Bill Nygren wrote in his quarterly commentary about his fund: Are you a patient investor? Try this quick test: 1. A bat and a ball cost $1.10 in total. The bat costs a dollar more than the ball. How much does the ball cost? 2. If it takes 5 machines 5 minutes to make 5 widgets, how long would it take 100 machines to make 100 widgets? ... I think there are important similarities between this quiz and being a value investor. To succeed on the quiz, subjects need to ignore the obvious intuitive answers that end up being wrong. Similarly, successful value investors need to ignore obvious negative news that has been more than fully reflected in a stock's price.
Recently, I received an e-mail from a shareholder who was concerned about our Fund, saying he questioned every single stock we owned because anyone watching the news was aware that these companies all had problems. He’s right. The reality is that value investors are always invested in companies that have problems – that’s why stocks become undervalued. Where we differ from consensus is in our assessment of the magnitude and duration of these problems.
As consumers, we are all used to the trade-off between price and quality. Not everyone drives a Ferrari, shops at Tiffany’s, and wears Armani suits. If not for price, they probably would. Consumers who choose other products aren’t making negative statements about these prestigious brands, but rather are simply saying that their price premiums are too high. In consumer purchases, price prevents the best products from achieving 100% market share. But for some reason, when consumers invest their money, they seem to forget the importance of price. When we bought Pulte Homes, shareholders asked, “Haven’t you read about the housing bubble?” We have. If all stocks were priced the same, then an investor’s job would simply be to identify the companies with the highest combination of growth and dividends. In that world, believing that new home construction would decline would be sufficient reason to avoid owning a homebuilder like Pulte. But in reality, stocks aren’t all priced the same. Pulte is one of the very few stocks now selling at less than half the S&P 500 P/E multiple. At that valuation, a significant housing decline appears to be discounted in the stock price. Just like in the test, the intuitive answer – that housing stocks are bad – may not be the right answer.
Our portfolios are full of similar stocks: media companies that are losing advertising dollars to Google; H&R Block, which is losing market share to other tax preparers; financial stocks that earn less when short-term interest rates rise; and retailers that missed last season’s styles. By simply reading the newspaper, an investor could avoid investing in companies that are experiencing such problems. But, by the time these problems are common knowledge, it is nearly certain that other investors have already reacted, forcing stock prices lower. And at that point, even mildly negative news can be viewed by the market as positive. Although it is natural to want to avoid investing in companies that have had disappointments, this may be the same response that produced the wrong answers on the test. It is important to remember that a great business can reach a high enough price that it becomes a bad investment, and an average business can reach a low enough price that it becomes a great investment. Value investors normally own the latter: stocks priced so low that even mediocre-at-best businesses can become good investments. Most times, we believe superior businesses are priced too highly to merit consideration for our portfolios. However, today, many of what we consider to be the best businesses have lost their premium price due to uncertainty about the sustainability of their growth rates. So our portfolios now have an uncharacteristically high percentage of assets in such names. When Ferraris get priced like Fords, we’ll gladly purchase them!