In addition to our individual stock research, feature articles, special reports and model portfolios, Intelligent Investor Share Adviser analysts also operate a question and answer forum. It’s free to browse for non-members, although you’ll need to sign up for a 15-day free membership (or become a full member) if you want to ask a question. So long as the question is investment-related, we’ll do our best to provide an answer – although bear in mind that we’re only able to provide general advice.
Reproduced below is a question and answer we received recently from a member, which we thought worth reproducing, as it goes to the heart of investing.
Question: Hi Team, I noticed that you guys have been getting hammered on some of your recommendations where your main thesis was that although mediocre (or worse) the business was cheap – ie the cigar butt mentality. Examples include The Reject Shop, Fleetwood Corp, Mining services businesses.
You also have a habit of avoiding or selling businesses that are viewed as great by the market, and so rarely even get to fair value as opposed to cheap. Some examples include Amcor, Ramsay Healthcare, Invocare, Seek, REA Group and CSL.
I want to quote Buffett on this issue (and pan Benjamin Graham):
“A horse that can count to ten is a remarkable horse – not a remarkable mathematician. Likewise, a textile company that allocates capital brilliantly within its industry is a remarkable textile company – but not a remarkable business".
And more to the point: "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 realise 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 per cent on cost. Time is the friend of the wonderful business, the enemy of the mediocre".
My questions are:
1) Why would you put a sell (or avoid) on a business just because it’s expensive? Why not buy/hold and buy more if drops back to average down?
2) Why are you averse to paying up for quality?
3) Why do you look for cigar butts in competitive and uneconomic industries or assume that there is only one cockroach in the kitchen?
Answer: Hi, Excellent questions, which really get to the root of investing. It all comes down to price and value – the former of course being what you pay and the latter being what you get. The idea is to get something immensely valuable – a high-quality business – at a cheap price, but the market being what it is, that’s not always (or even often) possible.
I don’t think we have a tendency overall to favour cheapness over quality – although it may seem a little like that at the moment, because the market has bid up the quality end of the market to such extremes. This probably does have us hunting around the bargain basement a bit – which as you note can be a dangerous place to be. It can also be the source of some genuine bargains if you tread carefully. They might not quite be cigar butts, but Echo Entertainment and Caltex weren’t viewed by the market as high quality when we bought them towards the end of 2013, but they delivered returns of 50% and 95% before we sold them recently.
As a rule, though, we’d be much happier sticking to wonderful businesses at fair prices rather than fair businesses at wonderful prices, as Charlie Munger put it (as repeated frequently by Warren Buffett). There are a few high-quality businesses on our buy list at the moment, and over the past few years we’ve had buy recommendations on quality businesses such as ASX, Carsales, Cochlear, Computershare, CSL, IOOF, Perpetual, Platinum Asset Management, ResMed, Sirtex Medical, Sydney Airport and Trade Me. On most of these (including CSL) we still haven’t recommended selling. We also typically place much higher recommended maximum portfolio weightings on these kinds of stock, compared to the few per cent we might recommend in cheaper, lower quality business.
A look at our portfolios also shows how we try to hang onto these businesses over the long term, even if they do reach sometimes fairly extreme prices. We recently sold the last of our Growth Portfolio’s holding in Cochlear, for example, after hanging on for more than a decade and getting a fivefold return.
You do have to draw the line somewhere. Buffett and Graham are the first to stress that the future returns you make from a stock will be dictated by the price you pay. If you overpay, your potential returns will undoubtedly suffer and may even end up being negative. The problem comes, of course, with a stock like REA Group that’s growing more quickly than your opportunity cost (that is, the returns available elsewhere). If it could keep doing this then it would by infinitely valuable and never worth selling at any price – but that only tells you two things: (a) that at some point its growth must slow or it will end up owning the entire world; and/or (b) that if there are opportunities like this around, then the opportunity cost you’re using in your calculation of value is too low.
Margin of safety
To deal with this kind of thing, Buffett and Graham themselves have always emphasised the importance of a margin of safety. If you don’t extrapolate a company like REA’s growth too far into the future, and if you use a high opportunity cost to discount its future earnings, then you’ll allow yourself a margin of safety and potentially save yourself a lot of trouble.
Of course beauty is also in the eye of the beholder, and a margin of safety provides some protection if you're wrong about a company's quality credentials. (I wouldn't rate Amcor as a quality business, for example, due to the large incremental capital investments needed, the lack of product differentiation, the competitive nature of the industry and the powerful customers.)
Right now, allowing a big margin of safety means a lot of quality companies we’d love to own are out of our price range, but history shows that opportunities will appear if we’re patient.
Hopefully all that answers your first two questions. The third begs the question of what is a 'competitive and uneconomic industry'. The only industry I’d personally regard as irredeemable and therefore not worth buying at almost any price is the airline industry, as partly explained in an article I wrote recently: Qantas turnaround spells trouble for aeroholics.
As to the cockroaches, well you have to balance them against the price you pay – with cheap stocks we’re normally expecting to see a few, but naturally when things turn out badly it’s because we’ve got more than we’ve bargained for.
In short, we’d agree that backing quality is a great way to go – but you do also need to keep any eye on the price you pay and your margin of safety, and I’d suggest that’s probably especially true right now.
Our thoughts on price, value and all the rest of it are further explained in our book, Value, which Intelligent Investor members can get for free as a pdf download. Warren Buffett also expanded on these topics in the 'Berkshire – Past, Present and Future' section of his latest annual letter (marking the 50th anniversary of his taking charge of Berkshire Hathaway), starting on page 24.