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Value Investing for Mothers-in-Law: 'Quality' Requires More Than a Story

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Although some new investors think it's possible to pick a stock and create a tale about it, it's also necessary to have quantitative measurements.

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My mother-in-law is known to my kids as Doodles. The name's origin is a long story, but what's important here is that she is extremely smart and a very capable businesswoman (she doesn't go by "Doodles" professionally). Despite her business expertise, she is always asking me questions about the stock market that seem to miss the underlying philosophy behind long-term value investing.

In an effort to not seem like an evasive jerk, I will attempt to explain once and for all what I actually do.

(For the record, Doodles is just a proxy for every social acquaintance who has ever asked me a question about the stock market. If I am addressing a dumb statement, assume that it was an insane distant relative who inspired my commentary. If the question is nuanced and complicated, assume it was the work of Doodles.)

In What "Buy and Hold" Really Means, I talked about the characteristics you might look for in a suitable candidate for long-term investing. I suggested that you want to look for businesses with an identifiable competitive advantage that one would expect to strengthen or at least remain intact for the foreseeable future. Forgive me, Doodles, if I made it seem like all you have to do is pick a stock and create a nice fairy tale about what makes the company so great. You are probably going to need some quantitative way to filter out the weak options and focus your deeper investigations on the juiciest targets. Then you can work on the fairy tale.

Remember, we are trying to find businesses where the returns of the business exceed the costs of the capital that is required to run the business. An easy conceptual example might be the lending activities of a bank like JPMorgan Chase (NYSE:JPM), whose product is money. Way back, JPM obtained money from the capital markets (either by borrowing from investors or selling equity in themselves). Getting access to that money cost JPM (either explicitly via interest on its debt, or implicitly by needing to meet equity investors' expectations in exchange for them forking over their hard-earned cash). Then they lend that money at some interest rate to earn profits. OK, OK… the real JPM is a little more complicated than that (it actually has a bunch more ways it makes money), but the general idea is that there better be a decent spread between the cost of the money and the amount JPM earns by lending it. Otherwise, it will eventually be out of business.

Non-bank businesses work the same way, but they add the step of turning that money they raise into other assets and then selling those assets, thereby converting them back to money.

To find a list of potentially attractive businesses that maybe, possibly fill this prescription, we'll need some way to quantify the quality of the business. I like to use a screen to quickly whittle down the vast universe of publicly traded companies. Our choices for screening criteria need to provide useful information, but not be so specialized that they make comparing companies on the list an exercise in apples and oranges.

We could set the criteria at "high margin businesses." In general, I'd say I am in favor of higher margins (who isn't, besides the occasional FTC regulator?). However, you can't look at margins in a vacuum. Margins don't tell us anything about how many dollars we get out of a business for each dollar we put in.

For example, a business like Costco (NASDAQ:COST) has fairly low margins (operating margins were just under 3% for the trailing 12 months). We might conclude that the business really stinks because it is not super-profitable compared to its revenue. If we just looked at margins, Kohl's Corp. (NYSE:KSS) would look significantly more attractive at a ~10.6% operating profit.
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