The Golden Rule Of Investing: Keep It Simple

Dave Forest's picture

Wednesday, July 22, 2015 - 10:30am

by Dave Forest

Sometimes, an insult is actually a compliment. Warren Buffett once quipped that an idiot in the corner office is not necessarily a bad thing.

I'll let the Sage of Omaha say it is his own words: "I try to buy stock in businesses that are so wonderful that an idiot can run them. Because sooner or later, one will."

It's actually a brilliant bit of insight. Let me explain.

So many companies have floundered once the management baton has been handed from the founders to the next generation of management. The only way such a transition can be successfully handled is by establishing clear and simple principles that are easy to execute. The next CEO just has to keep his hand on the rudder and keep the boat sailing on the right heading.

I'm always cognizant of that notion when adding new holdings to my Top 10 Stocks portfolio. I would never want to invest in a company that required a lengthy explanation of its mission statement.

"Keep it simple," is the mantra that we should all heed.

Here's the real problem with complex business models. Their management teams often have to navigate a range of tricky market dynamics, which lends a great deal of uncertainty to future results. Simple businesses tend to generate consistent results year after year, and you can usually own them for the long haul without the need to ride out booms and busts.

Let me go back to Warren Buffett to show why this approach matters. In 1983, his firm, Berkshire Hathaway, Inc. (NYSE: BRK-B), acquired a majority stake in Nebraska Furniture Mart. The company had been successfully selling furniture, flooring and appliances since 1937.

Buffett simply had to look at the books to determine how much profit was being made -- and what valuation he was paying relative to cash flow for the business. And with a commodity like furniture, there was little likelihood that demand would trail off -- chairs have been with us for hundreds of years and will likely be around for hundreds more.

And because of the simplicity of this industry, it was easy to compare Nebraska Furniture Mart's results to other competitors. Looking across the industry, Buffett could see that this company's prices were far superior to other vendors -- giving the firm an advantage in terms of generating sales that was unlikely to be eroded anytime soon.

A Simple Way To Spot A Simple Business
The question for investors: how can we spot simple businesses? It's not as easy as it sounds. Some companies, such as McDonalds, Inc. (NYSE: MCD) don't just peddle burgers and fries, they run massively global logistics systems. There are many variables to manage, and fixing broken aspects of the business can become much harder than many might anticipate.

As an investor, you simply can't stay abreast of all the moving parts when assessing a company like McDonalds. Instead, I like to focus on one simple measure: free cash flow.

Simply put, these are the profits left over after all of the needed annual investments are made in a business. It's the money that fuels dividends, buybacks, debt reductions and acquisitions. Great companies have great free cash flow. Everything else is just noise.

In the July issue of my Top 10 Stocks newsletter, I worked through an example of a powerful-yet-simple business model. This company, which I just added to my Top 10 Stocks portfolio, is one of the largest suppliers of electrical and mechanical wire and cable in the United States.

Here's the unusual thing. The company's products are quite straightforward -- most of the items for sale were designed decades ago. Yet this company's key clients tend to operate in much more advanced and complex business environments. They have all sorts of risk embedded in their business model.

This portfolio holding is living proof that simplicity is a virtue. I looked at its operations over the past 40 years and found that free cash flow has always been robust. That's because the company has relatively low levels of capital spending requirements. In fact, capital expenses since 2007 have averaged just 7% of the company's average annual operating cash flow. Ample operating cash flow, paired with low levels of internal investments always leads to robust free cash flow.

Contrast this with McDonalds, which spends $2.3 billion per year on capital expenditures to maintain operations. That spending amounts to a full 34% of McDonalds' operating cash flow being taken up in order to keep complex operations rolling.

How does robust free cash flow pay off for investors? Well, this new portfolio holding sports a dividend yield of nearly 5%. That's quite impressive when you consider that this company has maintained or boosted its payout every year since 2007.

Let's recap. Focus your investment energies on companies with simple-to-understand business models that have a history of powerful free cash flow. Such companies can typically be counted on to produce portfolio gains for years -- perhaps decades -- to come.

P.S. -- A few months ago I revealed the secrets behind the world's most reliable companies to a live audience at St. Edward's University in Austin, Texas. In this presentation I revealed The Top 10 Stocks To Own For The Rest Of Your Life and the key traits they possess which make them so great. For only a limited time, I have authorized StreetAuthority to share the video recording with StreetAuthority Daily readers. To start the video, please click the play button below.
 

Dave Forest does not personally hold positions in any securities mentioned in this article.
StreetAuthority LLC does not hold positions in any securities mentioned in this article.