“Price is what you pay – value is what you get” Warren Buffett
One of the greatest shortcomings we observe of many investors is their inability to value a company without any reference to its current or past quoted valuations. To us, this is a crucial trait required in ‘value’ and ‘franchise’ investing.
Ben Graham taught us to invest with a ‘margin of safety’ but this can only be assessed by an independent estimate of an absolute fair valuation. All of the investments we favour are assessed on their likely absolute return over the medium term (3 years) and long term, not on their relative attractions vs other stocks or markets.
As Messrs Buffett and Munger have been so successful investing in high-quality ‘franchise’ companies, others have looked to copy their approach. However, ‘quality’ companies are often valued accordingly (i.e. highly) and therefore most portfolios constructed with 50 such companies might do moderately well but they are unlikely to excel due to the high starting prices of such holdings.
With our approach, we only buy into high-quality companies when we feel they are significantly mispriced. As a result, our research ideas and portfolios can have an actionable list of a small number of companies or, at times, a strong sector concentration. Here is an example:
A well-respected global company that many investors would accept as a good quality franchise today makes a return on its tangible capital of 15%. The intrinsic value of this company is likely to rise, we assess, by c.11% many years into the future, therefore it is an interesting company. What we believe makes it a compelling investment today, however, is its starting price of 10x current earnings (PE). We think it is wrong that an investment which can compound at c.11% for many years can be purchased for 10% earnings yield and therefore, in time, its mispricing will be corrected by markets. So, a move to a justifiable PE of say 13x in 3 years’ time, added to an 11% compound annual return, results in an investor IRR of c.21% over the next three years. However, the exact same company shares purchased at, say, a PE of 20x earnings that then falls to a multiple of 15x 3 years would make an annual return to the investor of less than 1%.
Such a thought process can only be applied if: a) our analysis makes us pretty certain of the quality of the company and its likely growth rate; and b) we are confident enough to value the company independent of the current market assessment that suggests there is something wrong with it. Clearly in the above example, we think we have found a good company priced like a bad one.
Over very long periods of time the return from owning a share will closely match the company’s achieved intrinsic value growth rate. That is why we seek those with the best growth rates, at the best price. The reason why our favoured list of stocks is often short is that in mostly efficient markets only a few quality franchises at any point in time may be mispriced. This is the logic to why all the best investors run more concentrated portfolios. It is also why Buffett observed “when it is raining gold reach for a bucket not a thimble”. In short, price matters. Only by buying great quality companies at cheap prices will we work our way up the compound interest chart and have a margin of safety.
Agree