When investing, it’s important to get the question you’re trying to answer right. When I discuss investment opportunities that look particularly intriguing, I am not making the statement: “This is the cheapest price the stock will ever see.” I don’t attempt to answer that question because it’s something I never could get right—it involves predicting what *other people* will do at a particular point in time, and at best, it’s something that would never amount to more than speculation.
Instead, I try to answer this question: If I were to purchase the stock today, what would be the amount of profits that the company will be generating 10+ years from now, and then relate that answer to (1) my degree of conviction and (2) the price of the stock today.
Take something like Warren Buffett’s purchase of Wells Fargo throughout the financial crisis. During the absolute low of 2009, the price of the company’s stock hit $7.80 per share. When you hear that Buffett added Wells Fargo to the Berkshire portfolio during this time, you might assume that he was able to buy the stock near these prices—I know that was my initial assumption, but that wasn’t the case. When you look at the quarterly reporting figures for Berkshire Hathaway, there was never a quarter where Buffett averaged purchasing the stock in the single digits.
His cheapest conquest? In the first quarter of 2009, Warren Buffett bought about 12 million shares at an average price of $14.24. In 2007—before the financial crisis hit even started bringing down the prices of banking stocks—Buffett found it wise to pay $35.56, $35.17, and $35.62 for three batches of Wells Fargo stock that added 70 million shares to Berkshire’s rolls.
Here was a situation where you had the most famous investor, who is one of the best stock-pickers in the world, pay 5x the price of what the stock would trade at just two years later. But here’s what happened: by the end of this year, those shares he bought at $35-$36 will pay out $7.03 in total dividends and currently trade at a price of $51.20 per share. He bought on the eve of the second-worst financial crisis in the past century, and yet, he still earned a 65% return in seven years on his money. Those returns will continue to accelerate in the coming years as Wells Fargo gets its dividend in order and the earnings per share growth translates into a higher justifiable value (unleashed by things like rising interest rates, the re-growth of Wachovia, and expanded loan portfolios).
And, of course, once the financial crisis happened—Buffett continued to buy. He bought aggressively in the $20 range in both the final half of 2009 and throughout 2010. This proved quite beneficial—it knocked the average cost basis of Berkshire’s shares down to the $20 range. Berkshire currently owns 483,470,853 Wells Fargo shares that have a cost basis of $11.871 billion. That means Buffett averaged down from his purchases in the $30 range to get his average cost down to $24.55 per share.
If you’re someone who doesn’t anticipate ever having the skill set of predicting short-term price movements, this seems like a highly intelligent way to behave:
One, you identify a company that you plan to own for a very long time. In Buffett’s case, it is out of necessity. It’s hard to move 483 million shares of something without affecting the price. And plus, selling would trigger a tax event—and the permanent deferral of taxes is one of the underrated yet substantial reasons why it makes to approach the altar without a divorce in mind (you get to avoid all the breakup fees).
Two, you identify a price point at which it makes sense to buy. When you look at the company’s future earnings power, and make an estimate of what the fair value will be and the dividends paid out over that time will be, you view the decision to allocate capital as a singular event. Does buying Wells Fargo at $35 per share make sense? Will you be satisfied with the results in 2017, 2027, and so on? In Buffett’s case, the answer was a resounding yes.
Third, and this is where most people deviate from the Buffett approach—you don’t let future price downturns cause you to regret your buy decision. You don’t program yourself to say, “Dang, why’d I buy that stock at $35 when I could get it for $25.” Instead, you say, “I’ve been handed this opportunity to increase my ownership position with an added margin of safety, and I will either purchase more from available cash or reinvest dividends to take advantage of this moment.”
Certainly, there are times when price declines don’t simply mean a stock is getting cheaper—it can mean that the fundamentals are deteriorating as well. But even in these cases, the price often declines at a rate faster than the fundamentals. To use an obvious example, BP’s oil spill obviously lowered the company’s growth prospects compared to an alternative universe in which the company didn’t have to sell $35 billion in assets to meet legal obligations. But the price went from $60 to $27 in 2010. The earnings power may have been affected by 20%, but the actual price decline was somewhere around 50%. As a result, it would have made sense to add BP even though part of its earnings power had been comprised, because the price decline had been more substantial than justified by the damage done.
Incidentally, this is why the bulk of my finance writing focuses on established companies with great historical dividend track records that sell a wide array of profitable products for which the long-term demand is unlikely to diminish. It’s because these are the companies in which you can have high certainty when you choose to average down. Life’s a lot easier when you buy McDonald’s at $90 and know you would buy it at $80. It’s a lot easier when you buy BP at $48 but would be more excited to buy it at $40. It’s a lot easier when you’d buy Coke at $40 but would buy a lot more at $30. As far as self-reflection goes, there’s a lot of wisdom in asking yourself whether you’d buy more of a stock if the price went down. It immediately cuts to the heart of how well you understand a particular business, and how seriously you take the principle of increasing your margin of safety.
Originally posted 2014-10-27 11:20:22.