Part 1 in a series of tutorials on value investing, the mispriced markets way.
An Introduction To Value Investing
You can approach investing from many different angles. Some investors focus on dividends. Others are drawn to growth companies. Adherents of technical analysis spend their time looking for patterns on stock charts while fundamental analysts pore over financial statements. There are passive investors and momentum investors. Day traders and “buy and hold” investors. Even amongst the community that label themselves value investors there are a variety of approaches. Here, some focus on earnings while others emphasize book value or free cash flow. Warren Buffett devotees spend their time looking for moats while Peter Lynch disciples search for growth at a reasonable price. Followers of Joel Greenblatt and his magic formula will spend their time calculating returns on capital and enterprise values.
I’m not going to talk about all of these competing ideologies. I’m going to talk about the way I invest. With some relatively minor refinements and enhancements along the way, I’ve been investing essentially the same way for the past 20+ years. And my track record suggests that my approach is as good a one as any and, in fact, far, far better than most.
The Two Elements Of A Successful Value Investing Strategy
I’m a value investor at heart. That means essentially two things. One, that I spend the time to evaluate what I consider to be a business’ intrinsic value, what I call it’s “fair value”. This is the price that a private investor might be willing to pay to buy the entire company outright. Second, I look for companies whose stock prices are trading at a significant discount to this “fair value”.
To be successful in this game, you have to be reasonably good at assessing a company’s intrinsic value and then you have to spend the time turning over a lot of rocks to find the rare companies that are selling at a big discount to that value. When I find such a stock, I buy it. And then I wait. I may be waiting for 6 months or a year or two or three. But more often than not, if I wait long enough, other investors begin to see the value that I saw and they bid the share price up until it reaches a more reasonable level. At that point, I sell my position and move on to the next opportunity. Wash, rinse and repeat. Do this over and over again and your portfolio will grow and prosper.
Buying Companies, Not Stocks
I use some mental tricks to help me frame my investment decisions in the right way. When I buy a stock, I like to think of myself as buying the entire company. People who don’t know me sometimes get confused because I talk about the companies I own, not the stocks I’ve bought. While I may not have the wherewithal to take over entire companies, when I buy a stock I am nonetheless buying a part ownership stake in the company and I take that purchase decision very seriously.
To me, the stock market has always seemed almost too good to be true. With the simple push of a button, I can buy a piece of a profitable, growing company. With that little twitch of my index finger, I instantly become a part owner of the enterprise. From this time forward, everyone from the CEO on down to the mail room clerk is now essentially working for me. While I’m out skiing or having a coffee at the local coffee shop, there is some Harvard trained MBA working his or her butt off morning, noon and night to make my company the most successful it can be. And it gets better. I can pick and choose out of a smorgasbord of thousands of different companies. If I don’t like the look of one, I can move on to the next. If I’ve done my research right, I can buy stakes in profitable, well run companies with lots of potential and I can buy these stakes at fire sale prices! If things don’t turn out as well as hoped, I don’t have to lose sleep worrying about how I will keep the lights on at my factories or how I will meet next week’s payroll. With another click of a button, I can sell my stake as easily as I bought it and move my money into a more promising situation.
After all these years, I still can’t quite believe that the system works this way. It really doesn’t seem fair somehow. There are pitfalls to be sure. Investing is no walk in the park. But it’s not rocket science either. Successful investing, in my opinion, starts with this core concept: when you buy a stock you are not buying a piece of paper or a ticker symbol or a lottery ticket, you are buying a piece of a very real business. You are becoming a part owner of that business and that is not something to be taken lightly.
Buying For The Long-Term
I take this thought process a step further and generally consider myself to be buying a more or less permanent ownership stake in that business. I like to buy with the idea that I am going to own this business for the next 10 or 15 or 20 years, through boom periods and through recessions. If I am not comfortable owning a company for the long haul then I don’t buy it. If something goes wrong, I don’t assume that I will be able to “get out in time”; I assume that I am riding this puppy all the way down to zero. (And, in fact, I’ve done just that on a number of occasions.)
This way of framing your investment decisions naturally leads you to make very healthy choices. You’re much less likely to take a “flyer” on some hot start up company. You’ll be paying keen attention to the risks associated with an investment and the financial strength of the companies you are buying. And if you’re focused on the long-term prospects of a business, you won’t be relying on a “greater fool” to come along and give you a quick exit.
One of the single, greatest advantages that a small, private investor has (and there are many) is this ability to adopt a long-term outlook. So many investors and so much of the Wall Street machine is geared towards immediate gratification and short-term results. If you can take the long view, you can find incredible opportunities that the myopic masses have missed.
It’s All About The Price You Pay
So I’m buying whole companies and I’m buying them for the long-term. (Or at least, that’s the mental framework I use.) The next crucial question is what price should I pay for these companies? I typically run a small, concentrated portfolio of a dozen or so stocks. Apart from my house, my entire net worth is tied up in this handful of companies. Given this, the price I’m paying for these businesses becomes crucially important. Overpaying for even a few of these holdings can put a significant dent in my long-term results.
To a value investor, the price you pay is more important than the company you are buying. There are thousands of companies out there (tens of thousands if you’re willing to venture further afield). There are great companies, good companies, mediocre companies and disasters waiting to happen. All of these companies have a fair price. The great company will obviously be worth a good deal more than the mediocre one but both have value. The great company can be a terrible investment if the price is too high and the mediocre company can be a wonderful investment if the price is low enough. I have bought great companies. I have bought mediocre ones and on a few occasions I have even bought the disasters in waiting. In each case, I put myself in the position of an investor who was buying the entire company and was going to hang on to it through thick and thin and then I asked myself what price would an investor like that be willing to pay for this investment? What would be a “fair” price? And only if I can buy the company for a big discount to that fair value do I pull the trigger.
Great Companies Don’t Always Make Great Investments
This is the key concept that many investors miss. They find great companies and think that will make them great investments, but it doesn’t. The two are very different things. Imagine if you were buying a business outright. Imagine you had spent months kicking the tires of various businesses and finally found one that you really liked, with lots of long-term potential. Would you then go to the owner and say “I love your business and I’d like to buy it. Here’s a blank cheque. Just write whatever you feel like on there.”? Of course not! And yet, this is exactly how many investors approach the market. They find a company they like and they buy the stock without any consideration of whether the price they are paying is proportionate to the company they are buying.
A more value-oriented approach would be to find a business you like. Research it thoroughly so you can make a good estimate of what a fair price to pay for it would be and then offer the owner 25% less than that. If he refuses, move on to another business and try again.
In the stock markets I have generally found that if I search long and hard enough, I can usually find enough companies to fill a portfolio if I use a cutoff of 40% for my discount to fair value target. So if I think a stock has a fair value of $10, I would be looking to buy it for $6. Of course, I would love to buy it for $5 or $4 and the lower the better, but realistically, the market rarely offers up deals that extreme. The 40% discount cutoff is what has let me beat the market year in and year out by a wide margin for over 20 years now. If I wasn’t buying at a discount then, over time, I should expect to simply match whatever the overall market is doing. It wouldn’t matter how good or bad the companies I was buying were. If I were paying a “fair price” for each of the companies I put in my portfolio then I should expect my portfolio to simply track the market.
The value discount is the secret sauce; that is what drives superior returns. Most stocks are not heavily discounted. After running all the numbers, you’ll usually come to the conclusion that the company you’re looking at is at least within spitting distance of fairly priced. The market is not perfectly efficient by any means. It does make mistakes. But the collected wisdom of thousands of investors all acting independently does a reasonably good job of keeping stock prices relatively coherent. If you look long and hard enough, though, you can occasionally find stocks whose prices have drifted far enough away from their fair value to offer you the chance to make those market beating returns you’ve been looking for.
You’ve found your mispriced market!
(In the next post in this series, (Part 2: The General Store), I’ll elaborate more on how I begin to calculate a company’s fair value.)