We all know the famous Warren Buffett quote about only swinging at a “fat pitch”. It’s a beloved quote and a lot of people use it to describe their own investment process.
But they use the “Fat Pitch” as a guaranteed home run and that is the wrong way to use it.
The original quote is this
The trick in investing is just to sit there and watch pitch after pitch go by and wait for the one right in your sweet spot. And if people are yelling, ‘Swing, you bum!,’ ignore them. [emphasis added]
Warren Buffett is a big fan of Ted William’s book The Science of Hitting. In that book, Ted describes how he broke the standard strike down into 77 smaller baseball-sized zones along with his batting average in each zone.
And the Baseball Hall of Fame Display.
Ted Williams the greatest hitter in baseball history got a hit only 40% of the time on a fat-down-the-middle pitch.
Once he made contact with the ball, there was a myriad of external factors out of his control that dictated whether or not that contact turned into a hit.
It was never a guaranteed hit let alone a home run. But Ted knew that his greatest odds of success were within this small zone.
What Warren Buffett was saying is find your zone.
Figure out where your highest batting average is and then swing at every ball in that zone while ignoring the rest. Don’t worry about whether or not it’ll be a home run. Put the ball in play. Some will be singles, some doubles, some will be home runs, and some will be outs.
Focusing on this highly productive zone you increase your odds of success but it’s never guaranteed. Like with hitting, there is a myriad of external factors outside of your control that will dictate whether or not your investment is a hit or an out.
But you won’t know this till after you make contact. So don’t miss an opportunity at a hit while you dither on whether or not it’ll be a home run or a single.
The filters we use to find “fat pitches”.
A consistently high Return on Invested Capital is a good indication that the company has a strong competitive advantage that warrants further investigation.
Gross profit margin demonstrates competitive advantage: it is the purest expression of customer valuation of a product, clearly implying the premium buyers assign to a seller for having fashioned raw materials into a finished item and branding it.
Quality Investing: Owning the best companies for the long term
High gross margins also reflect low asset intensity.
High gross margins in relation to industry, competitors, and the overall market are a sign of pricing power. It acts as a buffer against rising raw materials costs and they allow for greater operating flexibility. The company can redirect more money to R&D or increase their marketing spend or both.
Stable or Growing Competitive Advantage
It isn’t about the size of the competitive advantage. It’s really about what direction that competitive advantage is heading in.
Paul Black on What Got You There Podcast
This is mostly a qualitative exercise about the strength of a company’s competitive advantage but you can assess it quantitatively with Returns on Incremental Invested Capital (ROIIC).
A high ROIIC shows that a company still has high reinvestment opportunities that will strengthen the company’s future competitive advantage.
A declining ROIIC or low ROIIC means the company is investing in suboptimal projects or, worse, they’re investing in projects that don’t cover their cost of capital and our destroying shareholder value.
Secular growth is long-term growth driven by a persistent shift in demographics, new technologies, consumer behavior, and how businesses operate.
We want to invest in companies in a secular growth trend because they’ll grow faster than the overall economy and if they have a high ROIC or a growing ROIC they’ll create tremendous shareholder value.
Dividend Initiators and Growers
Dividend initiators and growers tend to outperform the market over the long-term.
There are a lot of high-quality companies that don’t pay a dividend but again ew’re using these filters to focus our attention on a small highly productive zone.
Finally, if a company passes all the previous criteria then it needs to be trading below our estimate of fair value.
Baseball has a set strike zone rule. A fat pitch is the same for every batter.
Investing doesn’t have a set zone.
Our zone is quality dividend growth investing. This is the style of investing that suits us but it doesn’t have to be yours.
Your zone could be distressed investing, arbitrage, short selling, growth, deep value, etc. The only thing that matters is to find your fat pitch zone and then swing away at the opportunities within this zone.