You know what I would like to read? A biography of the successful life decisions made by biographers using the knowledge acquired while covering the strategies of other successful people. I have this in mind anytime I read an interview with Alice Schroeder in which she discusses how her intense study of Warren Buffett’s tactics and philosophy have made her a better investor.
Specifically, she has mentioned that early in her career, she would often put up a mental block against purchasing companies that are trading at a higher price than existed when she first studied the stock or first purchased shares. It’s a very human form of mental anchoring. Joseph Steinberg, the founder of Leucadia National, has written that it’s difficult for him to buy a $10 hamburger because he remembers being a kid when it cost $0.10.
There are two logical ways to work through this mental block and try and overwhelm that basic gut response:
(1) First, remind yourself that the existence of an objectively good deal is not diminished because an even greater bargain was once available. Getting front-row tickets to see Bruce Springsteen for $80 is a good deal even if someone else comes along and snags up front-row seats for $50 in another city. Someone who bought Colgate-Palmolive stock in 1985 still got 15% annual returns, even though the price had risen over 200% compared to the 1980 investors that got over 17% annual returns. An individual investment may still be the best use of your opportunity cost when adjusted for earnings quality, valuation, and your circle of competence even if the valuation is not as favorable as it once was.
(2) It is useful to remind yourself that a business is not the same company that it was at the previous time you studied it. Stocks like Disney, Starbucks, General Electric, and US Bancorp trade at much, much higher prices than they did during the 2009 lows or even during the regular trading periods of 2011 and 2011. But they’re also better businesses now than they were then. General Electric has substantially overhauled its liquidity. US Bancorp has displayed earnings strength that didn’t seem quite so clear a few years ago. An improving economy has enabled Disney and Starbucks to exercise pricing power over its customers that remained latent during the 2008-2011 period. Even though the company bears the same name, the underlying operations are different. The 2010 version of Disney offered you $2.07 per share in underlying profits; the current version offers you $4.90 per share in underlying profits.
I think there is much to learn from the recent news that Warren Buffett added 24.6 million shares of Wells Fargo (WFC) to the Berkshire Hathaway common stock portfolio during the first quarter of 2016. Berkshire owned 479.9 million shares of Wells Fargo at the end of 2015, 500.0 million shares at the time of the annual shareholder letter, and 504.3 million shares at the time of the first quarterly filing report.
Over the past seven years, Warren Buffett has purchased Wells Fargo in the $10s, the $20s, the $30s, and now the $40s. That is an important point. A lot of people, fortunate enough to buy Wells Fargo at $14 per share, would watch the rapid price appreciation in the coming years and not feel an impulse to buy it at a much higher price. Why pay $48 for something that you previously (or could have) purchased at $14?
The answer is that it’s still the best risk-adjusted opportunity you can find with your money in 2016. Wells Fargo, which has grown profits to $4.12 per share, trades at only 11.6x earnings. The dividend only consumes a third of profits, and profits could hit $6 per share quickly in response to a two percentage point increase in interest rates. If Wells Fargo rises to trade at 14x earnings, consistent with its mid-1990s valuation, the stock could trade at $84 per share in response to a combination of lending growth + higher interest rates + improved valuation metrics in response to the first two elements. That is a cumulative capital appreciation of 75% that could await those shares in the next 3-5 years, plus there is the additional effect of dividends.
I have found that many of the companies I identify as exceptional tend to move from strength to strength. The great challenge for a rational investor is trying to overcome the perfectly natural psychological biases that seem to contain some merit or truthiness to them. If you have a pool of capital that you want to invest, you have to get the question right. For me, the question is: “Which investment opportunity offers the best risk-adjusted future returns in terms of: (1) expected future dividends, (2) expected per share earnings growth and (3) valuation changes adjusted for (4) personal mandates such as adequate diversification?”
If that is the question you are trying to answer with each investment, then the attractiveness of past opportunities won’t act as investment ghosts that prevent you from making the most intelligent decisions in the here and now. If Wells Fargo is your best risk-adjusted idea, pursue it. If Diageo is your best idea, pursue that. But don’t settle for a 12% investment when you also know of a 13% investment that previously offered 15% returns.