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The Science of Hitting
The Science of Hitting
Articles (543) 

Overpaying for Quality

Some thoughts on paying up for great businesses

July 02, 2019

I was recently discussing Wells Fargo (WFC) with a fellow investor (who also owns Wells), and he relayed a conversation with a hedge fund manager. After my friend laid out his thesis, the fund manager responded with a simple question: “What’s the catalyst to move the stock higher?”

That’s a sentiment that seems pervasive in the investment business. While many proclaim to be long-term investors, the reality is they’re chasing stocks that give them reason to believe attractive returns are due in the coming months, not years. In many cases I’d argue that their impatience is justified: They have to answer to clients or investors that will likely pull their money if short-term results are unimpressive. Given the same incentives, you and I would act in a similar manner.

I’m happy to be competing with these individuals. Because of the inherent constraints of what they’re being asked to do, we’re playing a completely different game. These managers are fighting with their peers to see who can get closest to next quarter’s earnings per share estimate or predict a short-term change in sentiment. They don’t really care about the only thing that matters to me as a long-term investor: the value of a business.

Now, the distinction isn’t black or white. The two games are intertwined. The signal from short-term developments (like quarterly earnings) can be a useful data point that influences your estimate of intrinsic value (determining what's a signal and what is noise is part of what makes this game difficult). But at some point there is a distinction. And the path you choose or are pushed down impacts how you think about the world of business and investing.

I wrote an article recently where I discussed that my focus when I start looking at a potential investment is singular: Is this a great business that is highly likely to have significantly higher per share earnings power a decade from now? If the answer to that question isn’t “yes,” I want to move on. I’ve spent enough time falling into the trap of looking at “cheap” stocks where the lower valuation may make up for the quality of the business. As I discussed in that article, I think this is a mistake.

This point was brought home to me when I read a recent article from a successful investor who passed on Berkshire Hathaway (BRK.A)(BRK.B) in the early 1980s (when the Class A shares were trading at less than $100 per share). Here’s what he wrote:

“The role of financial markets is to take money away from mediocre and underperforming companies and put it in stable, growing, high return on capital companies. Money has an almost metaphysical attraction to places where it is put to careful, good use. You can fight that trend, and invest in companies, for instance that are deeply undervalued and mismanaged – and some people are successful investing in the dregs – but very few over the long term. To use a whitewater kayaking analogy, freshwater seeks saltwater, and you can fight that if you want, but paddling upstream eventually is likely to become highly problematic.”

Now, I can hear what you’re thinking: Sure, business quality is obviously important, but doesn’t that only matter in the context of price relative to intrinsic value? Said differently, if you are unable to find great companies trading a discount to intrinsic value, isn't that a moot point?

Here’s where I think the author makes another compelling point (bold added for emphasis):

“The approach that’s worked best in my experience is investing in high return on capital, low debt, growing companies that have the ability to reinvest earnings in the business and generate high returns on those reinvested earnings. The power of compound interest is so profound (mind-boggling really) that over time, returns in investments in those companies are enormous. The trick is finding companies that are compound interest machines. As in the case of Berkshire Hathaway, trying to invest in those companies based on an analysis of value is more likely to result in opportunities missed than it is make money.”

That’s a sacrilegious statement to a value investor like myself. I bet you feel the same way.

But with some experience under my belt, I’ve changed my tune: With a truly long-term perspective (and that part is really important to what I’m about to say), the analysis of value should be a secondary consideration than partnering with high-quality individuals running great businesses.

Over the course of an investment lifetime, the cost to the long-term investor of missing great opportunities will greatly outweigh the benefits of avoiding temporary drawdowns of 20% or 30%.

Like anything, this has its limits. If something is trading at a 100% premium to your estimate of intrinsic value, it’s hard to argue that you should disregard the price you’re being asked to pay. But I think that’s often less common than the flip side of the coin – passing on an opportunity to own a great business with an extraordinary leader when it trades at a relatively small premium to your estimate of its intrinsic value. For what it’s worth, I think Warren Buffett (Trades, Portfolio) agrees. Here’s what he said on the topic at the 1997 Berkshire Hathaway shareholder meeting:

“Generally speaking, I think if you’re sure enough about a business being wonderful, it’s more important to be certain about the business being a wonderful business than it is to be certain that the price is not 10% too high ... That’s a philosophy that I came slowly to. I originally was incredibly price conscious. We used to have prayer meetings before we would raise our bid an eighth. But that was a mistake. And in some cases, a huge mistake. I mean, we’ve missed things because of that.”

Conclusion

As I noted in the introduction, much of this comes down to the game you’re playing. If you’re focused on what the business will produce in the next quarter or the next year, this probably isn't applicable to you. On the other hand, if you’re truly a long-term investor looking to partners with high-quality managers running great businesses for many years, I don’t think you’ll regret paying slightly more than what you think is fair (with the benefit of hindsight). That’s the game I’m trying to play. And based on the track record of some of the long-term investors I admire – people like Warren, Charlie, Tom Russo (Trades, Portfolio) and Chuck Akre (Trades, Portfolio) – it’s clearly a game that can be very lucrative when played well.

I don’t know if I have the intelligence to play like them. But I do think I have the temperament, when combined with the focus on what truly matters, to at least put myself in a position to try.

Disclosure: Long Wells Fargo and Berkshire Hathaway.

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About the author:

The Science of Hitting
I'm a value investor with a long-term focus. My goal is to make a small number of meaningful decisions a year. In the words of Charlie Munger, my preferred approach is "patience followed by pretty aggressive conduct." I run a concentrated portfolio - a handful of equities account for the majority of its value. In the eyes of a businessman, I believe this is sufficient diversification.

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Comments

stephenbaker
Stephenbaker - 2 weeks ago    Report SPAM

Good thoughts. 10-year long bull markets will try the patience of most investment professionals and any value investor. The good news (bad news?) is we are ever-so-closer to a time where more opportunities will be evident. Shooting fish in a barrel is much more profitable than fishing a dry lake.

The Science of Hitting
The Science of Hitting - 2 weeks ago    Report SPAM

Stephenbaker - That's a fair point. It's easier to write that article during a period where Mr. Market seems willing to pay more and more for "quality" with each passing year. Thanks for the comment.

jtdaniel
Jtdaniel premium member - 2 weeks ago

Hi Science, I really enjoyed your piece and the article you referenced. Having watched Visa advance upwards for years while waiting for a “buying opportunity”, I can certainly appreciate the logic in paying up a little for the elite businesses. Ten years into a bull market may be a little too late to decide to start paying up for the stocks everyone already owns or wishes they had bought.

Maybe the catalyst for Wells Fargo is that classic value investors have very few US large caps left to choose from. As a long term holder I believe WFC will eventually benefit from a prolonged cycle of rising mortgage interest rates. Best,dj

The Science of Hitting
The Science of Hitting - 1 week ago    Report SPAM

Jtdaniel - Fair points. As always, none of this is black or white. That's what makes the game fun, right? :) And we'll see on WFC! Thanks for the thoughtful comment.

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