value investing


If you have been a value investor for some time I am sure you once had to explain value investing to a novice. Among one of the classic first question is the following:

“What happens if the stock never closes its gap to fair valuation and stays cheap forever?”

Chances are you would answer “…sure, the stock can stay cheap for a long time, but eventually it will trade at fair value.”

In this article, I will reflect on the importance of eventually and try to like this to the Buffett quote “I rather buy a great business at a mediocre price than a mediocre business at a great price”.

First, let me define my usage of some termini. A “great business” for me is a business that has the sustainable ability to generate returns on capital that are in excess of its cost of capital. Don’t label a business “great” too easily as some businesses generate great returns for a while but these returns seem to disappear suddenly.

How come? In my experience, a “not-great” business can generate great capital returns when industry capacity is very well utilized or management has been brilliant for a while. This does not mean high returns on capitalcause a business to bet great! A “not-great” business – let’s call it a mediocre business – is able to extract returns on capital that approximate their cost of capital, if we consider the company life-cycle and not a momentary view.
I would go as far as to say: all great businesses generate high returns on capital but not all high return businesses are great.

In the end, the difference between great and mediocre comes down to whether or not a given business possesses competitive advantages. If it does, they can defend their high capital returns for a long time. If it does not, competition will push capital returns down to the cost of capital.

Leaving out “special situations”, you normally confront either one of two situations in value investing:

A mediocre business at a great price

A great business at a mediocre price

Let me present to you a framework how our initial question – “when does the gap between value and price close” – play into each of the two situations:

A mediocre business at a great price

A mediocre business is worth its replacement value. In a clear-cut world, the long-term earnings power of a mediocre business equals replacement value times cost of capital. Obviously, we do not live in a clear-cut world but still, the replacement value * cost of capital = earnings power equation seems to work pretty well.
The calculation of replacement value and cost of capital is not the topic of this article (which does not mean they are not important- quite the contrary!), so let’s assume you have a given replacement value of 100 for a mediocre company. The stock trades at 50 so you have the epic situation of value investing right in front of you: “to buy a dollar for fifty cents”.
They pay out 5 as a dividend and reinvest 5 into the business. In the next period, the replacement value is 105, the earnings power is 10,5 and they would pay out 5,25. This really looks great at first sight, but it is of no incremental value for you as an investor! You should be indifferent to whether you or one of your portfolio companies compounds money at the cost of capital.
What you look out for is excess return, i.e. the stock going from 50 to 100. Also, the chance of the stock going from 50 to 100 is a compensation for bearing the company-specific risk.
Ascribing a utility to the price/value differential for a mediocre business fully depends on the time horizon it takes for the gap to close. As we have seen earlier, letting time pass does not really add value to a mediocre business so there is no structural “drift” that pushes down the price/value gap of a mediocre business.
So would I never touch a mediocre business? In fact I would not as long as I have no catalyst that allows me to realize the price/value differential in a timely manner. What would be such a catalyst? This is stuff for another article but let’s name a few: the company is a likely takeover candidate, it pays a huge dividend, it is aggressively repurchasing stock,… all factors that “free-up” value.
If this sounds too esoteric, read next week’s article on catalysts in which I elaborate a little bit on the topic.

A great company at a mediocre price

Life is quite different when you own a great business. Unlike the mediocre one, this business yields returns on capital in excess of its cost of capital. Waiting therefore increases the intrinsic value of the business faster than your benchmark requires and letting time pass is actually a good thing.

In these cases, you do not really have to worry about when eventually exactly takes place, as any passage of time just increases your upside. Imagine a slingshot in which the sling is pulled further and further. At some point it’ll snap back and you make money. Actually this image is not 100% correct as most great business never trade at super-low prices.
As their value increases on its own, even a very soft tension in the slingshot might be reason enough to jump on the train and ride along with the great business. Almost ironically, a catalyst can be harmful to the investor of a great business. Imagine being bought out of See’s Candy by Buffett in 1972: nice to get a little takeover premium but wouldn’t it have been nicer to reap the 40-year long harvest of a great business?
This allows us to conclude why Buffett once said “I rather buy a great business at a mediocre price than a mediocre business at a great price”. In case of a great business, time is on your side and you do not have to worry much about when the gap between value and price closes. However, do not leave out a mediocre business if a catalyst shortens the time it takes for the price/value gap to close.