Say I offered to sell you a business that generated $1 million in earnings over the past year. How much would you pay for it? Would you pay 10 times earnings ($10 million) or 30 times earnings ($30 million)?
Without knowing anything about the business, you’d be hard-pressed to make an educated offer. Much would depend on how financially sound the business is, what industry they are in, and what their future prospects for growth are. I’m sure you wouldn’t pay a sky-high price for a business that retails printed books or rents movies.
For our example, let’s assume the business is not a “buggy whip” and is financially sound. Two buyers approach the business owner to make an offer: Frugal Frank and Bid’em Up Bob.
Frugal Frank looks at the balance sheet and determines a price based on the book value of the business. He values the current inventory, short-term investments, and real estate at $7 million. He hates to overpay for anything and makes an offer for $10 million, or 10 times earnings. Frugal Frank figures that he really is paying only three times earnings for the operating business (since he is paying dollar for dollar for the assets), which is an attractive price.
If he made a mistake in his valuation of the operating business, he could sell the assets and limit his downside to a loss of only $3 million. At the price he paid, Frugal Frank is not paying much, if anything, for the business’s future growth. He figures that if a few things go right and he can increase the value of the business, he would make a very handsome return on his investment. In other words, he only wants to pay for the “knowns” (current business) and very little or next to nothing for the “unknowns” (future growth).
Bid’em Up Bob takes a different approach when putting together an offer. Unlike Frank, Bob places a high price on future growth. While he would agree with Frank that the assets alone are worth $7 million, he has no trouble valuing the operating business at $23 million, or 23 times earnings.
Bid’em Up Bob leaves himself no room for error. If he made a mistake in the valuation of the business, he could lose $23 million. Even if most, but not all, of his plans for future growth take place, it still may not increase the value of the business enough for him to make a meaningful return on his investment. Bob is paying a rich price for the business based on his confidence regarding future events.
Our Edge: Volatility
Stock investors fall into two groups: those investors who are willing to pay for future growth and those who are not. The two groups are further broken down by how much or how little they are willing to pay for it.
The higher the stock price is relative to earnings, the greater the expectations an investor has for the future. The lower the stock price is relative to earnings, the lower the expectations.
Value investors have nothing against buying companies with great growth prospects; it’s just that we don’t want to pay for it. Trying to anticipate future growth borders on speculation. It is difficult for a business to deliver outstanding results for long periods of time in a world that is extremely competitive.
Stock analysts tend to overshoot and prepare projections that show a rosy future. Investors bid up share prices to unrealistic levels, only to see them come crashing down as soon as the company doesn’t meet an earnings target.
Stock prices rise and fall based on future expectations. According to Robert A. Haugen, there are basically three reasons why stock prices are volatile:
Event-driven volatility: Price movements based on responses to real economic events (e.g., a company loses a major customer).
Error-driven volatility: Price movements based on the over- or underreaction to real economic events. The market overreacts to good news and later corrects when it realizes the news wasn’t all that it was cracked up to be. The overreaction and correction contribute to huge swings in price.
Price-driven volatility: Price movements based on the interactions among traders with each other and price. The price goes up, traders chase the trend, other traders follow, prices continue to rise … until it stops and then heads lower.
The Inevitable Wealth Portfolio focuses in on error-driven volatility, which is where we find our edge. When Wall Street overreacts to a news event or a company’s stumble, investors sell first and ask questions later.
We’re looking to find stocks that Wall Street has overreacted to on the downside and that are tossed into the unloved and unwanted pile. That’s when we love to buy them.
Two stocks we recently sold, Rowan Companies (NYSE:RDC) (sold 02/07/11, +50.3%) and Reliance Steel & Aluminum (NYSE:RS) (sold 02/16/11, +51.3%), are good examples of Wall Street’s overreaction and our approach.
When we added Rowan, it had a P/E of 6.5; Reliance Steel had a P/E of 7.5. The stock market had low expectations for these two financially sound businesses. Rowan produces equipment for the drilling, mining, and timber industries. Reliance Steel operates more than 200 locations throughout the world that process metals and distributes a line of more than 100,000 metal products. These two companies are not in sexy or exciting industries like Apple or Netflix are.
Rowan’s stock price had plunged more than 75% and Reliance Steel’s stock price had fallen more than 50% since their highs in 2008. At the prices we added them to IWP, we were able to get a great business and pay virtually nothing for future expectations.
CHART: Rowan (NYSE:RDC)
Caption: Rowan Co. was unloved and unwanted in 2009
CHART: Reliance (NYSE:RS)
Caption: Investors had low expectations for Reliance Steel at the end of 2008
In the private sector, financially sound businesses rarely sell at attractive prices. But that’s not the case in the stock market. Regardless of a bull, bear, or sideways stock market, the pickings are always good if you know where to look.
Our first priority is not to ever have a permanent loss of capital. The way we achieve that is to buy those companies that we determine to be financially strong and pay as little as possible for future growth. So far, this approach has allowed us to put together a string of winners … 42 in a row, with an average gain of 50.6%.
No guarantees or promises, but as long as we “stick to our knitting” and buy stocks when no one else wants them, we stand a very good chance of continuing our winning ways.
 Haugen, Robert A., The Beast on Wall Street, How Stock Volatility Devours Our Wealth. Upper Saddle River, NJ: Prentice Hall, 1999.