If you follow the Fama-French models or read the work of people like Larry Swedroe who espouse something called “the efficient market hypothesis”, you may think that it is dumb to invest in individual individual stocks because everything is already “priced into the market.”
This kind of logic is wrong, and I will tell you why: the value of any individual stock is always going to be determined by the amount of cash that it generates in the future, discounted back to the present. Of course, there are other factors that feed into this—What does the company’s balance sheet look like? What is the earnings quality/economic moat of the company? What is the probability that you can predict future profits—is this something with stable earnings like General Mills or wildly fluctuating performance like Sirius radio stock?
Since we do not know what the future will bring, we can never definitely determine what something is worth. Instead, here’s what I do: I try to find companies that either have incredibly long records of domination and show no signs of stopping (and then buy them at prices that appear reasonable), or I try to find companies that have incredibly low expectations built into them, so that all it takes is decent growth for the stock to shoot up in price.
Some examples of where I have done that in my own life:
I bought Bank of America at $7-$8 per share, and I still hold that stock to this day. The collective stock market participants did not recognize the fact that the Moynihan management team had cleaned up many of the toxic assets on the bank’s balance sheet, and that is why the bank was trading at a substantial discount to book value at the time I bought it. As the earnings have improved a bit, the stock price has doubled because the bank was left for dead—people were neglecting Bank of America because of the mess that Ken Lewis created with the Countrywide purchasing and general culture of overleveraging, rather than looking to the rise of Tier 1 Capital ratio at the bank. I fully expect a $0.40 annual dividend within the next 36-48 months, and which point I will have a 5% yield on the money I put into play, and I will likely get somewhat regular dividend increases thereafter.
And then there is General Electric, which I bought at $15.05 per share and have been reinvesting the dividends ever since, allowing me to almost double my position in a very short amount of time. When I paid $15 per share, people were thinking about the overleveraged mess than required federal handouts during the financial crisis. Other people were pissed at CEO Immelt for promising no dividend cuts right before…cutting the dividend. I focusing on the fact that the company had decreased its leverage by over 75% and had a work backlog of over $200 worth of goods and services. The earnings have been improving, and the stock price has reflected that.
More recently, there have been two decisions I have made with aims of taking advantage of pricing inefficiencies.
The first was my decision to purchase BP stock in the $39-$42 per share range. The logic there is that the company has over $100 billion in reserves, is an oil powerhouse, and the litigation risks are much more manageable than the headlines imply (see the Exxon-Valdez case for a rough trajectory analogy). It’s finally starting to pick up some capital appreciation now that it is up to $46, but it’s still likely undervalued, and the 5% dividend gives you a nice cash boost that is not fully reflected in the stock price. That’s a straightforward way to build long-term wealth.
And to use a more current example, I have been buying IBM after its recent slate of “earnings misses”. People keep ragging on the company because its total revenue has been treading water and the profits are not increasing as quickly as analysts. What they don’t realize is this—IBM is running one of the most comprehensive stock buyback programs in the country, and the lower prices of the stock allows the company to get more bang for its buck by retiring more shares from the open market—increasing the profits per share that each shareholders is entitled to, and over the long-term, this fact will be reflected in its valuation.
IBM is the only stock I own that is currently worth less than I paid for it, but this is a good thing. The dividends, if reinvested, will entitle me to more profits. The stock buyback program becomes more effective, increasing the profits per share of my ownership units. There’s no difficulty in this decisionmaking process—there’s no pain in losing money on paper, because I’m not selling the stock. You can be a manic lunatic that sells just because the price declines if you so desire, but the fundamental investing precepts advocated by Charlie Munger, Walter Schloss, and Irving Kahn indicate that you should buy more of a stock as its price declines, provided that the price decline does not reflect a commensurate decline in the firm’s earnings power.
A company’s current stock price does not reflect truth. Both Coca-Cola and Microsoft traded at over 50x earnings during the late 1990s. How can you claim that the stock market is rational when large-cap companies only gives you 2% earnings yields plus whatever future growth the firm brings to the table? The answer is: it’s not. Your job is to find a circle of competence where you can figure out conservative estimates of a company’s future growth, and then strike when the price means “some things can go wrong and I’ll still make money.” That way, you are covered if things go bad, and you make really good money if things turn out decent or better-than-expected.
Originally posted 2013-11-12 08:22:43.