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