As value investors, we are always on the lookout for bargains—stocks or bonds that are trading at prices below our estimate of Fair Market Value (FMV). Both research and common sense dictate that the greater the discrepancy between price and FMV, the better—it provides a higher possible margin of safety and implied upside. However, securities are often detached from their FMVs because the business is suffering, leaving investors to figure out whether the issues at hand will be minor and temporary or debilitating and permanent.
Buying the most statistically undervalued companies can be quite lucrative but can also expose investors to deteriorating businesses—some are clearly cheap for a reason. On the other end of the spectrum, the highest quality businesses tend to be fully priced—some unduly, due to their popularity—so high quality investment opportunities can be scarce. Hence, the quality quandary.
Investors generally fall into two camps. Value investors usually dwell in the bargain basement bin. In the other camp, which comprises most investors, are growth or momentum investors, who tend to gloss over valuation work as they prize business metrics over all else. Our philosophy requires both—a high quality business at an attractive valuation. Simply stated but not easily executed, because it requires additional analysis to determine a company’s lasting competitive advantages and the patience to await a price sufficiently below our FMV estimate to justify a potential outsized rate of return.
Our own philosophy has evolved. In years past, we emphasized the more undervalued opportunities, still preferring good businesses but valuation was a key driver. In emphasizing undervaluation, we held some less predictable businesses. Our migration toward higher quality businesses was motivated by our desire to have fewer clunkers—to lower the number of losers and to shrink the size of the losses.
We aim for more winners than losers. Who wouldn’t? And, to maximize the gains from our winners while minimizing the losses from our losers. But, again, simple to say, harder to achieve.