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CIGAR BUTTS & MOATS A"Phoenix"Capital"Research"Publica5on"

How  To  Make  a   Fortune  With   Value  Investing       ©  2013  ·  Phoenix  Capital  Research,  OmniSans  Publish,  LLC.  All  Rights  Reserved.  Protected  by  copyright   laws  of  the  United  States  and  international  treaties.  This  newsletter  may  only  be  used  pursuant  to  the   subscription   agreement   and   any   reproduction,   copying,   or   redistribution   (electronic   or   otherwise,   including  on  the  w orld  wide  web),  in  w hole  or  in  part,  is  strictly  prohibited  without  the  express  written   permission  of  OmniSans  Publishing,  LLC.  ·  All  Rights  Reserved.  

     

 

 

 

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How to Make a Fortune With Value Investing

In This Report

Welcome  Cigar  Butts  and  Moats.         The  purpose  of  this  newsletter  will  be  to  help   you  accumulate  wealth  through  the  careful   allocation  of  capital  in  high  performing,   investments  that  we’ll  hold  for  months  if  not   years.     Our  investment  strategies  will  be  heavy   influenced  by  the  thinking  of  Benjamin   Graham  and  his  legendary  student,  Warren   Buffett,  with  a  focus  on  investments  that  are   either  undervalued  or  which  offer   tremendous  compounding  potential.     Before  we  get  started,  I  want  to  lay  out  some   of  the  central  principles  of  successful  value   investing.       First  and  foremost,  you  need  to  know  that  few   if  any  investors  actually  beat  the  market  in  the   long-­‐term.  The  reason  for  this  is  that  most  of   the  investment  strategies  employed  by   investors  (professional  or  amateur)  simply  do   not  make  money  in  the  long  run.     I  know  this  runs  counter  to  the  claims  of  the   entire  financial  services  industry.  But  it  is   factually  correct.      In  2012,  the  S&P  500  roared  up  16%   including  dividends.  During  that  period,  less   than  40%  of  fund  managers  beat  the  market.   Most  investors  could  have  simply  invested  in   an  index  fund,  paid  less  in  fees,  and  done   better.  

• Two  critical  approaches  to   value  investing. • Benjamin  Graham’s  “Cigar   Butts”  or  looking  for  just  one   more  “puff.” • Warren  Buffet’s  quest  for   economic  “moats.” • How to make a fortune in long-term value investing.

 

     

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    If  you  spread  out  performance  over  the  last   two  years  (2011  and  2012)  the  results  are   even  worsen  with  only  10%  of  funds   beating  the  market.     If  we  stretch  back  even  further,  the  results  are   even  more  dismal.  For  the  ten  years  ended  1Q   2013,  a  mere  0.4%  of  mutual  funds  have   beaten  the  market.     0.4%,  as  in  less  than  half  of  one  percent  of   funds.     These  are  investment  “professionals,”  folks   whose  jobs  depend  on  producing  gains,  who   cannot  beat  the  market  for  any  significant   period.       The  reason  this  fact  is  not  better  known  is   because  the  mutual  fund  industry  usually   closes  its  losing  funds  or  merges  them  with   other,  better  performing  funds.       As  a  result,  the  mutual  fund  industry  in   general  experiences  a  tremendous  survivor   bias.  But  the  cold  hard  fact  what  I  told  you   earlier:  less  than  half  of  one  percent  of  fund   managers  outperform  the  market  over  a  ten-­‐ year  period.     So  how  does  one  beat  the  market?     Cigar  butts  and  moats.     “Cigar  butts”  was  a  term  used  by  the  father  of   value  investing,  Benjamin  Graham,  to  describe   investing  in  companies  that  trade  at   significant  discounts  to  their  underlying   values.  Graham  likened  these  companies  to  

old,  used  cigar  butts  that  had  been  discarded,   but  which  had  just  one  more  puff  left  in  them.       Like  discarded  cigar  butts,  these  investments   were  essentially  “free”:  investors  had   discarded  them  based  on  the  perception  that   they  had  no  value.         However,  many  of  these  cigar  butts  do  in  fact   have  on  last  puff  in  them.  And  for  a  shrewd   investor  like  Benjamin  Graham,  that  last  puff   was  the  profit  potential  obtained  by  acquiring   these  companies  at  prices  below  their  intrinsic   value  (below  the  value  of  the  companies   assets  plus  cash,  minus  its  liabilities).     Graham  used  a  lot  of  diversification,  investing   in  hundreds  of  “cigar  butts”  to  produce   average  annual  gains  of  20%,  far  outpacing   the  S&P  500’s  12.2%  per  year  over  the  same   time  period.     So  when  I  say  that  you  can  amass  a  fortune  by   investing  in  Cigar  Butts,  I’m  not  being   facetious.  For  this  reason,  cigar  butts,  or   deeply  undervalued  companies,  will  be  a  focus   of  this  newsletter.  And  like  Benjamin  Graham,   we’ll  only  be  holding  these  companies  in  the   short-­‐term:  until  they  reach  their  intrinsic   value.     The  other  term,  “moats”  is  in  reference  to  the   investments  Warren  Buffett,  a  student  of  Ben   Graham  and  arguably  the  greatest  living   investor,  seeks  out…     Buffett  amassed  his  enormous  fortune   through  a  systematic  investment  philosophy   consisting  of  a  few  key  ideas:    

     

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  1) Buy  companies  with  “moats”  around   them  meaning  that  they  have  a   competitive  advantage  that  stops   competitors  from  breaking  into  their   market  share.     2) Stay  within  your  “circle  of   competence”:  if  something  is  outside   your  knowledge  or  something  you   don’t  really  understand,  avoid  it  no   matter  how  great  it  sounds.  

(MCD).     For  starters,  MCD  has  a  moat.  MCD  was   launched  in  1940.  Burger  King  was  launched   in  1953.  Wendy’s  was  launched  in  1969.       Despite  these  competitors  moving  into  its   space,  MCD  has  thrived,  growing  to  become   the  largest  hamburger  based  business  in  the   world:  its  2012  revenues  were  $27  billion   compared  to  Burger  King’s  $1.9  billion  and   Wendy’s  $2.5  billion.     Today,  MCD  has  over  34,000  restaurants   based  in  199  countries  employing  1.8  million   people.  Obviously  the  company  is  able  to   defend  its  market  share  from  competitors.   That’s  an  economic  moat.     MCD’s  core  business,  selling  hamburgers  and   sodas,  is  easily  within  most  investors’  core   competencies.  That  is,  it’s  not  hard  to   understand  the  business  of  making  and  selling   burgers.     However,  do  not  let  the  simplicity  of  the   concept  (selling  burgers)  fool  you.  MCD  is  an   incredibly  well  run  organization.  The   McDonalds  brothers  who  created  the  first   restaurants  implemented  an  “assembly  line   approach”  to  producing  hamburgers  and  milk   shakes,  systematizing  the  process  until  they   were  producing  a  vastly  superior  product  at  a   faster  pace  than  their  competitors.  The  end   result  was  that  they  rapidly  took  market   share.     Ray  Kroc  who  bought  the  business  from  the   McDonalds  and  built  it  into  a  global   powerhouse,  took  this  approach  even  further.  

 

 

3) Focus  on  companies  that  have   “economic  goodwill”  meaning  they   have  an  intangible  quality  (such  as  a   brand)  that  permits  them  to  raise   prices  on  their  products  without   driving  consumers  to  a  competitor.   4) It’s  better  to  buy  a  great  business  at  a   fair  price,  rather  than  a  fair  business  at   a  great  price.  

  5) If  you  can  find  a  company  that  meets   these  criteria,  buy  it  and  hold  for  the   long-­‐term  to  allow  it  to  compound  as   much  as  possible  (Buffett  once  said  his   favorite  holding  period  was  “forever”).     Note  the  key  differences  between  Benjamin   Graham’s  strategies  (buy  lots  of  undervalued   companies  at  cheap  prices  and  hold  them   until  they  meet  their  intrinsic  value)  and   Buffett’s  (buy  a  small  number  of  companies  at   decent  prices  as  long  as  they  have  a  unique   position  in  the  market…  and  then  hold  them   for  the  long-­‐term).     To  consider  how  “moat”  investing  works  in   the  real  world,  let’s  consider  McDonalds        

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  Under  his  watch,  every  aspect  of  MCD’s   business  was  quantified  down  to  the  smallest   detail.       For  example,  a  MCD  beef  patty  must  have  fat   content  below  19%,  weigh  roughly  1.6   ounces,  and  be  3.875  inches  in  diameter.     This  methodology  was  applied  to  every  aspect   of  MCD’s  business  from  how  it  prepared  fries   (they  only  use  #1  Idaho  russet  potatoes  cut  to   be  7/32  inches  thick  with  at  least  21%   minimum  solids)  to  the  training  of  franchise   owners  (they  have  to  attend  a  week  long   training  at  McDonalds’  facility  “Hamburger   University”  where  they  learn  management   skills,  quality  control  and  countless   performance  metrics).    

As  a  result  of  this  systematization  as  well  as   clever  marketing,  MCD  has  developed   tremendous  economic  goodwill  that  has   allowed  it  to  become  the  #1  fast  food   restaurant  on  the  planet.       Between  this  and  the  company’s  focus  on   producing  returns  to  shareholders,  those  who   invested  in  MCD  and  held  for  the  long-­‐term   have  dramatically  outperformed  the  market   and  built  literal  fortunes.     Indeed,  had  you  in  McDonalds  in  1986,  you   would  have  outperformed  the  S&P  500  by  a   simply  enormous  margin  (see  Figure  1  below).   Not  only  that  but  you  would  have  crushed   every  asset  manager  on  planet  earth  with  very  

Figure  1:  MCD  shares  demonstrate  the  power  of  “moat”  investing        

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  few  exceptions.     Regarding  returns  to  shareholders,  MCD  has   paid  dividends  every  year  for  37  years  and   has  increased  its  dividend  at  least  once  per   year.     Dividends   per   share   have   increased   from   $0.11   in   1986   to   $2.87   in   2012.   Those   who   invested  in  MCD  shares  in  1986  are  receiving   a  yield  of  nearly  30%  per  year  on  their  initial   investment  today  just  from  dividends  alone.     MCD   is   so   focused   on   producing   returns   for   shareholders   that   the   company   has   bought   back  23%  of  its  shares  outstanding  in  the  last   ten   years.   So   even   investors   who   bought   in   2000   have   experienced   a   synthetic   yield   of   roughly  5%  per  year.       However,   the   most   dramatic   returns   produced   by   “moat”   investing   are   evident   through   the   power   of   compounding   as   illustrated   by   MCD’s   Dividend   Re-­‐Investment   Plan   or   DRIP   (a   plan   through   which   cash   dividend  payouts  were    automatically  used  to   buy  more  MCD  shares).     If   you   had   invested   in   MCD’s   DRIP   program   in   1988,  you  would  have  turned  $1,000  into  over   $23,000   by   the   end   of   2012.   This   is   not   by   adding   to   your   positions,   this   is   the   result   of   one  single  $1000  purchase  of  MCD  stock.     This  example   of   “moat”   investing   is   precisely   the   kind  of  wealth   generating  investment  that   has  made  Warren  Buffett  a  billionaire.     Cigar   Boats   and   Moats.   Focus   on   these   two   strategies,  and  you  will  produce  literal  fortune  

in  the  long-­‐term.          

     

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