Our investment strategy rests on the conviction that the price of a stock will converge to its intrinsic value over the long run. It stands to reason then that the most attractive investment opportunities would be in those situations where there exists the greatest discrepancies between price and value. For reasons discussed in our essay on “Short Selling,” we do not expect bets against overvalued companies to ever make up a large part of our portfolio. However, our portfolio does consist of the stocks which we believe to be the most undervalued in the entire market.
Some assets, like Treasuries and investment-grade bonds, are easy to value because information regarding their cash flows is readily available and highly certain. These assets rarely experience significant mispricings, because traders armed with extremely fast computers constantly scour the market, looking for even pennies that can be made from arbitrage. Stocks, on the other hand, are not so easy to value. The main reason for this is that the value of a stock depends on expectations regarding the future earnings of the underlying business or, in other words, the earnings growth rate of the business. A stock’s price at any given moment is a representation of what the market as a whole believes will be the business’ growth rate in perpetuity.
For example, consider two identical companies. Both have a share price of $100, but company A earns $5 per share, while company B earns $10 per share. Their earnings yields are then 5% and 10%, respectively. With a price of $100 for each of these stocks, the market is saying it believes that company A will have a growth rate 5 percentage points higher than company B in perpetuity (assuming all earnings are paid as dividends). Sometimes, the market will become very pessimistic on a particular company and assign them an absurdly low implied growth rate. In the above example, if you understood the two businesses well and knew that they would have similar growth prospects over the long term, then clearly company B is the better deal.
In theory, the return of any asset should be equal to its yield plus growth. For example, if you expect company B to grow at a rate over the long term of 2%, then you should earn a 12% return. If, after considering the earnings yields and growth prospects of all your alternatives (other companies, bonds, real estate, etc.), you believe that company B will offer the highest total return, then you should buy Company B. There is also an added potential bonus to this strategy. If the market wises up to the discrepancy in total return potential between company A and company B, company B’s stock price should increase and be brought in line with that of company A. This means that all of that excess return you would have had to wait for by holding company B, you instead earn all at once.
Calculating a business’ earnings yield is, for the most part, fairly simple arithmetic. What we spend most of our time on when analyzing a business is a qualitative assessment of its future earnings potential. This is inherently a very imprecise exercise. Fortunately, the market sometimes makes our job much easier when, as mentioned above, it assigns to a business a ridiculous implied growth rate. Though we might not be able to tell the difference between a 2% growth and 3% growth business, a stock’s price sometimes implies continual decline while a level-headed assessment of its prospects clearly indicates the opposite. In such a case, an attractive investment opportunity may very well exist.
While this discussion has been a simplification, it is essentially how we choose our investments. We source our investment ideas in a number of ways. Sometimes we use screeners to find companies with high yields (earnings, free cash flow, dividends), sometimes we look at what other managers have in their portfolios, sometimes a company we owned in the past will become cheap again, and sometimes we might simply stumble across a great opportunity.
I said earlier that our portfolio consists of stocks which we believe to be the most undervalued, but there is a caveat. Our portfolio consists of the stocks which we believe to be the most undervalued among those for which we can form a reasonable picture of future earnings. Our capital is simply too precious to us and our partners to send it out without a clear idea of how it will come back to us. Though we have a few ways of narrowing down, sifting through the 3,500 publicly traded companies in the U.S. is no easy task. Fortunately, it is something that we thoroughly enjoy doing. To us, achieving investment success for ourselves and our partners is as much about the process as the result.