How to Buy the Most Capital-Efficient Stocks, Safely

Editor's note: Steve says stocks have further to fall before we see a bottom. But soon, the time will come to invest in great companies at fantastic values. In today's essay – originally published in a 2013 special report – our founder Porter Stansberry covers the exact steps you can take to buy stocks at "no risk" prices...


Make sure you save a copy of this letter.

It's a step-by-step, paint-by-numbers guide to making a fortune in stocks. No, I can't promise that your investments will pan out as well as a few of mine have over the last few years. But I believe anyone is capable of becoming a world-class investor. You only need to know three things.

These are the things I know work – no matter what else is happening in the world or in the markets. Let me explain...

Investing is a simple game.

The goal is to get the most in return for having given the least in exchange. Any serious study of this process will reveal just a few variables control the outcome.

First, the amount of capital employed is important. Thus, the cardinal rule is: Don't lose money. Money lost cannot be invested. Money lost will not compound.

Second, time matters. The duration an investment may be held continuously with dividends reinvested is critical.

And the third important factor is the rate of compound growth.

What's funny about this list is how simple the game really is... and how few people pay any attention to the most basic rules. I doubt many subscribers consider these variables before they buy a stock. What most people consider is simply, "Will this stock go up? By how much? And when should I sell?"

The questions they should be asking are almost the complete opposite.

They should try to figure out...

  1. How fast are these shares likely to compound, assuming I reinvest all of the dividends?
  1. How long will I be able to hold this company safely?
  1. And most important, what's the most I can safely pay for this stock?

I share these ideas with a large amount of trepidation. These are not ideas that sell newsletters. You, gentle reader, may expect me to deliver the name of a stock that will surely double in the next month, then double again next year. Believe me, if it were that easy, I'd oblige. But the truth is a bit more complicated...

There's one exception... one sure way to get rich. And that is to buy capital-efficient businesses that have long-lived products and are capable of increasing payouts year after year.

This approach is, without question, the best way to invest. It's exactly the approach master investor Warren Buffett uses. But it's difficult to explain. Worst of all... once you understand how it works, it's just too simple.

All you have to do is buy the kind of companies that require very little capital to operate and grow their businesses and therefore produce excess capital that they return to their owners (the shareholders). Then you reinvest that capital into more shares. Rinse and repeat. It's not much harder than washing your hair.

And that means it's boring. But the truth is, using this kind of a strategy over time will produce returns that dwarf the gains you're likely to make speculating, even if you're a great speculator.

Best of all, my approach, which is based on capital efficiency, is totally safe and requires almost zero effort. The whole trick lies in understanding which companies are capital-efficient and have good long-term prospects.

Once you know that... you only buy when you can get the shares at such a low price that they essentially carry no risk.

So how much should you pay for a stock like this, or any other long-term investment? This ends up being the most important variable, because the first rule of investing is "don't lose money." Remember... money you lose doesn't compound.

Here's an easy rule of thumb to use when trying to figure out a safe price to pay for a stock... Just 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. Imagine a company with an enterprise value of $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).

If that's more than its operating income... it can't currently afford to buy itself. But if its operating income covers that amount, you've got yourself a winner. And your chances are better when shares are cheaper, of course – because this pushes down the enterprise value.

Doing this kind of analysis shows whether a company could realistically repay all of its debts and 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.

And the only way to do that is to buy capital-efficient companies... at good, safe prices.

Regards,

Porter Stansberry

Editor's note: Last week, Porter hosted an online discussion that's crucial for investors today. He detailed what he looks for in the highest-quality stocks... the ones he considers the "Greatest of All-Time." And he shared why Americans are about to get a rare opportunity to buy these companies at great prices – and make money for generations to come. If you missed it, watch the replay right here.

Further Reading

Porter recently shared the No. 1 piece of information he wishes he'd known when he started investing. It's the difference between hoping you make money on a stock, and knowing you're buying a great business that you intend to own forever... Learn more here.

"A lot of people – even some smart ones – believe that trying to time the market is a fool's errand," Porter writes. But Porter believes that anyone with average intelligence and emotional stability can do it – and that they should... Get the full story here: Don't Be a Fool – You Can Beat the Market.

Market Notes
PROVIDING TESTING IN THE GLOBAL FIGHT AGAINST CORONAVIRUS

Today, we’re highlighting a company that’s ready to combat the COVID-19 crisis…

As coronavirus sweeps across America, the number of U.S. cases has grown to more than 200,000. Medical equipment and supplies are crucial to treat the influx of patients. But diagnostic tests also play an important role – so that states can understand where we stand and where outbreaks are happening. Today’s company recently got the green light to distribute its tests in America…

Quidel (QDEL) is a leading maker of diagnostic solutions, such as tests. Its products help clinicians quickly diagnose infectious diseases and more. As you’ve seen on the news, medical supplies – including masks, ventilators, and tests – are desperately needed by hospitals throughout the country. And on March 17, the FDA gave emergency authorization for Quest Diagnostics (DGX) and Quidel to distribute tests for COVID-19.

QDEL shares jumped 26% that day as a result, and then went on to reach new highs. With the overall market swinging wildly with uncertainty, one thing’s for certain… We need tests to combat this pandemic. And that should drive further gains for this stock…