Why people lose money on fast growing companies.

Most people pick stocks like this. First they find what looks to be a "good company". A company that qualifies as a "good company" usually has a high growth rate.

For example people who call themselves "growth investors" will look for a company growing at 40% or so. Maybe it has only been around for two years but grew earnings at 40% both years. They say to themselves. "If it keeps growing at 40% for two more years (and why shouldn't it?) and retains the same valuation, then I will have doubled my money in two years."

Other people who would call themselves value investors or Warren Buffett inspired investors have read all the Buffett books. They take a variation on this. First of all, they look for high and stable return-on-equity, low debt, and a fairly high growth rate, say 20%. Then they look at valuation. They might be willing to pay P/E = 18 for a company growing at 20% and ROE=20% and no dividend. They might use DCF to get the "right" valuation.

Most of these "growth investors" and "value investors" don't beat the market.

The growth investor gets it wrong because they never really trust these growth predictions. They need to diversify into 25 growth companies because they have little faith in each one. Because of this, they do not know the companies very well. Sometimes there is not much to know. They may be speculative at best to begin with. Some do very well and keep growing quickly. Some slow down and lose their high valuation and some simply go bust. They get an average return over long time periods.

The "Buffett investor" gets it wrong as well. They also do not beat the market by much if anything. They may not get big losses because they avoid the speculative bubbles but may have some real dogs. Many of their "good companies" stop being good, drop in value and are sold. What went wrong? They read all the Buffett books. They made sure all had high ROE and therefore probably an economic moat.

What is wrong with the intrepid value investor? I first discovered it by reading this article over at Tweedy Brown, called "Great 10-year record = Great Future, Right?
(You might need to click around for it under research reports). It is a great article, a real eye opener for me. Many of these Tweedy Brown articles are great reads.

The gist of the story is that the earnings growth of companies over the proceeding 5-year period is uncorrelated with the earnings growth the preceeding 10 years. Similarly, the ROE is also uncorrelated. Companies with high ROEs over the 10-year period do not grow faster than the average company. And stock returns are not better for these high ROE companies.

What??!! You mean you can't turn Warren Buffett's performance into a simple formula based on high ROE? Sorry but no. Maybe that isn't surprising to you. After all, there are not many Warren Buffetts around despite everyone reading the books on how to emulate him.

Of course Warren never said it was that simple. He talks about many things including mangement, strong brands or economic moats. He talks a lot about fully understanding the business and being able to predict earnings. He talks about buying only cheap companies which he defines as companies selling below their intrinsic value.

I don't really think there is any great mystery to how Buffett does it. It is simply that he does it better than everyone else. When he says "really understand a business", he sets a higher threshold than most people. That is, he understands their competitors. He understands, whether their costs will likely rise or fall. He only buys companies for which he thinks he can undertstand what the demand for their products/services will be. He looks for companies that have little risk of underperforming his goals. It is these rare companies that he fully understands for which he can predict where they are going to be in 10 years. Once he knows this, he knows the value of the company and if it sells well below this value, it is a buy.

The bottom line is that Warren is hard to emulate because he does a lot of hard work that most people do not or will not do. It takes a long time to analyse an entire industry. Also, he has that rare constitution for investing. He doesn't get spooked out. He has confidence in what he is doing because he knows everything he needs to know. He doesn't get distracted. He doesn't violate his principles. He is of course the complete package, as Michael Jordan was the complete package in basketball. You can read books on how to be like Mike but that won't get you that far without talent.

One last thing about Buffett that I should point out. A rare quality he has is incredible patience. I see dozens of companies that I like and would invest in (and have invested in). Buffett aparently sees none. He has been sitting on $40B for several years and has invested very little of it. Clearly, his standards are much higher than most people. That kind of patience is incredibly rare among investors.