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Priced for perfection

By: Devan Robinson

"In the short-term, the market is a popularity contest.  In the long-term, the market is a weighing machine." -Warren Buffett


Disclaimer:  This post is for educational purposes only.  This article is not investment advice.  Devan Robinson and clients of Fairlead Financial Group may own positions in the securities mentioned.

A quick side-note: if you are a client of Fairlead Financial Group you are a value investor even if you don't own individual stocks.  I apply value principles systematically at the portfolio level.  I prefer this for most clients because hunting value across an entire index allows us to reduce volatility and risk in the portfolio.  Individual stock investing comes with its own added level of risk.

My guy Warren.

Value Investing

There are many styles of investing: growth, value, momentum, technical, and so forth.

My style?  I'm a value investor through-and-through.  I always have been and probably always will be.  I think it comes from my Dad; he was a value-guy in his absolute core.  The most famous value investor you may have heard of is Warren Buffett.  My Dad was a massive Buffett fan and so am I (obviously)

I know you're probably sick of Warren Buffet quotes but here's how he characterizes value investing:

"It's far better to buy a wonderful company at a fair price, than a fair company at a wonderful price."

It sounds simple but like much of investing it's harder to achieve in reality.

What does value investing mean in practice?  

It means I don't chase high-flying stocks (and that isn't always a popular opinion).  I prefer a wonderful company that's out of favor.  Value investing sounds intuitive but is stressful and difficult in practice.  There's career risk to being a value investor.  It's hard to resist piling into popular areas of the market especially when clients want you to.  You have to be able to stand on your principles and say no.

Value investors are often contrarian and being contrarian is unnatural.  Humans aren't wired for contrarianism.  We are social, pack animals and there is comfort and safety in the herd.  Value investors must often go it alone and zig when the crowd zags.

Priced for perfection

Many of you have heard me say stock ABC is priced for perfection.  Clients know I am rarely a fan of the hot stocks of the day and I don't chase them.  Occasionally a hot stock can also be a value (Apple was a great example) but often they can be traps.

Value investors worship price; price is the core of everything.  Price is my due-diligence as Buffett once said.  Priced for perfection is another way of saying you might be paying too much.

How do I know if I'm paying too much?  First you have to determine a company's intrinsic value.

Intrinsic value

Every company has an intrinsic value.  Intrinsic value is what we estimate the true value of a company to be. 

Let's use McDonald's (MCD) as an example:

Past performance may not be indicative of future results. Indexes are not available for direct investment.

Before COVID-19, MCD was trading around $200/share.  Sixteen trading-days later MCD traded at $140/share.  That was the depths of the COVID bear market.  In those sixteen trading days MCD went from being a company worth $148 billion to $104 billion.  Did MCD fundamentally lose a third of its value in March or was the market being emotional?

What is the intrinsic value of MCD? No one knows for certain (that's what makes it a market).  What I do know is that my son Maxwell did not stop asking for Happy Meals during that $44 billion drop.  Markets are efficient but can get emotional at times.  Those emotional moments?  Value investors love them because they provide opportunity to buy below intrinsic value.  

How do you determine intrinsic value for a company?  You study the heck out of it.  You pour through 10-K's, listen to earnings calls, talk to the company, study their competitors, and so forth.

Once you have a sense of a company's intrinsic value you can get to work.  You can now chase a margin of safety.

I believe margin of safety is the most important tool in the value investor's toolbox.  If an investor is patient, has done their homework, and is willing to go against the herd they get to capitalize on a margin of safety.

Margin of Safety

Margin of safety was a concept popularized by the most famous investor you haven't heard of: Ben Graham.  Ben Graham was Warren Buffett's college professor and mentor.  Graham is the intellectual godfather of value investing and margin of safety was his magnum opus.

What's margin of safety?  It's simply buying companies when they are trading below their intrinsic value.  It's buying $1 for $0.50.  It looks like this:

The black line is a company's intrinsic value; what we believe a company is actually worth.  The blue line is the market price.  If you can buy a company when it is trading below what it is truly worth you have a margin of safety.  Employing a margin of safety gives you breathing room and lets you sleep well at night.  The further market price falls below intrinsic value the greater the margin of safety.

As I mentioned above price is everything to a value investorValue investors worship price. 

Imagine you wanted to buy a car-wash in your town.  The price you pay will dramatically impact its success as a long-term investment.  It could be a wonderful car-wash in a great location with tons of revenue but if you pay too much for it nothing else matters.  If you can instead get it at a bargain price?  That's the game of investing and business.

If you overpaid for the car-wash you don't have much room for error.  The price you paid is demanding perfection from the business.  Machinery breaks down?  Uh-oh.  You scratch someone's car and they sue?  Yikes.  A freezing winter runs long and you have to stay closed?  That's uncomfortable.  You simply don't have much room for error and business is a messy and chaotic world.

Imagine you instead bought at a great bargain price.  These normal business issues are now acceptable; you have a margin of safety.  You can have several things go wrong at once and as long as you paid a good price you will be fine.

TESLA

Mr. Market has provided me a great visual to demonstrate some of these tenets of value investing: the electric-car manufacturer Tesla (TSLA).

Below is Tesla's recent stock performance:

Past performance may not be indicative of future results. Indexes are not available for direct investment.

Year-to-date TSLA is up 250%.  Since last summer? 500%.  It's a truly incredible run.  Wall Street calls these kind of parabolic runs face-rippers.

At $1,500/share Tesla is now the world's most valuable automaker surpassing Toyota.  Should they be?  I have no clue but I'm skeptical.  Tesla is now worth more than Honda, Volkswagen, General Motors, Daimler, Fiat-Chrysler and Ford COMBINED.  Profitable companies with strong brands and good management.

Top 15 automakers by company value

At $1,500/share it isn't a stretch to suggest Tesla might be priced for perfection.

The same margin of safety principles we applied to the car-wash apply to stocks.  A stock is simply ownership share in a business.  The further price gets from intrinsic value the murkier the waters get.

When a company is priced for perfection everything must go perfectly.  You can't have a bad quarter and you can't make any mistakes.  Even the greatest managers are still human.  A massive decline in price can happen if business doesn't go perfectly.  Business is messy and rarely goes perfectly.

A value investor hunts for upside surprises and avoids downside surprises.  I'd much rather own a company that might do surprisingly better than expected because they are out-of-favor.  I'd much rather own a portfolio of companies that could easily exceed expectations given them by the market.

Back to Value

Value investing is unnatural.  Humans are wired for pattern recognition.  We see Tesla's parabolic stock chart and our imagination runs wild.  We don't want to miss out.

Where is intrinsic value on Tesla's chart?  Are you buying at a discount or a premium?  What's the margin of safety at today's price?  

I have no clue what the future holds for Tesla.  I am a big fan of Elon Musk's vision with SpaceX and Tesla.  We need to be on Mars and we needed electric cars yesterday.  I'm in his corner rooting for his success.

I would love to own a Tesla car someday.  Tesla as a stock?  Simply not the type of company I like as an investor.  I hope the stock does well; I just worry it's priced for perfection.  Bubbles have a gravitational pull sucking you into orbit at exactly the wrong time.

The managers at Toyota are very good at what they do.  Toyota's epic rise out of nuclear-annihilated Japan to challenge the great American automotive-might is one of the all-time great business sagas.  Why doesn't Toyota just make a luxury electric car like Tesla?  They are certainly capable of manufacturing one.  They've seen it all so why don't they just do what Tesla does?

Below is Tesla's Net Income line from their most recent 10-K:

Tesla doesn't make money building Teslas.  Could that be why Toyota doesn't make them?

Thanks for reading,

(Now that I've written this let's enjoy watching Tesla climb to $1 trillion/share by the end of 2020)

Devan Robinson

The foregoing content reflects the opinions of Fairlead Financial Group LLC and is subject to change. Content provided herein is for informational purposes only and should not be used or construed as investment advice or a recommendation regarding the purchase or sale of any security. There is no guarantee that the statements, opinions or forecasts provided herein will prove to be correct.

 Past performance may not be indicative of future results. Securities investing involves risk, including the potential for loss of principal. There is no assurance that any investment plan or strategy will be successful, or that markets will recover or react as they have in the past.