Tuesday, 3 April 2018
How Warren determines the right time to buy a fantastic business
HOW WARREN DETERMINES THE RIGHT TIME TO BUY A FANTASTIC BUSINESS
In Warren's world the price you pay directly affects the return on your investment. Since he is looking at a company with a durable competitive advantage as being a kind of equity bond, the higher the price he pays, the lower his initial rate of return and the lower the rate of return on the company's earnings in ten years. Let's look at an example: In the late 1980s, Warren started buying Coca-Cola for an average price of $6.50 a share against earnings of a $.46 a share, which in Warren's world equates to an initial rate of return of 7% [$.46 / $6.5 = 7%]. By 2007 Coca-Cola was earning $2.57 a share. This means that Warren can argue that his Coca-Cola equity bond was now paying him $2.57 a share on his original investment of $6.50, which equates to a return of 39.9% [$2.57 / $6.50 = 39.53%]. But if he had paid $21 a share for his Coca-Cola stock back in the late 1980s, his initial rate of return would have been 2.2%[$.46/ $21= 2.2%]. By 2007 this would have grown only to 12% ($2.57 / $21 = 12%), which is definitely not as attractive a number as 39.9%.
Thus the lower the price you pay for a company with a durable competitive advantage, the better you are going to do over the long-term, and Warren is all about the long-term. However, these companies seldom, if ever, sell at a bargain price from an old-school Grahamian perspective. This is why investment managers who follow the value doctrine that Graham preached never own super businesses, because to them these businesses are too expensive.
So when do you buy in to them? In bear markets for starters. Though they might still seem high priced compared with other "bear market bargains," in the long run they are actually the better deal. And occasionally even a company with a durable competitive advantage can screw up and do something stupid, which will send its stock price downward over the short-term. Think New Coke. Warren has said that a wonderful buying opportunity can present itself when a great business confronts a one-time solvable problem. The key here is that the problem is solvable.
When do you want to stay away from these super businesses? At the height of bull markets, when these super businesses trade at historically high price-to-earnings ratios. Even a company that benefits from having a durable competitive advantage can't unmoor itself from producing mediocre results for investors if they pay too steep a price for admission.