The full quote by investment guru Warren Buffett is actually: ” I would rather buy good companies at fair prices than buy fair companies at good prices.”. Why does Warren Buffett say this? He is probably the most famous investment guru who practises value investing; isn’t value investing buying an asset worth $1 for $0.50? I will explain what he means here in this article.
First, we need to define what constitutes a good company. A good company by Warren Buffett’s definition has 3 attributes:
- It has a broad and durable competitive advantage, or economic moat
- It has low capex requirement and high returns on invested capital
- It has profitable growth
I won’t repeat here on the importance of a good company having a competitive advantage, you can read about various types of economic moats a company can possess. Having a competitive advantage be it cost advantage, switching cost etc allows a company to defend its revenue and earnings growth and ward off competition from taking away its market share. This also allows the company to have immense pricing power, thus maintaining or even growing its profit margins.
The second point relates to how much capital expenses (capex) are required to be put back into the business so that the company can continue to operate or innovate through say R&D, buying additional equipment etc, thus launching new products or improving on existing products. A classic example given of a low capex requirement company is a stock owned by Warren Buffett and that’s Moody’s Corporation which is a rating agency. The only capex they need is probably just some additional new computers and furniture every year. Moody’s is therefore definitely a better company compared to say a pharmaceutical company which has to constantly plow huge amounts of money into R&D to discover new drugs.
Profitable growth is essential for the share price of a company to appreciate over time, especially in the long run. When a company grows its revenue profitably year after year, it will also grow its earnings (or earnings per share) year on year. While Mr Market may misprice the value of a stock at a particular point in time, the market usually recognizes the true value of a company in the long term.
This brings me to explaining why Warren Buffett said what he said through the following diagram. You see, the value of a good (I call it wonderful) company grows over time. Of course, it is better to buy a wonderful company at a good discount, or margin of safety as we call it. However, even if you buy it at a fair price (or even buying it slightly overvalued like the point circled red), the price eventually catches up with the growing value of the company and you should be okay. The key is to buy only good companies and holding it long term. Conversely, if you buy a fair company or bad company, the value is eroded over time and you can expect share prices to drop and huge losses may be inevitable.
There are a number of benefits if you invest through this simple approach:
- You have no worries about timing
- It is more forgiving in terms of your actual purchase price
- There is much less risk of permanent loss of capital
- You sleep better
For further reading, the book below by the founder of Gurufocus.com Charlie Tian devotes 4 chapters out of 10 just talking about the above concept, it is definitely a good read which will make you a better investor.
Of course, you will still need some financial analysis to reaffirm that a company is indeed a wonderful company and you need to learn how to determine the intrinsic value of a company through various valuation methodologies. Journeywithmoney is holding a Stock Investment Workshop (sign up through this link) on 17 October and we invite you to understand the Stock Investment framework we use to analyze individual stocks.
This is the final Stock Investment Educational MasterClass for the year 2019, so please don’t miss it.
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At Journey With Money, we are practitioners of Value Investing for Singapore and US stocks. We are passionate about sharing our Stock Investment knowledge and experience but the materials we present do not constitute stock recommendations and readers are urged to do their own due diligence for any investment decisions.
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