Buying Undervalued Companies Is Seriously Overrated

Q & ABuying Undervalued Companies Is Seriously Overrated
CHONG KOK CHEN asked 6 years ago

Dear Peter Lim,
I received this email from one investment expert, I think, Nick Kraakman <nick@valuespreadsheet.com>, what’s your view about this?
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Hi KC,
Hope you are doing great! Are you ready for a controversial idea? I know you are.. 🙂
 
Grahamian struggles
Benjamin Graham, the “Father of Value Investing”, used to buy companies when they were significantly undervalued with respect to their actual-, or intrinsic value. The spread between the current stock price and the intrinsic value is what he referred to as his “margin of safety”. This spread essentially told him how much money he could potentially make.
Buying a stock at $10 a share while you believe the intrinsic value is around $13 gives you a 30% Margin of Safety, or, in other words, a potential 30% return on investment. Buying undervalued companies seems like a great idea at first sight, but what if it takes 3 years for the stock price to reflect the intrinsic value of the stock? This would mean your 30% return diminishes to a 9.14% annual compounding rate of return (because $10 * 1.0914^3 = $13).
Decent, but a lot less impressive than 30%..
The problem is that Graham focused purely on value, without paying much attention to how well a business was performing. He simply bought anything that was cheap. Graham needed a larger Margin of Safety if he expected it would take longer for price to reflect the intrinsic value. This created a realization of value problem, since the stock price of some crappy companies never reached the value Graham calculated. In fact, some even saw their value decline over time!
 
Buffettology
Buffett started out with this exact same strategy of buying undervalued companies, but soon his business partner Charlie Munger convinced him to pay more attention to business fundamentals. Finding “excellent businesses” with a “consumer monopoly” became his primary focus. Valuation came later.
Buffett believes that these excellent businesses, which consistently earn high returns on equity (ROE), are often bargains even at high valuations since they have an expanding value, fueled by the awesome power of compounding. In other words, these cash flow generating businesses become worth more over time. Their intrinsic value constantly increases.
Remember Buffett’s words: “It is far better to buy a wonderful company at a fair price, than a fair company at a wonderful price.” Let’s find out why..
So what is the strategy Buffett applies exactly? In the bestselling book Buffettology, which I HIGHLY recommend, the authors explain that Buffett does not calculate the intrinsic value and then buys at half the price like Graham did. Instead, he 1) looks for excellent businesses with an expanding value, 2) determines the expected annual compounding rate of return*, 3) compares this to other available investments, and 4) buys the one which offers him the highest expected return.
Let’s take two hypothetical companies:
Company A
Price: $100
Value: $120
Margin of Safety: 20%
Growth: 5%
Company B
Price: $100
Value: $95
Margin of Safety: -5%
Growth: 15%
Which company would you rather buy? Graham would have bought Company A, since it is significantly undervalued. Buffett, on the other hand, would prefer Company B, because it offers him an expected annual compounding rate of return of 14.4% for each of the coming 10 years, versus a mere 6.9% for Company A. The reason for this massive difference is that the value of Company A would have grown to $195.47 in ten years time ($120 x 1.05^10), while the value of Company B would have grown to an impressive $384.32 ($95 x 1.15^10).
So even though Company B is currently overvalued, it still offers a far superior investment opportunity for the long-term investor thanks to the presence of a rapidly expanding value.
When I first found out about this it was a revelation, and I hope it offers you some fresh perspectives as well. So look for excellent businesses with an expanding value and then buy the one which offers you the highest expected annual compounding rate of return. Apply this strategy consistently and you will do very, very well for yourself!
Good luck!
Nick
P.S. You can use the valuation models from the How to Value Stocks eBook I sent you two weeks ago to determine the future value, from which you can then calculate the expected rate of return