Thinking like a business owner

Investors who take a business-owner approach and shut out market noise are in the best position to distinguish between price and value, Julian Morrison writes. 

People who have founded, built and grown successful companies over time dominate lists of the world’s wealthiest people. When considering how to build long-term wealth, there are some lessons to be learned from them. 

In most cases, they have built their families’ wealth by recognising a great, long-term business opportunity, and have taken equity (founding capital) in that business at a bargain price. They were pioneers - identifying and supporting the prospects of a business that nobody else did at the time. 

For those of us who cannot build companies, we should at least acquire equity in existing businesses at bargain prices especially when the opportunity arises to buy cheaply and particularly when a company stumbles and is unloved by most investors. 

Unfortunately, share market investors find it difficult to think like long-term business owners. Even if they see themselves as 'investors’ rather than 'traders’, they typically buy shares in anticipation of a short-term price increase. The average holding period for Australian Securities Exchange (ASX) listed shares is around 12 months. 

Moreover, the constant flow of information on companies, markets and economies can overwhelm rational thinking. As humans, we have great trouble weighing the importance of this information and making decisions based upon it because we are vulnerable to reacting to 'noise’. 

As Fischer Black put it, “People who trade on noise are willing to trade even though from an objective point of view they would be better off not trading. Perhaps they think the noise they are trading on is information. Or perhaps they just like to trade. Most of the time, the noise traders as a group will lose money”. 

The business owner distinguishes between price and value 

When buying a business privately, you have to undertake extensive due diligence to understand its ability to generate future earnings. This process is critical in assessing the value of the business to the buyer. A period of negotiation is also likely, where the buyer and seller each set out their assessment of value. This negotiation process ultimately leads to an agreement on price. 

If the buyer insists on a price they deem to be at or below value, they at least stand a chance of earning a decent return on their investment. In the share market however, the process often lacks discipline, and the rationale may appear more like the following: 

'My aim is to generate $50,000 in annual income. Company XYZ is a “blue chip” company, is financially strong, and pays a dividend of 50 cents per share. Therefore I will buy 100,000 shares, which will provide me with my income objective.’ 

The problem with this is that there is no assessment of fundamental value versus the share price, and no assessment of the risk of overpaying. Instead, income is being purchased regardless of price. To emphasise this risk in simple terms, if you pay twice what a company is worth and the share price later reverts to its true value, you can lose half your money. It may still be a great company, but that doesn’t help at all if you overpaid. 

Investors who recognise the risk of overpaying stand a better chance of dealing with it than their 'noise-trading’ counterparts. Try asking the following simple questions when considering a share purchase and you may foster a more effective 'business owner’ mindset: 

If I had to purchase 100 per cent of the business and could not sell it easily, would I buy it at this price? 

Do I understand the earning capacity of the business - not just for the next year or two but over a full business cycle - based on a diligent assessment? The answer to this question will form the basis of what the company is worth. If you do not have a sense of the true value of the business, you have no way of knowing whether you are overpaying at the current price. 

Why does someone else want to sell this business to me at this price? If the reasons cannot be clearly articulated, you may be overpaying. 

The business owner approach 

If the short-term average holding period on the ASX represents one end of the investor spectrum, the following quote from Warren Buffett represents the other end: “¨we approach the transaction as if we were buying into a private business. When investing, we view ourselves as business analysts - not as market analysts, not as macroeconomic analysts, and not even as security analysts”.  

Investors who are able to shut out the noise and think like business owners are more likely to discern between price and value. This is very important because the difference between the two will determine prospective risk and return. High risk and low return are two sides to the same coin - both of which result from overpaying. 

In our experience, approaching each investment as a long-term business owner leads to a more disciplined assessment of price versus value, it reduces the risk of overpaying and it increases prospective returns. 

Julian Morrison is national key account manager at Allan Gray Australia.