A guy that was in my fraternity, and took a job on Wall Street, found himself in the position of being able to invest $5,000 per month immediately after graduation. That’s a lot of money, but he is in New York, one of the few places in the world where that amount of money doesn’t actually do as much as it sounds. He calls me up to talk investing a few times per year, not because he wants my insight on anything, but because he knows I will nod my head and agree with him on what he is doing with his money: He is buying shares of credit card companies hand over fist. Visa, Mastercard, Discover, American Express, he picks one each month and then adds it to his brokerage account.
Usually, restaurant stocks are not something to get excited about if you are looking to hold the stock for awhile. The industry itself experiences over 90% failure, and the only real success story (from the perspective of making investors reliably rich) has been McDonald’s. Investors considering a restaurant stock find themselves in the following dilemma: Either the restaurant is the next big hot thing and the valuation goes to something crazy like 100x profits to price in many future years of growth already, or a company has fallen out of fashion and can only stimulate earnings per share by opening up new stores rather than making existing restaurants more profitable which usually leads to terminal growth in the 1-4% or worse (declining sales and a cheap private equity buyout).
When Bejamin Graham talked about stock market valuations, he often relied on trailing metrics like the P/E ratios over the past ten, fifteen, twenty year timeframe to determine whether a company was appropriately valued or not. You may wonder why this would be advisable, given that it is the growth of the business and the dividends paid out after you make your initial purchase that matters—not what the trailing metrics indicate.
What Graham understood was this: Using trailing P/E ratios rather than forward forecasts forces the investor to incorporate a margin of safety whether he likes it or not. It is a great way to guard yourself against undue optimism that sets the stage for disappointment. In his supplement to the shareholder letter this weekend, Charlie Munger explained one of Berkshire’s methodological advantages in this way: “It never had the equivalent of a ‘department of acquisitions’ under pressure to buy. And it never relied on advice from ‘helpers’ sure to be prejudiced in favor of transactions. And Buffett held self-delusion at bay as he underclaimed expertise while he knew better than most corporate executives what worked and what didn’t in business, aided by his long experience as a passive investor. And, finally, even when Berkshire was getting much better opportunities than most others, Buffett often displayed almost inhuman patience and seldom bought.”