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Don't Be Afraid to Pay a Little Bit More

May 18, 2014 | About:
Grahamites

Grahamites

156 followers

“Whether appropriate or not, the term ‘value investing’ is widely used. Typically, it connotes the purchase of stocks having attributes such as a low ratio of price to book value, a low price-earnings ratio, or a high dividend yield. Unfortunately, such characteristics, even if they appear in combination, are far from determinative as to whether an investor is indeed buying something for what it is worth and is therefore truly operating on the principle of obtaining value in his investments. Correspondingly, opposite characteristics – a high ratio of price to book value, a high price-earnings ratio, a low dividend yield – are in no way inconsistent with a ‘value’ purchase.”

- Warren Buffett (Trades, Portfolio)’s 1992 Letter to Shareholders

While reviewing my investment journal a few days ago, I noticed something interesting: MasterCard showed up in my journal multiple times since 2011 and each time my note was something like “it’s not cheap enough, pass.” I wrote almost the same note about Priceline for the past several years. Until recently I had been foolishly proud about my self-perceived discipline - they have never gotten cheap enough for me to buy it.

This all changed in my Omaha trip this year. Through my conversation with a few renowned value investors such as Chuck Akre (Trades, Portfolio) and Gaynor, I learned something enormously important yet often lost in plain sight: the fear of paying a high multiple for compounding machines often leads regrettable mistakes of omission.

If we think about it, this is such a profound statement. I’ve only been a value investor since 2011 but all these years, I’ve suffered from the fear of paying a high multiple for extraordinary businesses.Looking back, MasterCard and Priceline rarely looked cheap from a multiple valuation perspective.

When I first looked at MasterCard back in 2011, it was almost 50% cheaper than it is today and the P/E ratio was about 25. How could I blame myself for not investing in a stock that had a P/E of 25? Such is the power of ignorance combined with sloth.

Chuck Akre (Trades, Portfolio) talked about MasterCard’s superior business model in his presentation at the Value Investor Conference. During his presentation he gave the following example: Say a company’s stock is selling at $10 per share, book value is $5 per share, ROE is 20%, which means earnings will be a dollar and P/E is 10 and P/B of 2. If we add the $1 earning to book value, the new book value per share is $6, keeping the valuation constant and assuming no distributions, with 20% ROE, new earnings are $1.2 per share, stock at $12, up 20% from $10, which is consistent with the 20% ROE. This calculation is simple and not perfect, but it has been helpful in terms of thinking about returns on investment. So we spend our time trying to identify businesses which have above average returns on owner’s capital.

We can apply similar framework for MasterCard. In 2011, MasterCard had a trailing EPS of roughly $1.4 per share, split adjusted. It had a net profit margin of about 30% and a ROE above 30%. Since it became a public company, revenue had been growing at more than 15% a year and EPS had been growing at more than 20% a year.

When I wrote my note in 2011, MasterCard was trading at about $35 a share, split adjusted, or 25 times trailing 12 month EPS.

If the growth rate of 20% continues for another 5 years, MasterCard’s EPS will be approximately $3.5 a share 5 years from 2011.

Here is when things become really interesting. The price of a stock is driven by both fundamentals and market expectation, which is reflected in the multiple assigned by the market. A P/E of 25 is very reasonable for a business that growth earnings at 20% per year, has a net margin of 30% and ROE of above 30%. For the sake of simplicity, let’s discard other possibilities and say 5 years from 2011, MasterCard still trade at 25 times P/E. With earnings of $3.5 per share, MasterCard’s implied price will be $87.5 per share. Now the question is, had you bought MasterCard at $35 in 2011, what would your compounded annual rate of return look like in 5 years if MasterCard trades at $87.5 a share? It’s exactly 20%. You’ve more than doubled your money.

Obviously it is not as simple as that. What if the multiple contracted to 20? What if earnings only grew 15% a year? These scenarios are out of the scope of this article but I encourage the readers to take the time and do the math. The results will make you think.

What if we change the time horizon to 50 years, or even 100 years? Think about the money you could have made if you invested in Coca, Cola in 1919, or American Express in 1963, or Berkshire Hathaway in 1974. You can sit on your ass and let those compounding machines do the job. In the end, you will make a lot of money. This is the beauty of investing in compounding machines. But if you hold back because you think Coca is expensive at 18 times earnings, or American Express at 20 times earnings, you will incur enormous opportunity cost.

I hope the lesson is clear now: truly extraordinary businesses are rare and they rarely look cheap. When you identify one, don’t be afraid to pay a little bit more than whatever your fair value is.


Rating: 4.8/5 (16 votes)

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Comments

Grahamites
Grahamites premium member - 7 months ago

Cesc: First off, thanks for the nice words.

I absolutely agree with your great point. For companies such as IBM/MSFT/PM/JNJ, the multiple absolutely contract once they enter the mature stage. I will be afraid to pay a little bit more for them if the growth rate slows down substantially.

I probably should've added some clarification in my article. Like you said, outstanding businesses have high margins and high ROE. But as I pointed out in another article, the business needs to have average or better than average growth for them to be a great compounder. This lack of growth contributes to IBM's stagnant stock price in my opinion. Same as MSFT and JNJ. As such, they are not the kind of business I feel comfortable paying a little bit more.

But if you look at MasterCard, Visa and Brown Forman, you see a different story. These are high margin and high ROE businesses that can grow at a good rate for a long time. Therefore, these are potentially better investments than MSFT and JNJ in my opinion. You can pay a little bit more for them.

Thanks again for bring up a great point.

jtdaniel
Jtdaniel premium member - 6 months ago

Hi Grahamites,

I think your article has great value to investors who have given thought to taking profits, now that we are five years into a strong bull market. If there is a common trait (other than frugality) that I have observed among value investors through the years, it is that we tend to make to make better decisions when buying than selling. I have no excuse, as I have seen first-hand what has happened to Exxon shares that were purchased in the 1920s - 1950s and never sold. Nevertheless, the fear of giving up paper gains in shares of an over-priced stock has more than once led me to unwise sales (ADP comes painfully to mind)

An inference I gleaned from your article led me to take a hard look at my portfolio to identify any true compounders. These should not be sold, except possibly in the case of extreme overvaluation, for as long as the compounding factors remain in place. I learned that if I was just determined to sell something, I would be willing to part with Heineken, but not Diageo; PetSmart, but not Walgreen. This is a useful exercise even for those who are never inclinded to sell, as it helps to clarify which businesses in the portfolio are worthy of new investment dollars.

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