This is Warren Buffet’s simple method to make investing a “sure thing”

From the S&A Digest:

Investing in companies that can grow richer every year without demanding continued investment has helped Warren Buffett compound his wealth at an astonishing rate. It can help you do the same.

In today’s essay – pulled from the February 16, 2012 edition of the free e-letter DailyWealth – Porter Stansberry, editor of Stansberry Investment Advisory, discusses the most important decision you can make when following Buffett’s method…

How much should you pay for a “sure thing”?

 

Back in December 2007, I first recommended shares of Hershey (HSY) – calling it “Our Best No-Risk Opportunity Ever.”

When I recommended Hershey, I was convinced it would become one of the greatest investments of my career. I remain convinced now. Why am I so certain?

First, because it’s incredibly capital efficient. Since 2005, Hershey had repurchased more than $1 billion worth of its own stock – more than 10% of the company, in addition to paying large ($200 million-plus) cash dividends. It has paid 325 quarterly dividends in a row – for 81 years. It has increased its dividend payout every year since 1974.

On a combined basis (dividends and buybacks), the company pays out a remarkably large amount of the cash it produces. For example… in 2008, the company produced a little more than $500 million in cash from operations. It spent nearly $300 million on dividends and share buybacks. (It also repaid $128 million in debt.)

Hershey can afford to return so much capital to its shareholders because it requires little capital to grow. Over the last 15 years, the company’s annual capital spending has remained essentially unchanged. In 1997, the firm invested $172 million in property and equipment. By the end of 2010, its annual capital budget had only increased to $179 million – essentially unchanged. Meanwhile, cash profits had reached nearly $1 billion – growth of nearly 200%.

As I showed you yesterday, this is the beauty of a capital-efficient business: While sales and profits grow, capital investments don’t.

But when I made my recommendation of Hershey, there was another consideration… It was selling for a “no risk” price.

I use an easy rule of thumb when trying to figure out a safe price to pay for a stock…

First, figure out how much money it would take to buy back every share at the current market price and add in the total net debt of the company. The number you’ll end up with is called enterprise value. That’s the figure it would cost (in theory) for the company to buy itself. Next, just figure out if there’s any realistic way the company could afford to buy itself.

Few companies actually go private this way… But bear with me.

In Hershey’s case, its enterprise value is currently $15 billion. For the company to borrow this much money, it would have to afford roughly $1 billion a year in interest payments (assuming 7% interest). That’s more than its operating income… which means Hershey can’t currently afford to buy itself.

On the other hand… when we first recommended the stock, its shares were about 50% cheaper, which put its enterprise value down around $10 billion. Doing the same calculation leaves you with an annual interest bill of around $700 million – something that was just inside the range of possibility back in 2009, when the company earned $769 million from operations.

Doing this kind of analysis shows whether a company could realistically repay all of its debts and buy all of its shares. Assuming it can afford to do both, there’s no fundamental difference between the risk of its stock and the risk in its bonds – because all the bonds and shares could be repurchased.

And that means on a fundamental basis, you’re getting all the upside of the shares – all the upside of being an owner – with the same low risk of being a creditor.

I call this buying at a “no-risk” price. There’s no additional risk to buying the equity compared with the debt.

This is the best analysis to consider before you buy any stock – but especially one you’re buying to hold for the long term. You have to make sure you will be comfortable enough to wait for the payoff. You have to make sure you’ve bought at a good, safe price.

While Hershey is too expensive to buy right now, based on this analysis… you should watch the stock closely. Assuming shares pull back about 10% or so, it could again be purchased using our no-risk criteria. In this case, you’d have a situation where you are extremely unlikely to lose money that’s likely to compound at about 15% per year over the long term, and that you are extremely unlikely to ever have to sell.

That’s exactly the kind of situation you should be looking for all the time.

I urge you to make a list of companies like Hershey, companies that are extremely capital efficient. Strive to buy the companies whose products and services you believe are most loved and most likely to be extremely long-lived. Try to acquire assets that your children’s children will never want to sell.

Determine the price at which you can buy them on a no-risk basis… And then wait for your opportunity. This is the secret to Warren Buffett’s investment approach that few people talk about. It has allowed him to compound wealth at an astonishing rate. It can help you do the same.

Crux note: Buying capital-efficient companies at “no risk” prices is the single best way to protect yourself from the inflationary crisis Porter sees coming… A new law is set to go into effect in July that could devastate the American economy. Porter says commodity prices will soar. Banks will close. Social Security checks will halt.

In a new report, Porter walks through what he is doing personally – and what you can do as well – to help protect your family and your wealth. Learn more about what will happen when the new law takes effect – and access his new report – right here.

Further reading:

Porter Stansberry: My top warning signs for 2014

Porter Stansberry: These charts say the “End of America” cannot be stopped

Porter Stansberry: How to completely eliminate fear from your investing

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