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Rule #1: Invest in a great company. Rule #2: Get a good price. Rule #3: Rule #1 > Rule #2

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March 25, 2014 – Comments (15)

Being a value investor at heart, I tend to migrate toward articles, blogs, and headlines that speak to value or discount stocks.  For me, finding items at 10, 20, or even 30% off the sticker price feels like a bargain, psychologically.  (I find myself not only doing this with the stock market, but in other aspects of life, too.  I once purchased a coat at 70% off the retail price.  I ended up wearing it once.  It sat in my closet for 2 years before I finally took it to a Goodwill.)  I even read a tweet just this morning that said “ultimately, it’s all about the price you pay.  Everything else is secondary.”

With investing, this is a mistake.

The first thing a long term investor should look for is not a bargain, but a great company - companies that have reputable brand names; companies that have moats; companies that sell products people love.  From a quantitative perspective, these companies have industry-leading operating margins, high returns on assets & shareholders’ equity, and a low-to-reasonable amount of leverage.

Only after you have come to the conclusion that a company is, indeed, a great company, then you can start debating whether or not the price is right.

The man himself, Warren Buffett, speaks about his own struggles with investing in “great” companies rather than “cheap” companies in several of the Berkshire Hathaway Letters to Shareholders (emphasis mine):

If you buy a stock at a sufficiently low price, there will usually be some hiccup in the fortunes of the business that gives you a chance to unload at a decent profit, even though the long-term performance of the business may be terrible. I call this the “cigar butt” approach to investing. A cigar butt found on the street that has only one puff left in it may not offer much of a smoke, but the “bargain purchase” will make that puff all profit. Unless you are a liquidator, that kind of approach to buying businesses is foolish. First, the original “bargain” price probably will not turn out to be such a steal after all. In a difficult business, no sooner is one problem solved than another surfaces— never is there just one cockroach in the kitchen. Second, any initial advantage you secure will be quickly eroded by the low return that the business earns. For example, if you buy a business for $8 million that can be sold or liquidated for $10 million and promptly take either course, you can realize a high return. But the investment will disappoint if the business is sold for $10 million in ten years and in the interim has annually earned and distributed only a few percent on cost. Time is the friend of the wonderful business, the enemy of the mediocre. You might think this principle is obvious, but I had to learn it the hard way—in fact, I had to learn it several times over.

Our goal is to find an outstanding business at a sensible price, not a mediocre business at a bargain price.  (It must be noted that your Chairman, always a quick study, required only 20 years to recognize how important it was to buy good businesses. In the interim, I searched for “bargains”—and had the misfortune to find some.)

I believe it was Charlie Munger that heavily influenced Buffett regarding the selection of high quality companies rather than cheap companies (though it seems that Buffett also received quite a bit of education through personal experience).

Speaking of personal experience, I also went through a period of trying to find cheap companies.  Through 2011-2012, I hunted for cash-heavy, debt-light companies that appeared inexpensive from an EV perspective.  I found a few clothing companies (True Religion and Jos A Bank) and a few industrial companies (Superior Industries and Miller Industries) that met this criteria.

Sure enough, 2 of these 4 companies actually went on to be acquired (through no action of my own, I assure you).  My thesis turned out to be right.  However, the final premiums fetched were not worth the anguish of watching operations falter and the stock price swing +/- 20% in a given month.  JOSB had terrible inventory management and True Religion saw operating margins drop each and every year like clockwork.  Unless investments were made at near-perfect times (summer 2012 for TRLG; summer 2013 for JOSB), you didn’t even outperform the S&P 500 with these trades!

I’ve since sold off my SUP and MLR positions, as well.  While I didn’t lose money in absolute terms, these investments greatly underperformed the S&P 500 during my holding periods.

Other companies I got drawn toward based on assets and Enterprise Value attractiveness included Corning, EMC, Green Dot, and IAMGOLD (ugh).  Over the past 5 years, investments in any of these companies have mostly lagged the market.

I’ve said this before, but I’ll say it again: Unless you’re running deals at a Private Equity firm or unless you’re Carl Icahn, don’t invest in companies based on EV principles, alone.  You don’t have any say in what a company does with their assets, including excess cash.  Instead of hoping that management is going to create shareholder value with the assets they are sitting on, find a company whose management is actually creating shareholder value.

15 Comments – Post Your Own

#1) On March 25, 2014 at 10:33 AM, Mega (99.97) wrote:

Not sure EMC fits here - it is a growth stock.

My experience with Corning has been positive. I got in too early, but added when it was really cheap a year and a half ago. I look at all the excess cash primarily as downside protection, not upside.

Cash rich companies outperform in some markets and underperform in others. I think it's good to have some style diversification in your portfolio.

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#2) On March 25, 2014 at 11:27 AM, ElCid16 (96.80) wrote:

Not sure EMC fits here - it is a growth stock.

I was not attempting, nor am I going to try to argue whether EMC is a growth stock or not.  The reason it was included in this list is because I felt that the VMW stake wasn't being fully accounted for.  I invested in it because I felt the assets were being undervalued.

Cash rich companies outperform in some markets and underperform in others.  

I'm guessing that you're implying cash rich companies outperform during bear markets.  But consider this: Corning shares fell over 70% during 2008.  Their cash cushion provided zero downside protection.  

I am a HUGE advocate of using cash as a hedge.  One of my favorite James Montier white papers is "An ode to cash."  But the cash that I prefer to hedge with is not cash and assets sitting on a company's balance sheet – it is cash that is sitting in my portfolio!  I try to maintain an 80/20 stock/cash balance at all times.  If the market corrects during a bear market, I can't use Corning's excess cash to invest in cheap equities.

I'd rather have A) an 80/20 stock/cash balanced portfolio with the 80% stock position including companies with ROE values of 35%, rather than B) an 80/20 stock/cash balanced portfolio accounting for the excess cash on the balance sheets of my stock holdings.  Striving to achieve B would inevitably leave you selecting under-performing companies from an operating perspective, because you would be limited to selecting only companies that have excess cash.

Don’t select cash rich companies for the sake of trying to “outperform in some markets.”  Just maintain a larger cash position - that way you can stick with investing in only the best of breed companies.

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#3) On March 25, 2014 at 11:56 AM, Mega (99.97) wrote:

I'm guessing that you're implying cash rich companies outperform during bear markets.  But consider this: Corning shares fell over 70% during 2008.  Their cash cushion provided zero downside protection.  

Cash rich and cheap companies do outperform during bear markets. Corning was not cheap in 2008 at 4x book value and 20x cash flow. Even if they had been cheap, they would just be a single data point.

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#4) On March 25, 2014 at 12:09 PM, Mega (99.97) wrote:

(It must be noted that your Chairman, always a quick study, required only 20 years to recognize how important it was to buy good businesses. In the interim, I searched for “bargains”—and had the misfortune to find some.)

Note that Buffett's returns were highest during this early bargain hunting phase of his career. He doesn't often mention that when disparaging cigar butts.

Cigar butts are not for everyone, but successful asset investing produces money just as green as quality/growth investing.

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#5) On March 25, 2014 at 12:13 PM, ElCid16 (96.80) wrote:

Mega - fair points.

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#6) On March 25, 2014 at 12:27 PM, ElCid16 (96.80) wrote:

Note that Buffett's returns were highest during this early bargain hunting phase of his career. He doesn't often mention that when disparaging cigar butts.

Just one more thing - his successful returns early in his career might not necessarily be attributed to his style of investing, but the environment in which he invested. In other words, while his cigar butt investing may be correlated with his best returns, that might not be the primary cause of his returns.

The average market P/E ratio during the 50s, 60s, 70s, and early 80s was a lot lower than the average market P/E ratio of the late 80s, 90s, and 2000s.  [I'm guessing] that there were likely a lot of"cheap options" during his cigar investing days.  But do those types of opportunities still exist at the same valuations and quantity?

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#7) On March 25, 2014 at 12:32 PM, ElCid16 (96.80) wrote:

Cash rich and cheap companies do outperform during bear markets.

Do you have a study on this you could share?  

What I'd like to know is: would a portfolio of cash rich companies (EV/Mkt Cap = 80%) perform any better than a portfolio of non-cash rich companies and a proportionate cash balance (Stock Balance/[Stock+Cash Balance] = 80%) during a bear market?

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#8) On March 25, 2014 at 9:30 PM, Mega (99.97) wrote:

Not exactly. Piotroski is a good study that covers the late 1970s bear market.

http://www.bengrahaminvesting.ca/Research/Papers/Value_Investing_The_Use_of_Historical_Financial_Statement_Information.pdf 

"the mean return earned by a high book-to-market investor can be increased by at least 7.5% annually through the selection of financially strong high BM firms,"

Also this:

http://finance.wharton.upenn.edu/~rlwctr/papers/0505.pdf

Your study idea sounds cool. 

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#9) On March 25, 2014 at 11:02 PM, Mega (99.97) wrote:

Value strategies in general did pretty poorly in 2008, but Graham screens requiring some excess cash (P/B less than 1.5 and current ratio over 2) did well.

http://www.ndir.com/SI/articles/0114.shtml 

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#10) On March 25, 2014 at 11:05 PM, Mega (99.97) wrote:

For some reason that link is finicky. If it doesn't work try copying and pasting it into the address bar.

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#11) On March 26, 2014 at 6:43 PM, ElCid16 (96.80) wrote:

thanks for the links, Mega.  Here's one in return:

http://philosophicaleconomics.wordpress.com/2014/03/22/wmt/

 

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#12) On March 27, 2014 at 12:52 PM, Mega (99.97) wrote:

Thanks. Philosophical Economics is a great blog, unique and smart viewpoint. I think I had read one of his posts before, but the entire thing is worth reading.

That particular post definitely makes me wish I was investing in the 70s. Particularly with regards to asset mix which I feel was a more straightforward decision then.

I will note that the comparison of Walmart and Kodak's fair value multiples (1500x earnings versus 1x earnings) has a significant real world problem. In the real world, stocks appear to stray from fair value on a systematic basis. A stock trading at 1x earnings has a natural tendency to trade upwards, even if fair value is 1x earnings. The inverse applies to 1500x earnings.

Put another way, Kodak would have positive option value at 1x earnings and Walmart would have negative option value at 1500x earnings, even assuming you have a crystal ball that tells you those are the correct multiples.

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#13) On March 27, 2014 at 1:00 PM, Mega (99.97) wrote:

And it probably goes without saying that if you don't have such a crystal ball, which we don't, the optionality effect is far stronger.

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#14) On March 27, 2014 at 3:29 PM, ElCid16 (96.80) wrote:

Yeah - I know you're a bit bigger on taking advantage of intermediate term pricing inefficiencies (I think).  For instance, I felt - and I believe you felt - that Big Lots was pretty cheap at $26 just earlier this year.  Sure enough, the stock popped 40%.

But what is Big Lot's end-game?  What will the company be in 10 year's time?  Do you pick up your 40%, and move on?  How many times do you have to do that per year?

I'd rather generate long term returns by picking long-term winning stocks.  That doesn't mean I have to invest in Chipotle at a 50 P/E or Amazon at a X00 P/E or Tesla at a X00 P/E.  I can sit tight until something more reasonable comes along, that still has that long term potential.  

I just don't know if I have the stomach to play the pricing inefficiency game over the long haul...

By the way, congrats on absolutely killing it lately.  Hope your RL portfolio is doing equally well. 

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#15) On March 27, 2014 at 7:56 PM, Mega (99.97) wrote:

For instance, I felt - and I believe you felt - that Big Lots was pretty cheap at $26 just earlier this year.  Sure enough, the stock popped 40%.

But what is Big Lot's end-game?  What will the company be in 10 year's time?  Do you pick up your 40%, and move on?  How many times do you have to do that per year?

Yeah, I looked at Big Lots around $27 and passed. My thought process was that they are a pretty good business, but the short term trends (rough Q4, closing down their Canadian stores) looked bad enough that there was no hurry to buy. I'm surprised that they traded up so sharply since then.

You're right, I don't think they're good enough to own for the next 10 years. But I think they're good enough to own for 2 or 3 years, at the right price.

I'd rather generate long term returns by picking long-term winning stocks.

Growth/quality as practiced by Buffett, Munger and Fisher is a great strategy. I'm just not quite suited for it. My approach blends in more cheapness/relative value, like Einhorn or early Buffett.

Making a quick 40% return and having to find a new investment is a problem I've never minded at all.

Hope your RL portfolio is doing equally well. 

Thanks! Same to you.

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