High Quality Vs Low Price

If you pay peanuts, you get monkeys. ~ Old adage

If you remember the stock market crash of 2008, you also remember that it spared almost no stock. Companies, even the well-managed ones, lost half or more of their market capitalization in few months.

As an example, Pidilite (makers of Fevicol), which was one of those extremely well-managed businesses then, lost 55% between December 2007 (just before the crash started) and March 2009 (the bottom). Titan and HDFC Bank, two other stalwarts, lost 50% each. In short, the crash was like a bad dream for people even in these marquee stocks.

But for those who held on to their nerves, and to these stocks, the next decade was about to turn into a beautiful dream.

As an example, assume you were owning Pidilite near its peak in December 2007 and went into a deep sleep that continued till today (June 2018). Your return from the stock would have been around 1,000% (CAGR of 26%) over this decade!

Also assume you had Titan and HDFC Bank in your portfolio then (remember, you slept for the next 10 years thus didn’t do anything with these stocks), CAGR return from these would have been 26% and 19% respectively till date.

Not bad, right? 20% CAGR over 10 years is 6-times your money. 25% CAGR over 10 years is more than 9-times your money. Plus, you made this kind of money while sleeping, and that too from the peak before a major market crash!

Wait, I forgot to add that you woke up for a bathroom break in March 2009 and realized that a few companies you did not own had fallen by 80-90% in the previous fifteen months. You were too sleepy to look at your portfolio and asked your spouse to buy a few of these new, terribly depressed stocks as you went back to sleep.

One of the stocks was Unitech, which your spouse bought in March 2009 after it had already fallen 95% since December 2007. She also bought large chunks of Suzlon and Jaiprakash Associates in your portfolio. After all, these were down around 85% from their peaks and thus appeared cheap.

Your spouse also slept after placing these orders for you and with the excitement of giving you the great news of buying these stocks at throwaway prices, when you woke up.

But that was not to happen. When you both woke up in June 2018, Unitech was down another 85% from your spouse’s buying prices, and Suzlon and Jaiprakash Associates were down another 85% and 70% respectively.

You were in a state of shock, as you thought you had bought these stocks cheap in March 2009. What could have gone wrong?

You also realized that a few stocks that you were owning before the crash started, like Pidilite, Titan, and HDFC Bank, had turned up 1000%, 1100%, and 500% respectively! What could have gone right?

Well, the answer to both these questions is the same – it’s the business, stupid!

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If you want to create wealth from stocks, long-term, buy good businesses not cheap stocks (and please, please don’t average down on bad businesses that have become cheap stocks).

Let me clarify here that I am not advising you to buy a good business at any price. Valuation, Buffett says, is fuzzy but terribly important.

Pidilite was trading at a P/E multiple of nearly 45x in December 2007 (when you were owning it in the above-mentioned scenario). Titan and HDFC Bank were at 70x and 50x respectively. So, your stupendous returns from these stocks happened despite high starting multiples. But here, I am assuming that you were owning these stocks from lower prices and had not bought them in December 2007. There is, after all, a big difference between owning stocks that have become expensive versus buying stocks that are expensive.

Anyways, on the other hand, when your spouse bought Unitech for you in March 2009, it was at a 5x multiple. Jaypee and Suzlon were at respectable 30x each (the pain in earnings was yet to come). So you lost huge money even when the starting multiples were not very high.

Reminds me of Warren Buffett, who says –

It’s far better to buy a wonderful company at a fair price than a fair company at a wonderful price.

And why? Well, Buffett reasons –

Time is the friend of the wonderful company, the enemy of the mediocre.

In today’s word, when ‘high-quality cheap-stocks’ are missing from the picture most of the times, you must pay up (not overpay) for quality.

P/E isn’t a good valuation metric (it’s crude at best), but I consider paying 25-30x last year’s earnings for a high-quality business as ‘paying up’. Paying more than that is ‘overpaying’. My stock analysis excel, which includes simple models like Graham Formula, Expected Returns, and Dhandho Framework, also helps me in my valuation process.

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One final lesson – when you own high-quality businesses, please take advantage of time and keep owning them till they remain good.

There’s no point in predicting market crashes. There’s no point in trying to time the market (“I’ll sell before it falls, and buy after it falls”). And please remember this simple message – Avoid the mistake of buying ordinary companies just because they have fallen in price and/or are trading cheap, just because you have nothing to buy among high-quality businesses.

Learning this lesson was hard for me. I hurt myself a few times looking for cheap stocks after bull runs before I got it. But it doesn’t have to be a hard lesson for you. Now you know it.

Avoid having an investment process that starts with looking for cheap stocks. Instead, have one that starts with looking for high-quality businesses that benefit from established competitive advantages and business models that produce large and growing distributable cash flows. And when you find some such businesses, wait for the right valuations (which won’t be cheap but at a premium to their peers) for them, even if you must wait for a long time.

Remembering Charlie Munger who said –

It’s waiting that helps you as an investor, and a lot of people just can’t stand to wait. If you didn’t get the deferred-gratification gene, you’ve got to work very hard to overcome that.