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The Cast Away Principle
One of my favorite movies is "Cast Away" with Tom Hanks.
In the film, Tom Hanks is a Fed-Ex employee. His plane crashed over the Pacific Ocean in 1995, and he had to fend for himself on an island for five years. Everyone back home assumes he is dead.
Because I have a one-track mind, I usually watch and think: "I wonder what happened to his portfolio?"
He was likely presumed dead, and his investments went to his beneficiaries.
What if his beneficiaries held onto his stocks?
He would likely have done extraordinarily well if he had some stock investments and didn't sell them from 1995-2000. After all, 1995-2000 was a helluva great time for stocks.
This begs the question: if you were to buy a stock and knew you couldn’t sell it for five years, how would that change your decision making process?
I think this is a great template to think about investing.
Whenever I buy a stock, I put myself in a "Cast Away" situation. If I were to get stuck in this position for 5-10 years and I could not sell, would I be ok with that?
This style of thinking sharpens the decision-making process and leads to better decisions.
After all, if you were to buy a cast-away stock, then you would want it to meet some critical criteria:
1) You would only buy a business with an established moat.
Anything can happen in the next ten years. There will likely be technological disruptions. You want a company that probably won't lose its competitive situation.
You're going to avoid ultra-cheap companies in industries in secular decline. You'll also avoid fast-growing companies in rapidly changing industries on the other end of the spectrum. You want something with a moat that is unlikely to be disrupted by a start-up.
The sort of things you’ll look for: a defense contractor, Coca-Cola, Google, etc.
The sort of things you won’t buy: a rapidly growing brand new company in a hot industry. Anything that can get disrupted by San Francisco folks on laptops.
You also won’t buy a company in a declining industry even if it’s trading at a substantial discount to tangible book. You can make money in those situations, but once they reach tangible book (your ‘one free puff’), you have to sell quickly because the company is dead meat in the long run.
2) You would want a recession-resistant business. It can’t be too cyclical. It can’t have a lot of debt.
In any decade, it's virtually a guarantee that there will be a recession or two.
Most businesses suffer during a recession.
Some companies do more than suffer - they go out of business. A good example is airlines. In nearly every recession, there are multiple bankruptcies in the airline industry. Even if they don't go bankrupt, they usually suffer catastrophic drawdowns. You’ll want to avoid highly cyclical industries like airlines.
There are many industries that go through a relentless boom-bust cycle that have to be timed correctly. Gold miners come to mind. You need to get in when prices are depressed and sell when prices are high. That’s not the sort of situation you can let ride for five to ten years.
In the same vein, you'll want businesses that don't have a lot of debt. A high debt load leads to catastrophe whenever the inevitable recession comes along. It can supercharge returns when cash is flowing. When it stops flowing, watch out. As Peter Lynch put it, "Companies that have no debt can't go bankrupt."
3) You'll also want to purchase from an attractive starting price.
You aren't riding a momentum trade and selling whenever the momentum fades. You're on an island. You’re stuck in the stock for 5-10 years.
You need to purchase from an attractive valuation. The classic example of overpaying for a great company is Microsoft in the year 2000. Throughout the 2000s, Microsoft's fundamentals grew, but the stock imploded. Revenues and earnings doubled from 2000-10. However, the stock turned $10,000 into $6,000. Why? At the peak in 2000, Microsoft was at an absurd valuation of 50x EV/EBIT. By the end of the decade, it was 8x EV/EBIT. If you don't pay a ridiculous price, you should avoid that valuation implosion.
4) You’ll want a business that can actually grow and deliver high returns on capital.
If the business can’t grow, then it doesn’t meet the criteria of a cast-away stock. Growth can be minimal - say, with nominal GDP (5%, typically). It might simply ‘grow’ by cannibalizing its stock. However, you can’t simply buy a stagnant (or declining) business for a multiple re-rating. You need a business that will likely be worth more in 5-10 years than it is today. Additionally, you’ll want something with high returns on capital - or at least decent returns on capital. A business with high returns on capital will grow in value over the long term. In short, you need a realistic path to growth when buying a cast-away situation.
The Cast Away Principle
The Cast Away principle is the thinking behind the checklist that I run through for each investment.
I want to own things that I can buy, hold, and won't cause me to worry. I want something where I can go to an island for five years and not worry about it.
I want to initiate an investment where I can go on vacation and don't have to check the price every day. Ideally, I’d like to go on vacation and not log into my brokerage account at all.
I want to own the sort of investment where I could not log onto my brokerage account for ten years, and it will probably be OK.
The cast-away approach is for my peace of mind and sanity as I'm a no-drama kind of guy. I don't want to have to worry about my investments. I’ve tried that approach and it didn’t work for me. I do not admire someone who is hyper focused and looking at every price tick on a Bloomberg terminal. Even worse: I do not admire someone forced to actually watch CNBC on a daily basis. To me, that’s one of Dante’s levels of hell to be avoided.
I want to buy a great company at an attractive valuation and give it a chance to work out over the next five or ten years. I don't want to worry about where we are in the economic cycle or the latest report from the Fed. I don't want to hold my breath before checking out a K or Q.
In addition to helping my sanity, I think this style results in better decisions.
That's for the better, in my view.
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