest risk form of investment today and the US Treasury issues debt at 10, 3 and 5 years.
There is a set interest rate and today, a 10-year Treasury yields around 3%. So you give your government $1,000 and you get $30 a year in interest. At the end of 10 years, you get your $1,000 back, so that's very, very secure and kind of provides a floor. Now, obviously, if you're going to make a loan, you can lend money to the government and earn 3%. Well, if you can lend money to a lemonade stand, you'll want to earn a lot more, so in this case the lender charges a 10% interest rate. Why 10%? Because they want to earn a good margin on what they can earn by lending to the government because a startup lemonade stand business is a higher risk business.
Stock investors think about things in a similar way, so the higher the valuation, the riskier the business, the higher the rate of return the stock investor will expect and the lower the risk of the business, the lower the risk. It will be the return that the stock investor will expect. and stock investors don't earn interest the same way a lender does. What stock investors get is the potential to receive dividends over the life of a company. Let's talk about raising capital. You started this lemonade business. Now, the goal of this was to make money in the first place.
The business is going very well, but I, having started the business with a name and a concept, hired all the people, I haven't earned anything, right? So the business has gained value, but where is my money? I need money to buy a car, for example, so I want to buy a car for $4,000. What are my options? What I can do? Well, we've taken all the cash the business has generated. We have reinvested it in the business. Now the good news is that we have taken all that money. We have been able to use it to purchase more lemonade stands and these lemonade stands are becoming more productive and the value of the business has increased faster and faster.
Now my alternatives might include, instead of growing the business so quickly, instead of investing in more lemonade stands, I could have simply paid myself dividends. Now the good news is that I make money along the way, but the bad news is that the business would not grow as fast and if you have a business as profitable as this lemonade stand company and you just open a new lemonade stand and people win: we can earn hundreds of dollars on each new booth; It makes sense to continue investing. Well, how can I keep my business going and growing, taking advantage of opportunities, but taking some money off the table?
How can I do that? Well, I could sell the company, so I could sell my lemonade stand business. I started this one in New York. Maybe there's someone in New Jersey who wants to buy me out and consolidate my lemonade stand business. Well, the problem with that is that once I sell it I can no longer participate in the opportunity in the future and I believe in this business. I think it will be very successful over time. So that's an alternative. The other alternative is that it could pay a dividend. By year five, we have over $2,000 in the bank, so I could pay that money to the company's shareholders, but that would really slow my growth rate in the future because I couldn't afford to build and buy more lemonade. it is maintained and it is not the $4,000 I need to raise money.
So I'm going to consider taking a business public. What does that mean? Well, first of all, before we take our business public, we want to think about its value. It's year five. We have been doing a good job. We have a business that is profitable. Everything seems to be going well. Well, the problem is that I have some personal needs. I have founded this company. I have taken all the cash the business generates. I have reinvested the cash into the business. I bought more and more lemonade stands. Growth is accelerating. I feel really good about that, but I need money.
How do I get money? What should I do? Well, I have a business that generates a lot of cash every year, but I've been reinvesting it, so an alternative is that maybe it won't grow as fast. I don't buy as many lemonade stands and start sending that money to myself as a dividend. Therefore, each year I pay a certain amount of cash to the company. My need is really greater than that. Currently, the company only has about $2,000. If I ship it, it's half of what I need for a car. So how do I get the rest of the money or how do I get more money?
Well, I could sell the company, so that's an alternative, but the problem is that I have a really good business. It is growing very fast. Why would I want to get rid of it right now? Then what should I do? The other alternatives, apart from selling 100% of the business, is to sell a part of the business and I can do that privately. I can find an investor who wants to buy a private stake in the company and if the business is worth enough, I can sell them a part of the business and we can be successful.
The other alternative is that I can take the company public. Everyone has probably heard of an initial public offering (IPO), an Internet company going public, and people getting rich from an initial public offering (IPO). The interesting thing is that an IPO doesn't make anyone rich. All it really does is take a business they already own, sell a portion of it to the public, and list it on an exchange like the New York Stock Exchange. An IPO, the abbreviation means initial public offering and is initial because it is the first time a company goes public. Going public means selling shares to the general public rather than finding an investor to buy interests in the company and its offering because you are offering people the opportunity to participate and the way to do that is to hire a good lawyer. .
You get a good bank, an investment bank. It will be your insurer and you will prepare a document called a prospectus, which will discuss all the risks and opportunities associated with investing in your company. You will have a history of how the business is performed over time. It will have the balance we talked about. It will have results statements from previous years. You'll have cash flow statements and investors will read that document and know if this is a business they want to invest in and how to think about what price they want to pay for it.
When you decide you want to take your company public, you will have to disclose a lot of information to the public to attract investors to participate, and the Securities and Exchange Commission will study this prospectus very carefully. They will ensure that you disclose all the various risks associated with investing in the company and you will also have the opportunity to talk about the business. It is a combination of a marketing document and a list of appropriate risks that people should consider before purchasing shares of the company. That takes time to prepare. It costs money to prepare.
You will need good lawyers. You will need a good investment bank and will go through a process where you file with the FCC with a copy of the offering's initial registration statement or prospectus. The FCC is going to comment on it and eventually you will have a document that you can then sell shares to the public. This is an exciting time for you because when you sell shares to the public, that is really, in most cases, the way to get the optimal high price for the company, but you don't have to sell 100% of the business to the public. .
In fact, you usually only sell a small percentage. You can keep the rest. You can keep control of the company, but you can raise money in the offering and you can use that money to buy the car we were talking about earlier. Now, before you decide to go public or even sell it, it's probably a good idea to find out how much the business is worth. So let's talk about valuation or how to value a company. One way to think about the value of your business is to compare it to other similar businesses. Now, the stock market is actually a pretty interesting place to look at.
Now the stock market is a list of companies that have sold shares to the public and you can search in the New York Times or the Wall Street Journal or online, on Yahoo Finance or Google or other sites and see the stock prices of Coca-Cola, for example. MacDonald's and what those stock prices tell you is what the company is worth. And how is the value of the company calculated? Well, look where the stock price is. It counts how many shares are outstanding. The outstanding shares will be listed in various filings with the FCC. The shares outstanding are multiplied by the share price.
That tells you the price you're paying for the company's equity, so if you go back to our example of our little lemonade stand, we have 1,500 shares outstanding. We sold them initially for a dollar, a third of them to an investor and the business was initially worth $1,500. So how much is the business worth today? Well, one way to look at it; Let's take a look at other lemonade stand companies. Suppose other lemonade stand companies have sold in the private market or public market at a price of 10 times earnings or 10 times earnings, which will give you a sense of value.
You could look at the stock market if there are other examples of a business similar to a lemonade stand company. Perhaps a company that sold soda every month would be a good example, but let's use a comparable example. So, let's say another lemonade stand company trades at 20 times earnings on the stock market. Well, we made a dollar a share in the fifth year. If we put a multiple of 20 on that dollar, the business is worth, according to the comparable, about 20 dollars per share. We have 1,500 shares outstanding. We multiply 1,500 by 20. Now our business is worth $30,000. So we had a company that started with 1,500, five years later it's worth $30,000.
Actually, that's pretty good. Well, how do we raise $4,000 if that's the appropriate value for our business? Well, if we sold 200 of our shares, 200 of our shares that are worth $20 each today, we could raise the $4,000 we're talking about. What would that do? What would happen if we sold 200 of our shares in the market? Well, our interest in the business would diminish because today we own 66 and 2/3 percent or 2/3 of the company. A third belongs to our private investors. Well, if we sold shares in the market, if we sold 200 of the shares that we would own, our ownership would go from 67% to 53%, so the good news is that we would still have control of the business because in most public stock companies Owning a majority allows you to control the business in the future, but as the company is now owned by public shareholders, you need to ensure that your interests are adequately represented, so you need to have a board of directors, a group of people to represent you. the interests of shareholders who have a duty to ensure that their shareholdersare treated appropriately and you would not have the same degree of flexibility that you had when you were a private company because you have other stakeholders that you have to think about.
Now the benefit of the IPO is that the shares would now be liquid. There would be a market where you would trade on the public markets and then over time if you wanted to sell more shares you could do that or if new investors wanted to come in they could buy shares and our shares would now be liquid. It would make me feel better about this business in terms of my ability to exit at some point or if I wanted to raise more money, I could sell shares pretty easily on the market because every day you can look up the price on the web. or in the New York Times or anywhere else and you can find out how much your business is worth.
Well, now what do you care about this? Now, the purpose of our lemonade stand example is simply to give you an introduction to what companies are, what they do, how they make profits, what are the various reports that they provide to investors so that investors can find out how much they are worth. and the purpose of this lecture is to give you an idea of some of the things that you need to think about when you're thinking about investing maybe some of your own money, whether you want to invest in a lemonade stand or a company in the market , so some basic points to think about.
One of the most important is that if you are going to be a successful investor, it makes a lot of sense to start early. That's a difficult thing. Today you are probably a student. You don't have much extra money. Keys to investing successfully Well, let's say that at 22 years old you have a pretty good job. Instead of spending your money on gadgets or a fancy or not-so-fancy apartment or going out and drinking a good amount, you put some money away and start investing money. Let's say you could save $10,000 at age 22 and you can earn a 10% return on that money from now until you retire.
What would you have in 43 years? The answer, if you save $10,000, don't save another penny and invest it in your money and earn 10% of your money each year, you would have $600,000 in year 43 and the reason for this is in year 1. Your $10,000 will be will become 11, in year 2 your $11,000 would grow by 10% and therefore you would earn interest not only on your original principle, but you would earn interest on the interest you had earned the previous year and that compounding effect allows you money grow almost exponentially. Now obviously if you earn more than 10% you can get even higher returns.
Now, if you save $10,000 at age 22, you will have $600,000 in 43 years. That's pretty good. That you had to wait until you were 32 to earn the same 10% annually? The problem is that by year 33 you would only have $232,000. Maybe that's not enough to retire, so the key here is that if you're going to be an investor, one of the most valuable assets you have today as someone who is 18 or 19 years old is your youth. You want to start early so your money can grow over time. And now what would happen if you could earn 15%? I'll give you a better idea of how powerful compounding is because remember that at 10% for 43 years you would have $600,000.
That's pretty good, but if you earned 15% you would have more than 4 million. You're in a pretty good position now, and obviously making smart decisions about where you put your money makes a big difference in your retirement assets. Now, obviously, if you could save more than $10,000, if you could save $10,000 every year, then your wealth would be pretty huge. Now, just for fun, if you were one of the world's great investors, Warren Buffet being a good example, if you could earn 20% a year for 43 years you would have $25 million. Again, the original $10,000 investment would increase about 2,500 times over that time period just by earning a 20% return.
Albert Einstein said that the most powerful force in the universe is compound interest, so the key is to start early, earn an attractive return and avoid losing money and you will have a very good retirement. Okay, now let's talk about the risk of losing money. Now let's say that in order to try to get a 20% return you took a lot of risks and it turns out that every 12 years you lost half of your money because you just won: you went through a bad run in the market or you became stupid. decisions. Well, your $25 million at 20% now would only be worth $1 million in 43 years, so a key success factor here is not simply trying to achieve the highest return.
You are avoiding significant losses during the period. Well, as Warren Buffet says, rule number one in investing is never lose money and rule number two is never forget rule number one, so if you can avoid losses and earn attractive returns over time, you'll have a lot of money. if you can maintain it for a long period of time. So how can you be a successful investor? Now I assume you're not in the investment business. I assume you are a doctor or a lawyer. You are going to pursue your passion, but you are going to have some money that you are going to save over time and I am going to give you my advice on the subject.
It's not necessarily definitive advice, but it's advice I would give to my sister, my grandmother, about what she should do if she were in the same situation. I think that's probably the right way to think about it. So, number one, how can you avoid losing money? What are the good places to invest? My first piece of advice is that despite the story about the lemonade stand, I would avoid investing in lemonade stands. I would avoid investing in startups whose prospects are not well known because, once again, it is not necessary to earn 100% a year to make a fortune.
You only need to invest with an attractive 10 to 15 percent return over a long period of time. Your money grows very significantly. So how do you avoid the riskiest investments? My advice would be to invest in public securities, invest in publicly traded companies, publicly traded companies. Because those companies tend to be more established. They have to overcome certain obstacles before going public. The shares are liquid, so you can change your mind if you want to sell. If you invest in a private lemonade stand, it's hard to find someone to bail you out of that investment unless the business becomes fabulously profitable.
So that's tip number one: invest in public companies. Number two, you want to invest in businesses that you can understand. What I mean by this is that there are many businesses that you walk into and deal with throughout the day in your personal life, whether it's a retail store that you know because you like to shop there or it's a product, your iPad. You think it's a great product, but you have to understand how the company makes money. If the business is too complicated you don't understand how they make money, even if they had a great track record I would avoid them and a lot of people thought Enron was an amazing business because they seemed to have a good track record but very few people understood how they made money.
It was good to avoid it. Another very important criterion is that you want to invest at a reasonable price. It could be a great business that is done very well over a long period of time, but if you pay too much for it you won't get a very good return investing in that company. The last thing is that you want to invest in a business that you could theoretically own forever. If the stock market closed for 10 years, you wouldn't be unhappy. what do I want to say with that? Again, if you're going to compound your money with a 10 or 15 percent return over a 43-year period, you really want a business that you can own forever.
You don't want to have to constantly switch from one business to another. And what are the companies you can own forever? Well, there are very few that meet that standard. Perhaps a good example is Coca Cola. What's so good about Coca Cola? It is a relatively easy business to understand. You understand how Coca-Cola makes money. They sell a formula or syrup to bottlers and retailers and make a profit every time they pour a Coke. People drank a lot of Coca Cola over a very long period of time. The world population is growing. It's sold in almost every country in the world and every year people drink a little more Coca Cola, so it's a fairly easy business to understand and it's also a business that I think is unlikely to be eliminated by the competition like result of technology or some other new product.
It has been around for a long time. People have gotten used to the taste. Parents give it to their children and hopefully it will last a long period of time. I think that's a good example. Another good example could be MacDonald. You may not like MacDonald's burgers. You may or may not be able to do it, but it is a business that has been around for 50 years. You understand how they make money. They open these little... they build these little boxes. They rent them to franchisees. They charge them royalties in exchange for the name and they sell burgers and fries and you know what?
People have to eat. It is relatively low cost food. The quality is quite good and they continue to grow every year. So I think the consistent message here is to try to find a business that you can understand, that isn't particularly complicated, and that has a long-term successful track record that generates attractive profits and can grow over time. So what are the key things to look for in a business that, as I say, lasts forever? Well, you want a company that sells a product or service that people need and that is something unique and that has loyalty to this particular brand or product and that people are willing to pay a premium for that.
Another good example could be a candy business. While people will buy generic versions of many types of food products, flour and sugar, they do not need to have the brand name product. When it comes to candy, people don't tend to like the Walmart version or the Kmart version. They want the Hershey candy bar, the Cadbury candy bar, or the See's Candy. They want the brand and are willing to pay a premium for it, and I think that's key. You want the product to be unique. You don't want it to be a good that everyone else can sell because when you sell a good, anyone can sell it and they can sell it at a better price and it's very difficult to make a profit doing that.
If you're investing for the long term, you'll want to invest in companies that have very little debt. In our small example above we were talking about our lemonade stand. There is a debt worth $250. That didn't put much pressure on the lemonade stand business, but if it had been $1,000 and we had hit a rough patch, the business could have gone bankrupt from not paying its debts. Shareholders could have been eliminated. So if you can find a company that can make attractive profits, doesn't have a lot of debt, or generates a lot more profit than it needs to pay the interest on its debt, that's a safe place to put your money for the long term. time frame.
You want companies that have what people call barriers to entry. You want a business where tomorrow it will be difficult for someone to create a new company that can compete with you and put you out of business. I mean go back to the Coca Cola example. Coca Cola has a strong presence in the market. People expect that when they go to a restaurant they can order a Coke and receive a Coke. It's very difficult for anyone else to enter. Of course there is Pepsi and other soft drink brands, but Pepsi has been around for a long time and Coca Cola and Pepsi have continued to exist side by side for long periods of time.
It's going to be very difficult for someone to come and propose a new soft drink that will simply put Coca Cola out of business, so when you're thinking about choosing a company, make sure it sells a product or service that it's difficult for someone else to make better. which you will change tomorrow. Look for something where people have real loyalty and don't change, and they don't; Even if someone offers the same similar product for 20% less, they will still want the high-quality, brand-name product. You also want companies that are not particularly sensitive to external factors, so-called extrinsic factors that they cannot control.
So if a company will be affected dramatically if the price of a particular commodity goes up or if interest rates go up and down or if currency prices change. You want a company that is fairly immune to what's going on in the world and I'll use my Coca Cola example. I mean, if you think about Coca Cola, it's a product that's been around for probably 120 years. During that time period there have been multiple world wars. There have been all kinds of nuclear weapons development, all kinds of unfortunate events and tragedies and so on, but every year the company makes a little more money than before and they are going to continue and you can be sure, based on history, that this It is a business that is going to exist almost regardless of whether interest rates are at 14%, whether the US dollar is not worth much, or whether the price of gold has risen. or down.
Those are the kinds of companies you want to invest in, long term, businesses that are extremely immune to events happening in the world. Another criterion, if you think about our lemonade stand company, as we grew we had to buy more and more lemonade stands. Now, thoseLemonade stands only cost $300 each, but imagine a business where every time you grew you had to build a new factory to produce more and more products and those factories were really expensive. Well, that company could generate a lot of cash from the business, but to grow you will have to reinvest more and more cash into the business.
The best businesses are those that do not require reinvesting a lot of capital in the company. They generate a lot of cash that you can use to pay dividends to your shareholders or you can invest in attractive, high-yield new projects. So the key here is low capital intensity, so let's talk about a low capital intensity business. Perhaps the best way to think about a low capital intensity business is to think about a high capital intensity business. If you think about the automotive industry before producing your first car, you will have to build a huge factory. You have to buy a lot of machine tools.
You have to make a huge investment before you can launch your first car and those machine tools wear out over time and as you make more and more cars you have to invest more and more in the factories, so it's a business that historically hasn't very attractive result for business owners. If you look at General Motors' stock price 50 years ago, it really hasn't changed significantly even until the last few years before it went bankrupt. If you ignore the most recent period, up until GM's bankruptcy, very few people made money investing in GM over a 40 or 50 year period and the reason is that GM had to constantly reinvest every dollar it made to build better and better factories. so they can be competitive.
If you compare it to Coca Cola, although there are bottling companies all over the world, many of those bottling companies are not even owned by Coca Cola. What they are really doing is selling a formula and in exchange for that formula, they get a royalty for every dollar spent on Coca Cola. Those are the best deals. Another good example could be American Express. If you think about the American Express card, when you take your American Express card and buy something, the American Express card gets a small percentage of every dollar you spend. Then you put in the capital and they get a return of several percentage points.
They get 3% of what you spent. So companies where you own a royalty on other people's capital are the best companies in the world to invest in. I guess the last point I would like to make is that if one is going to invest in public companies, it is probably safer to invest in companies that are not controlled. A controlled company is kind of like our lemonade stand business that we took public. The problem with a controlled company, unless the majority shareholder is someone you completely trust, unless there is someone who has a great track record of taking care of so-called minority investors, non-controlling shareholders can present a proposed takeover risk. investment. in that business because you are at the whim of the controlling shareholder and even if the controlling shareholder today is someone you feel comfortable with, there is no assurance that in the future he will be able to sell control to someone else who will not be as supportive of the shareholders of the company.
So it's not like you can just have a profitable business and a business that has done well. You have to make sure that management and the people who control the business see you as the owner and protect your interests. These are some of the key criteria to think about. The Psychology of Investing and Mutual Funds Now, when are you ready to start investing money? I assume you are a student. You probably have student loans. Maybe you even have some credit card debt. You're going to graduate. You're going to get a job. Therefore, you don't want to jump right in and, while you have a lot of outstanding debt, start investing in the stock market.
The stock market is a place to invest when you have an asset: you have money that you can put away that you won't need for 5 years, maybe 10 years. So if you're paying relatively high interest rates on your credit cards, you'll definitely want to pay them off first before thinking about investing in the stock market. Your student loans are probably lower in cost than your credit cards, but again, my best advice would be that if your student loans cost you six or seven percent, if you pay them off it's like you're getting a guaranteed return of six or seven percent and You better get rid of your credit card debt and even your student loan debt before committing a lot of money to the stock market.
So what do you do with your money while you wait to invest? The answer is that you pay off your debt and you want to have... even once you've paid off your credit card debt, maybe you've paid off your student loans, you want to have enough money in the bank so that even if you had to pay If you lose your job tomorrow, you'll have a good 6 months, maybe even 12 months of money set aside. These are pretty high standards and obviously make it harder to start investing sooner, but the safest course of action to be a successful investor is to have as little debt as possible.
Get comfortable with having some money in the bank so that if you lose your job tomorrow you can live until you find your next opportunity and once you've achieved those goals, then put money away that you don't need to touch. If you can do that, you can be a successful investor. So let's talk a little bit about the psychology of investing, we've talked about some of the technical factors, how to think about the value of a company. You want to buy a business at a reasonable price. You want to buy a business that's going to be around forever, that has barriers to entry, where it's going to be difficult for people to compete with you, but all of those things are important, but even... and a lot of investors follow those principles. .
The problem is that when you put them into practice and there's panic in the world and the stock market goes down every day and you see the value of your IRA or your investment account decrease, the natural tendency is kind of the opposite of that. it makes sense. It generally makes sense to be a buyer when everyone else is selling and probably to be a seller when everyone else is buying, but those are just human tendencies, the natural lemming tendency when everyone else is selling, you want to do the same thing. This encourages you as an investor to make mistakes, which is why many people sold in the '87 crisis when in reality they should have been buyers in that type of environment.
That's why I talked a little earlier about why it's very important to be comfortable. You want to be financially comfortable. If you have student loans, you want to have a manageable amount of debt. You probably don't want to pay anything; You don't want to have any outstanding revolving credit card debt. You want to have some money in the bank because if you're comfortable, the money you're risking in the stock market won't affect your lifestyle in the short term. As long as you don't need that money tomorrow, you can afford to deal with the fluctuations of the stock market and the fluctuations, depending on who you are, can have a big impact on you.
People tend to feel rich when stocks go up. They tend to feel poor when stocks go down and the reality is that the stock market in the short term is what Ben Graham or even Warren Buffet called a voting machine. Stock prices really reflect what people think in the very short term. If it affects the supply and demand of investors, the buying and selling of shares in the short term. However, over the long term, stocks tend to reflect the value of the companies they own. So if you're buying businesses at attractive prices and you own them for long periods of time and those businesses are growing in value, you'll make money over a long period of time, as long as you're not forced to. sell in any period of time.
To be a successful investor you have to be able to avoid some natural human tendencies to follow the herd. When the stock market goes down every day, your natural tendency is to want to sell. When the stock market goes up every day, your natural tendency is to want to buy, so in bubbles you should probably be a seller. In busts you should probably be a buyer and you have to have that kind of discipline. You have to have the stomach to endure the volatility of the stock markets. The key way to have the stomach to withstand stock market volatility is to be safe.
You have to feel comfortable knowing that you have enough money in the bank that you won't need what you've invested unless it's for many years. That is a key factor. Number two, we must recognize that the stock market in the short term is what we call a voting machine. It really represents people's short-term whims. Stock prices are affected by many things, by events that happen in the world that really have nothing to do with the value of certain companies that you are investing in, so you have to accept the fact that what you own can disappear. significantly its value after purchasing it.
That doesn't necessarily mean you've made an investing mistake. It's simply the nature of stock market volatility. How do you feel comfortable? Well, the way to get comfortable with volatility is that you do a lot of the work yourself. You don't buy stocks simply because you like the company name. You do your own research. You get a good understanding of the business. Make sure it's a business you understand. You make sure the price you're paying is reasonable relative to the company's earnings, and earlier we talked a little bit about earnings and how to analyze the value of a company by putting a multiple on earnings.
A more sophisticated way of thinking about a company is: the value of anything is actually the amount of cash you can get out of it over a very long period of time, and people build models to predict how much cash a company will generate over time. over a very long period of time. a long period. It's probably something a little more complicated than what we're going to address for the purposes of this lecture, but maybe another way of thinking about it would be helpful. So when you buy a bond and get an interest rate, today the 10-year Treasury pays about 3%.
You are earning 3% on your investment. When you buy a stock that is trading at a multiple of its earnings or the so-called PE ratio or a price-to-earnings ratio, say 10 times, it is very similar to a bond. In fact, if you turn the PE ratio around, put the E at the top, what the company earns and put the price you are paying for the shares at the bottom, it is the earnings per share over the price obtained that is called earnings yield and you can compare that earnings yield to, say, the 10-year Treasury, so a company trading at a PE of 10 is actually trading at a 10% earnings yield, so You can really think about stocks or buying shares in a business is very similar to buying an interest in a bond.
The difference is in the bonus, you know what the coupon is going to be. You know that 3% interest rate every year for the next 10 years. With stock you don't know what the coupon will be. The coupon on the stock is the amount of profit you make, and you can try to project those profits based on the history of the business and prospects, but those profits will go up and down each year. Now, hopefully, the long-term trend is bullish and so the way I think about the decision between buying a bond or buying a stock is that I want to make sure that earnings perform, that earnings per share exceed the price I am paying for the stock.
It's higher than you could get by owning a Treasury and that earnings yield is something that's going to grow over a long period of time. Now, if you had a business that was growing at a very, very high rate very often, or its profits were growing at a very high rate, very often people would be willing to pay a pretty high multiple of those profits. Because they expect earnings performance to grow, so if you had a business, you might even pay; one day it might be cheap to buy a business with 30 times its earnings or a 3% or 3.3% earnings yield, if you think about it. that 3.3% is going to grow at a high rate and eventually increase significantly at a rate of 5, 6, 7, 8 or 10 percent.
These types of investments are much riskier. Generally, the higher the multiple, the more risk you take because you are betting more on the future of the business. You are betting more on future profitability. So my basic advice in recommending the MacDonald's and Coca Cola's of the world is to find companies that, where you're going, are performing and your profits are high enough that you don't have to guess at a very high growth rate in the future. future to obtain an attractive rate of return. Okay, so the few key success factors to be an investor in the stock marketare one: do the homework yourself.
Make sure you understand the companies you are investing in. Second, invest money that you won't need for many years and third, limit the amount: Don't borrow money, certainly to invest in the stock market and limit that amount. of leverage, if any, that you have as an investor. Okay, so after this short 40 minute lecture I wouldn't immediately jump in and start investing in the stock market. You have some work to do. There are some books you can read and we will provide you with a list of recommended books at the end of the lecture that will help you learn more about investing.
Almost everything you need to know about investing can be read in a book. I learned the business by reading books instead of reading books and the experience associated with starting small and investing in the stock market. Let's say this just isn't for you. I don't want to invest, buy individual stocks. It just seems too risky. I don't have time to do my own research. What are your alternatives? Well, your alternatives are to outsource your investments to others. You can hire one money manager or you can hire a group of money managers and there are a couple of different alternatives for an emerging investor.
The most common alternative is mutual fund companies. So what is a mutual fund? A mutual fund, I guess technically it's a corporation, but where you buy shares of this corporation and the manager selects a portfolio of shares. So what they do is raise capital, money from a large group of investors. Let's say they raise a billion dollars and take that money and invest in a diversified collection of securities. Now, the benefit of this approach is that with a small amount of money, even less than $1,000, you can purchase a diversified portfolio managed by a professional manager who is compensated for doing a good job investing in the market.
Therefore, mutual funds are a good potential area for investment. The problem is that there are probably 7, 8,000, maybe 10,000 different mutual funds and some are fantastic and some are not particularly good, so you need to do your research to find a good mutual fund manager the same way you need to find stocks. individual. , so it's not just easy to invest in mutual funds. Here are some key success factors when identifying a mutual fund or money manager of any type to select. Number one, you want someone who has an investment strategy that makes sense for you; you understand what they do and how they do it.
They do not appeal to your insecurity using complicated words and expressions that you do not understand. If they can't explain to you in two minutes what they do, how they do it, and why it makes sense, then it's a strategy you shouldn't invest in. Number two, and not necessarily in this order. This should probably be number one: if you want someone with a reputation for integrity. Again, if you're just starting out, you'll probably want to invest in one of them (a mutual fund sponsored by some of the larger mutual fund complexes, rather than a small private mutual fund) from a mutual fund company you've never heard of. of that.
There is some benefit in the older institutions that have it, you can be more confident that your money will not be stolen. Want someone, an approach where the investor invests money based on value. Now this sounds a bit obvious, but value investing has a very long-term history and there are other types of investing, including technical investing, where people bet on stocks based on price movements, but I highly recommend those types of approaches. Therefore, you want someone to make investments where they buy companies based on their belief that the prospects of the business will be good and that the price paid relative to the value of the business represents a significant discount.
You want to invest with someone who has a long-term track record and I would say 5 years is the absolute minimum and ideally you want someone who has 10, 15, 20 years of experience investing in the markets because there is a lot you can learn. Be a long-term investor in the market. You want someone who has a consistent approach, who hasn't changed what they do materially year after year, who has a stated strategy that they have stuck to through thick and thin and that has enabled them to deliver attractive returns throughout their career. life. As an investor and I always say that in some ways the most important thing is that you want someone who will invest most of their own money along with yours.
Obviously it shouldn't be that they are investing your money. This is what they do for you, but for your money they do something significantly different. You want someone whose interests are aligned with yours. If it's a mutual fund, you want them to have a lot of money in their own mutual fund. If it's a hedge fund, which is a fund sold privately to investors who have higher net worth, you'll also want a manager to invest alongside you. I have a strong aversion to strategies that require the use of leverage, so in the same way that you want to invest in companies that use very little debt, you want to invest in investment strategies that use very little leverage.
If you can avoid leverage and invest in high quality companies or invest with high quality managers, it is difficult to lose a lot of money when using leverage. You can lose a lot of money. Now, in the same way, when you're creating a stock portfolio where you don't want to put all your eggs in one basket and you want a reasonable degree of diversification and the more sophisticated, the more work you do, the more concentrated the The quality of the business you invest in, the more concentrated your portfolio can be, but I would say that for an individual investor you want to own at least 10 and probably 15 and even 20 different securities.
Many people would consider this to be a relatively highly concentrated portfolio. In our opinion, you want to own the best 10 or 15 companies you can find, and if you invest in high-quality, low-leverage companies, that represents a comfortable degree of diversification. If you invest with money managers, you probably don't want to put all your eggs in one basket there either and here you probably want to have two or three different mutual funds or money managers, maybe four different alternatives, so again there you have some degree of diversification in their shares. Finances in our lives So we spent the
hour
.We started with a small lemonade stand business and the purpose was to give them some of the basics of how to think about a business, where profits come from, what are revenues, what are expenses, what is a balance sheet, what what? is an income statement, how to think about the value of a company, how to think about what is the difference between a good business and a bad business, how the debt offered is generally higher, actually lower risk, but lower return, how the capital Investors or investors who buy shares or ownership of a company have the potential to earn more or lose more and we use that background as a way of thinking.
We use that as—just as the basics of getting someone with the vocabulary. think about investing and we talk about investing in the stock market. We talked about ways to think about how to select investments and how to address some of the psychological issues of investing. We covered quite a bit of ground in a relatively short period of time. I now titled the lecture Everything You Need to Know About Finance and Investing in Less Than an Hour. Well, that's really not all you need to know. It's really just an introduction and I hope I haven't misled you, induced you to watch this for an hour, but there is a lot more that can be learned and there are wonderful books that can teach you on the subject, so I think it is interesting to invest, whether you Whether you choose this as a full-time career or not, if you are going to be successful in your career, you are going to make some money and how you invest that money will make a big difference in the quality of your work. life that you have and perhaps that your children have or the type of house that you are going to be able to buy or the retirement that you are going to be able to enjoy and we talk about the difference between a 10% return and a 15 and 20% return over a lifetime very long and what impact does that have in terms of how much wealth is created during the period, so investing will be important to you whether you like it or not, and learning more about investing will have a huge impact on your quality of life if the money It's something you need to achieve some of your goals.
Therefore, I recommend this as an area worth exploring and the more you learn about investing, the more; These same concepts, while useful when deciding how to invest your portfolio, are also useful when thinking about decisions such as buying a house. , making decisions in your line of work, if you are a lawyer and hiring additional people, these types of calculations and thought processes are useful and useful in life and I recommend that you learn more. So check out the reading list and good luck.
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