Many stocks currently trade at low prices despite the market's 50% gain in under six months. However, it can be difficult to determine which stocks to buy when seeking to efficiently apportion your capital.
Berkshire Hathaway BRK.A BRK.B chairman Warren Buffett (Trades, Portfolio) has a successful track record of allocating capital. His focus on buying stocks with economic moats and a willingness to pay premium prices for quality businesses may be reasons for Berkshire's long-term outperformance of the S&P 500.
Buying quality stocks at fair prices
It may be tempting for value investors to buy the cheapest stocks they can find at the moment. They may be aiming to maximize their long-term returns through buying those stocks that have the greatest scope for recovery.
However, in my opinion, the quality of a company is just as important as its price. For instance, the uncertain economic outlook means that businesses with solid fundamentals may be worthy of higher valuations than their weaker peers. Likewise, companies with wide economic moats may be better able to adjust their operations to suit changing consumer tastes.
Paying a premium price for a quality business can be justified if it offers a more attractive risk/reward ratio than cheaper peers. As Buffett once said, "It's far better to buy a wonderful company at a fair price than a fair company at a wonderful price."
Assessing industry growth prospects
It is impossible to predict how the Covid-19 pandemic will affect many industries and the wider economy. There are too many known unknowns that could affect consumer trends and tastes in the long run. Therefore, trying to predict which sectors can adapt to an unknown future may not allow you to allocate capital efficiently.
Instead, determining the competitive advantage of a specific business over its sector rivals may be a more productive use of your time. A dominant company in an industry with a long track record of above-average growth may enjoy impressive financial returns as the economy's performance improves. This may ultimately convert into higher profitability and a rising stock price.
Buffett has always sought to purchase businesses with a durable competitive advantage. As he once said, "The key to investing is not assessing how much an industry is going to affect society, or how much it will grow, but rather determining the competitive advantage of any given company and, above all, the durability of that advantage."
Focusing on long-term performance
The economy's weak performance in 2020 means that many firms are likely to report disappointing results in the current year. As a result, some investors may avoid them due to high valuations that are based on their recent financial performance.
However, trading conditions for a large number of companies are likely to improve over the long run. Therefore, basing your investment decisions on the recent financial performance of a business may mean you miss out on companies that have long-term revenue and profit growth potential.
In my view, assessing the long-term track record of a business is a more effective means of gauging its investment appeal than judging its recent performance. It may provide a more accurate guide as to how it is likely to perform in future after what has been a rare set of circumstances in 2020.
As Buffett once said, "Do not take yearly results too seriously. Instead, focus on four or five-year averages."
Disclosure: The author has no position in any stocks mentioned.
Read more here:
- Peter Lynch: Popular Stocks Don't Necessarily Make Great Investments
- Seth Klarman on Value Investing in a Bull Market
- Howard Marks: Approach Bull Markets With Caution
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