4 Simple Rules for Investing Success from an Investing Great

Thomas Gayner, the chief investment officer of the Virginia, U.S. based insurer Markel Corp., is someone that’s not particularly well-known even within investing circles.

But, he should be. A recent Wall Street Journal profile of Gayner showed that his stock market investments have been compounding at an annual rate of 11.3% over the past 15 years, significantly outpacing the 4.2% annual return delivered by the S&P 500 (a broad U.S. market index).

Since 1999, Markel’s annual reports have contained a short paragraph with the same language describing how Gayner goes about picking his stocks. Here it is:

“We look for, one, profitable businesses with good returns on capital and modest leverage; two, management teams with equal measures of talent and integrity; three, businesses with reinvestment opportunities and/or capital discipline, at; four, reasonable valuations.”

There are four main pillars to Gayner’s investing criteria as you can see, so let’s take a closer look at each.

“We look for, one, profitable businesses with good returns on capital and modest leverage”

The stock market operates in a simple manner – to paraphrase Warren Buffett, the stock price of a company will eventually do well if its business does well too. As such, Gayner’s first pillar makes lots of sense as they are hallmarks of a good business.

In Singapore’s context, one company that might fit the bill could be Vicom Limited (SGX: V01).

Vicom's profit, returns on equity (ROE), and balance sheet figures

Source: S&P Capital IQ

As you can see in the chart above, Vicom has grown its profit in each year since at least 2004, generated a solid return of equity of at least 16% over the past decade, and carried zero borrowings since 2005.

“[M]anagement teams with equal measures of talent and integrity”

For Gayner, one without the other can’t work. As my colleague Stanley wrote recently, “Ability without integrity can easily lead to enrichment of managers at the expense of shareholders; meanwhile, management teams that have integrity without ability may be great people to hang out with, but they will never get anything done.”

While it’s easy to think that individual investors will have a hard time figuring out the level of a management team’s talent and integrity since we can hardly get access to these people, it’s worth noting that Gayner actually finds most of what he needs to know through materials that everyone of us have equal access to, like interviews of management in magazines and companies’ annual reports.

A good way to spot management teams with ability could be a company’s track record in innovation and conquering new markets. Meanwhile, if management blames something like say the weather for a poor year and yet fails to mention the matter again when the weather pattern turns for the better and the company’s results pick up, then that could be a yellow flag to note on the issue of integrity.

“[B]usinesses with reinvestment opportunities and/or capital discipline”

A company with a large addressable market in relation to its current size could be one with significant reinvestment opportunities; one firm with such a dynamic in Singapore could be events caterer Neo Group Ltd (SGX: 5UJ).

In 2014, research outfit Euromonitor did a study and found Neo Group to have been the leader of the S$363 million events-catering market in Singapore in 2013. But even so, the company had only a 10% share of the market, suggesting a long runway for future growth and reinvestment.

As for capital discipline, things that investors could look out for may be how the balance sheet of a company evolves. Is the company piling on borrowings in order to chase growth? This can be a risky action as the use of debt reduces a company’s room for error.

“[R]easonable valuations”

This is a reminder from Gayner that even the best businesses can be a poor investment when bought at too high a price. But, it’s also worth noting that a “reasonable valuation” need not necessarily mean that a company must be trading at say, a price-to-earnings (PE) ratio that’s lower than that of Singapore’s market barometer, the Straits Times Index (SGX: ^STI).

Healthcare services provider Raffles Medical Group Ltd (SGX: R01) is a great example of how a share with a very high PE ratio can still end up be a great bargain. Back in June 2007, Raffles Medical was trading at between S$1.30 and S$1.50 apiece and had a PE ratio in the neighbourhood of 40. But today, Raffles Medical’s shares are up by more than 200% at their current price of S$4.59 partly as a result of solid growth in the company’s revenue, profits and cashflows.

Raffles Medical Group's growth in revenue, profit, and cashflow

Source: S&P Capital IQ

Great businesses can sometimes sell for what seems to be an expensive price. But on hindsight, that seemingly pricey valuation can turn out to be very reasonable instead.

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The information provided is for general information purposes only and is not intended to be personalised investment or financial advice. Motley Fool Singapore writer Chong Ser Jing owns shares in Markel, Vicom, Neo Group, and Raffles Medical Group.