At first glance, value investing looks like an easy strategy to replicate. All you need to do is buy stocks trading at a discount to book value. It is as easy as that. Or is it?
Buying cheap is not easy
Buying stocks that are cheap is not as easy as it may appear. There are hundreds of different websites out there today that detail those stocks that are cheap and those that are expensive using many different metrics to arrive at one easy to understand result.
Ninety-nine percent of the time these results are entirely useless. Warren Buffett (Trades, Portfolio), Seth Klarman (Trades, Portfolio), Ray Dalio (Trades, Portfolio) and Charlie Munger (Trades, Portfolio) did not become the world’s most successful investors by just screening the market using simple formulas to uncover stocks trading at cheap valuations. All four of these investors have approached investing as more of an art than a science, learning the ins and outs of the market, what creates a good business and what speed bumps may derail a business’ success.
Chief among these factors is the business moat or competitive advantage. Competitive advantage is as important in value investing as the margin of safety. If a stock is cheap, it is cheap for a reason. If this reason is because of market fundamentals, i.e. falling commodity prices, the stock is likely to get cheaper and management has almost no control over the business and its prospects. On the other hand, if a company's shares have become cheap due to temporary nonstructural factors or market gyrations, then a sound management team will be able to rekindle the company's business prospects.
The business moat
Warren Buffett (Trades, Portfolio) often talks about a company’s economic moat. What he means here is an economic advantage. Economic advantages can take many different forms. From a lower-than-average unit production cost to a large unrivaled network of infrastructure assets that would be almost impossible to replicate, brand popularity or technological advantage, economic moats can take many forms. However, their benefits to a business are always similar. Economic moats give companies the ability to maintain pricing power, set prices, keep margins steady when input costs rise and invest in future growth with a degree of certainty about how the investment will work out.
Some examples
Here are two very basic examples to illustrate the point.
Right now, even after OPEC’s decision to cut oil output last week, oil prices remain around 50% below the pre-crash peak. Low oil prices have decimated oil company profits, led to the bankruptcy of numerous oil service companies and sent shockwaves through the offshore drilling sector. These companies have suffered because none of them had pricing power. As oil prices fell, price deflation hit the oil service sector and service companies became price takers. Individual managements could no longer set prices at levels to suit their own businesses, and thus, those companies that could not adjust to the environment fast enough have collapsed into bankruptcy. One could also argue that banks around the world are facing a similar situation. Increasing regulation, competition and record-low interest rates have prevented banks from generating excessive levels of profitability, denting their attractiveness as value investments.
On the other hand, you have a business such as IBM (IBM, Financial). IBM has suffered over the past 10 years from the trend away from hardware and increasing competition in the information technology sector -- the company’s delayed entry into the cloud market has not helped either. However, one thing the business has could maintain is its ability to set prices. Customers still value the IBM brand and associate IBM with quality and durability, which is why over the past 10 years as IBM’s revenue has come under pressure, the company has been able to maintain operating and net income margins between 10% and 20% (varying quarter to quarter). This is a simple example, but it outlines why Warren Buffett (Trades, Portfolio) would choose a business like IBM over other companies that lack the ability to set their own prices.
Finding good businesses is not that difficult, you just need to know what you are looking for.
Disclosure: The author owns shares in IBM but in no other company mentioned.
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