As value investors, we are always on the lookout for bargains—stocks or bonds that are trading at prices below our estimate of Fair Market Value (FMV). Both research and common sense dictate that the greater the discrepancy between price and FMV, the better—it provides a higher possible margin of safety and implied upside. However, securities are often detached from their FMVs because the business is suffering, leaving investors to figure out whether the issues at hand will be minor and temporary or debilitating and permanent.
Buying the most statistically undervalued companies can be quite lucrative but can also expose investors to deteriorating businesses—some are clearly cheap for a reason. On the other end of the spectrum, the highest quality businesses tend to be fully priced—some unduly, due to their popularity—so high quality investment opportunities can be scarce. Hence, the quality quandary.
Investors generally fall into two camps. Value investors usually dwell in the bargain basement bin. In the other camp, which comprises most investors, are growth or momentum investors, who tend to gloss over valuation work as they prize business metrics over all else. Our philosophy requires both—a high quality business at an attractive valuation. Simply stated but not easily executed, because it requires additional analysis to determine a company’s lasting competitive advantages and the patience to await a price sufficiently below our FMV estimate to justify a potential outsized rate of return.
Curtailing Losses
Our own philosophy has evolved. In years past, we emphasized the more undervalued opportunities, still preferring good businesses but valuation was a key driver. In emphasizing undervaluation, we held some less predictable businesses. Our migration toward higher quality businesses was motivated by our desire to have fewer clunkers—to lower the number of losers and to shrink the size of the losses.
We aim for more winners than losers. Who wouldn’t? And, to maximize the gains from our winners while minimizing the losses from our losers. But, again, simple to say, harder to achieve.
The better the business, the more predictable are its earnings. The more predictable the earnings, the easier it is to estimate the value with relative confidence. Companies that are less susceptible to competitive threats, with higher returns on capital, and, efficient balance sheets are usually the steady growers. Therefore, these companies are more likely to have consistently rising FMVs. While certain companies trade at low valuation multiples, appearing undervalued, and can provide tremendous upside should the business improve, the risk of erring in our analysis, we believe, is substantially increased when the business has less predictability. That’s the reason we often invest in companies trading at 20% discounts to our FMV appraisals, rather than those trading at perhaps larger discounts, as high quality companies typically don’t detach too far from intrinsic value.
In between unanalyzable companies—the impossible ones to predict—and the highly predictable ones, lie most businesses, a wide swath for whose trajectory is less certain. These companies often have too many moving parts, too many competitors, are too levered—both financially and operationally (from high fixed cost structures)—and therefore are overly vulnerable to sudden changes in the landscape (i.e., new entrants, falling demand, higher interest rates, or regulatory changes). For these reasons we find ourselves mostly passing over opportunities which are potentially high reward but equally, if not more so, high risk.
Even though, in the last few years, the markets have been much less volatile, there are still enough instances where the shares of high quality companies fall to at least a 20% discount, allowing us to build a diversified portfolio. Usually, a 20% discount is as good as it gets for high quality companies. Only at the depths of bear markets, when everything’s on sale, can one normally find superb companies at larger discounts.
Bigger is Better
By no means should this imply that we will not make mistakes. Investing requires assumptions about the future prospects of companies, an activity which is fraught with errors in judgment. Even more reason for trying to stack the odds in our favour. And with large cap companies, the likelihood of their staying power or ongoing success is bolstered by size itself—whether driven by cost advantages, dominant networks (not easily replicable distribution channels or user bases), or key intangible assets (e.g., brands or patents). As important, if we are able to determine we are wrong in our analysis, especially if something has come out of the blue, then we can sell at a moment’s notice and move on to the next opportunity. And the types of companies we are seeking should offer a smoother ride as larger, high quality companies tend to have smaller gyrations.
Blemished or Rotten to the Core?
We have always liked the analogy between shopping for fruit and value investing. It’s our job to determine whether a business has sold off because of a minor blemish, one that could be cut out with a paring knife, or whether it’s rotten to the core. We are looking for opportunities where there was a short-term disappointment, industry concerns, or news flow that sparks uncertainty which unduly depresses a company’s share price. And, we do find ourselves passing over businesses all the time because they might be spoiling—they aren’t undervalued or are overly vulnerable, for example, to competition, cyclicality, government regulation, or a single customer.
If we do buy a position and it turns out that we erred in our analysis, then we must be prepared to alter our opinion and press on. This is the most difficult part of investing. Admitting you’re wrong is never easy—just ask our significant others. Taking a loss, with other people’s money, makes it even harder. But we need to constantly remind ourselves that small losses are preferred to large losses and that we can always find other opportunities where our conviction is higher.
How do Commodity Stocks Fit In?
Periodically we have found ourselves enamoured with Gold or Oil. By definition, in general, these are not industries that have competitive advantages. As they teach us in Econ 101, the companies in commodity industries are price takers, not price makers. We justify our holdings in these areas, though, in a few ways. We only intend to make purchases when our analysis provides 3 compelling evidence of a potential bull market in the underlying commodity. And, we won’t indiscriminately invest in any businesses exposed to commodities. Nickel, copper or zinc are extraordinarily cyclical and extremely difficult commodities to even attempt to predict. Gold and oil, on the other hand, have demand curves with much more stability. As we’ve noted many times before, the demand for oil lessens in a recession but, other than the '08 Great Recession, it does not normally suffer an outright decline. Importantly, within these sectors we also seek out high quality companies (low cost, well financed operators, with high growth prospects in stable jurisdictions), again in an attempt to mitigate downside risk. Furthermore, we find comfort in holding companies backed by hard assets, especially in times of rising inflationary expectations.
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