Price matters

In Dec 1999 Microsoft traded at a high of $59.62 but didn’t reach that price again for almost 17 years. Adjusting for dividends, shareholders earned a return of just over 1% per annum for 17 years.

One would think this performance is a reflection of a poor business, NO. While they had some challenges, Microsoft’s revenues still grew by an impressive 9.6% pa (avg).

Investing is not as simple as buying good companies. Buffett has suggested that paying too high a price for a great company has the ability of the undoing the effect of the next decades worth of favourable developments.

A share price reflects the expected future performance of its underlying business. Great returns will only be achieved if the business performs better than expected. This performance might be due to growing faster than expected or might even be that the business declined less than expected.

Point being, the share price does not necessarily follow revenues or earnings, especially over short and medium time frames.

The share price is the often overlooked element which determines if the investment is a bargain or a rip-off. Paying too high a price leaves us no margin of safety. It leaves us exposed to losses in an all too common scenario where the business performs poorly relative to our expectations.

On the contrary, a low share price might afford us a wide margin of safety to protect us when the business performance is poor. If the margin of safety is wide enough, it isn’t uncommon to earn a positive return even when the business performs poorly — so long as its performance is better than the implicit negative expectations.

“This is the cornerstone of our investment philosophy: Never count on making a good sale. Have the purchase price be so attractive that even a mediocre sale gives good results.” Warren Buffett

Some might say they are a long-term investor and observe that the Microsoft share price eventually recovered. Some may be patient enough to hold for 16 years poor returns, most wouldn’t. In 2009 (10 years later) the stock was down 74%!! One would be forgiven for giving up — no doubt many did around this time.

In 1999, Microsoft’s share price implied a multiple of 85x current earnings. A multiple in this region is common these days and to me is an aggressive price for any business. A price in this region assumes almost perfect execution, an impossible benchmark. It is far safer to only pay for what there is today not what we hope for the future. Let the upside be the upside, not the justification for the high price.

What is the stock today most at risk of mimicking Microsoft’s performance in the early 2000’s? Which of our market darlings will perform below expectations? Impossible to say for sure but I’m fairly confident there will be a few run backs.

Our experience tells us that bad businesses can make great investments and vice versa. Price matters to us. It determines value — the most essential ingredient to our decisions.

Variant perception

“Invert, always invert: turn a situation or problem upside down. Look at it backward. What happens if all our plans go wrong? Where don’t we want to go, and how do you get there? Instead of looking for success, make a list of how to fail instead. Tell me where I’m going to die, that is, so I don’t go there” Charlie Munger

You invest with us to receive greater than average returns. Our fees are structured to ensure we are only rewarded when we deliver above returns.

Variant perception is just a fancy investment phrase for thinking differently.

It seems logical that in order to deliver above average returns, we cannot invest like the average investor. My practical experience has supported this notion that in order to achieve a different return — we have to invest differently.

We are attracted to the ideas which are unique. The market will often overshoot at its extremes. It makes sense to us that a popular investment idea is reflected in a higher (more expensive) price. Vice versa for unpopular or contrarian ideas where value is often created by an overreaction to the downside.

In our experience, it very difficult to find value in a stock everyone seems to like.

Variant perception can come in two forms.

1. Out-of-favour (contrarian) investments. Investments where the consensus view is overwhelmingly negative. This is usually reflected in the media and a large share price decline.

2. Out-of-sight investments. Investments which are fairly obviously attractive but are outside of the lens of most other investors. Large investment firms generally focus their search on the top 200–500 companies in any given stock market. This leaves the overwhelming majority of companies available to us to consider without major competition. Private businesses (especially smaller ones) are also a fertile ground for us because we are often bidding without ANY competition. No competition makes for buyer favoured price discovery.

We are looking for value. It makes sense to us that we are more likely to find them in investments which the market has either hated for some time or hasn’t yet found.

Charlie Munger often talks about the importance of inversion. We try to look at mainstream perspectives and take the opposing view to see what is there. A fertile ground for this at the moment is in and around the environmental debate.

Public sentiment and capital flows is heavily against coal and fossil fuels. This is the right call long term but it has created a significant under-investment in coal and oil projects well before what is prudent. You only need to look at the energy crisis in Europe & the UK to see the unintended consequences of sentiment driven investment policy.

The variant perception in the climate debate makes for some interesting investment opportunities today which we are current taking advantage of.

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Acknowledgements: Charlie Munger, Warren Buffett.