Buy at a Wonderful Price or Buy a Wonderful Company?
Longview is known as a value investing firm. Value investors are, however, generally thought to belong to one of two schools.
Members of the “deep value” school are contrarians. They typically invest at a wonderful price, i.e. at a price far below a normal multiple of the company’s earnings or net asset value, with the expectation that the multiple will revert to a long term average within, say, a couple of years.
In contrast, “high quality” value investors focus less on finding a company that is statistically inexpensive and more on identifying highly profitable companies with a durable competitive advantage – wonderful companies. The goal is to buy these companies at a sensible price and own them for the long run.
In the real world, value investors fall somewhere on a spectrum, with deep value at one end and high quality at the other. So the real question is – where should investors focus their attention?
Deep value investing has been proven to work. Numerous independent studies have shown that if, at the beginning of each year, you buy only the cheapest 10% of available public companies – measured by a low price to earnings (P/E) ratio or a low price to book value (P/B) ratio – and sell them at the end of each year, and repeat the process for 10 years, your return will exceed the stock market average for that period.
There is no equivalent objective proof that buying high quality companies and holding them for the long run results in outperformance. In part, this is because the definition of a high quality company is somewhat subjective. And, even if we could agree on a few measurable quality factors, and wanted to run an objective test to see if these factors resulted in higher returns, how often would we change the portfolio? Every five years? Every ten years? It is difficult to objectively test the efficacy of buy-and-hold investing over the long run.
And yet, we know that Warren Buffett and other investors who focus on owning companies that are consistently profitable, with steady growth in earnings and a reasonably predictable long term future – companies such as Coca Cola, Johnson & Johnson and Nestlé – have, over time, far outperformed the market averages.
Why have these investors succeeded? As is so often the case in investing, it’s all about the hidden benefit of time. Time is the friend of the wonderful business and the enemy of the mediocre business.
Identifying high quality companies, knowing when to buy them, and having the patience to hold them, is not easy, but also not impossible. Some companies operate predictable businesses with a competitive advantage and a long runway. If a business has had consistently high profitability, and has an identifiable competitive advantage, there is a good likelihood that this will continue. This allows the company to reinvest its profits to earn more profits. A history of steadily growing earnings increases the predictability of future growth. These quality factors are not determinative over 12 months, but they make a huge difference over the long run.
For taxable investors, buy-and-hold investing has a crucial additional advantage. No capital gains tax is payable prior to the sale of an investment. Consequently, the compounding of capital takes place on a before-tax basis. Over time this adds greatly to your wealth.
So, at the end of the day, where should investors put the emphasis – deep value or high quality? At Longview, we believe that the key to outstanding investment returns is investing in high quality businesses at sensible prices – and owning them for the long run. As Warren Buffett once said in a letter to his shareholders, “It’s far better to buy a wonderful company at a fair price than a fair company at a wonderful price.”
A version of this edition of The Long View was published in the Globe & Mail on March 4th, 2014.