Compounders vs Cheap Stocks

Should an investor focus on finding high quality companies that can incrementally reinvest earnings at high rates of return (compounders), and ignore "cheap stocks"?

10 minutes

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I have recently given a lot of thought to my investment strategy. 

A question I found repeatedly thinking about was whether one should simply focus on finding high-quality companies that can incrementally reinvest earnings at high rates of return (compounders), and ignore “cheap stocks”. 

The rise to this debate initially came after reading Charlie Munger’s “Poor Almanack”. In his words, “a great business at a fair price is better than a fair business at a great price”.

I thought about if what Munger said was contradictory to the tenet of only investing with a margin of safety. 

This debate become stronger after studying Mohnish Pabrai and Guy Spier, two outstanding investors.

From what I learned, Guy Spier focuses on compounders, I have not heard him talk about buying bad or mediocre businesses at really cheap prices, or investing in special situations.

Mohnish, on the other hand, has made money in both strategies, but generally remains disciplined in buying only when the price is right. Nevertheless, in recent podcasts, Mohnish has talked about being okay with paying up for a great business and has remarked how he tries to focus on better businesses now. 

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So, should one focus their attention exclusively on high-quality companies?

Last week I finished reading Seth Klarman’s “Margin of Safety”. A fantastic read. In his view, it is better to buy high-quality companies at undervalued prices. However, given that these opportunities are easier to see, they are more rare. 

In addition to high-quality companies, Seth points to other attractive investment opportunities existing in undervalued companies. These companies do not necessarily have to be good businesses, if the price is low enough, they can too be good opportunities. A mediocre business selling at a very wide discount to book value can be an opportunity. 

Furthermore, in his book “You Can Be a Stock Market Genius”, John Greenblatt focuses on catalysts. Forces that will cause the realization of value to appear. 

For example, in the case of a company selling below tangible book value with significant amounts of real estate carried at cost, this value realization can be through liquidation.

Other opportunities can exist in spin-offs, restructurings, or a change in market dynamics that cause margins to improve.

Thinking of the above I do not think that one should only focus on one category and disregard the other.

If one manages small amounts of capital and has access to opportunities, why not consider both?

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Valuation vs. Return on Capital--Depends on Time Horizon

I think what Munger was trying to say when he said that “a great business at a fair price is better than a fair business at a great price”, is that over a long period of time, a great business will perform better. 

A driver of returns in the short term is the market’s correcting the value gap in a company’s valuation. This normally happens short to mid-term. 

Buying a stock at 50% of book value can work out very well if/when the market corrects itself and the stock gets revalued at 100% of book value.

However, over 10-15 year periods or longer, paying 2 times a book for a great business will work out than buying the mediocre business at a cheap price. 

The factor of time then becomes increasingly important when paying a fair price for a great business.

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When is it worth paying up for a high-quality company?

Because buying a great business at a fair price works over a long period of time, being right about the business becomes very important. 

A lot of things can happen during the next 10 - 15 years. A company’s competitive position can erode, and with it its margins too. 

Capitalism is brutal, as a result, it is very risky to pay up for a business in an unstable industry, where it is difficult to know what the company’s products will be 5 - 10 years from now.

I think this is why Buffett has avoided technology companies, the uncertainty of the world is simply too high to know where the companies will be in the future, and not having a margin of safety to protect the investment, makes it unattractive.

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How much should you pay up for a high-quality company?

Another question that I often think about when analyzing high-quality companies is how much to be comfortable paying up.

I generally think that one should not pay for expected growth, because of the uncertainty of the future. 

I like the idea of buying a high-quality company in a stable industry with a durable moat that can grow its earnings in the future. But, I think that price is still a very important component in the equation, even when dealing with a great business.

Things can happen that we do not see, this is why a margin of safety is important. 

Paying a high multiple for a business leads us exposed to our investment only working if a lot of good things happen. I do not want to be in that situation. I want to be in situations where I can win a lot, and lose very little. 

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Summary

In summary, I like quality businesses, I like great capital allocation, I like high returns on capital, but I demand value and a margin of safety because the future is uncertain. 

I think that both categories, “cheap stocks” and compounders, should play a role in my investment strategy. At the end of the day, it comes down to the price we pay. Both can offer high upside relative to the risk taken.

My goal is to create a low-risk portfolio with a high probability of achieving an attractive average rate of return.