It is Far Better to Buy A Wonderful Company at a Fair Price than a Fair Company at Wonderful Price

When Warren Buffett said, “It is far better to buy a wonderful company at a fair price than a fair company at wonderful price”, he is clearly stating that the investor should only buy excellent companies’ shares and pay a reasonable price for them. 

So there are two distinct caveats in his advice – Excellent Company and Reasonable Price.

What is an Excellent Company?  Buffett has given ample clarity.  It should not only have had a long and successful existence, but should also be capable of thriving for a long time in future, and its products or business should be such that people will need them for foreseeable future. Mere longevity is insufficient, the business should have been profitable for a long time into the future and should be capable of generating profits and “”Free Cash Flows” well into foreseeable future.  The company should stick to its core business, never or insignificantly borrow, and shall possess the culture of rewarding the shareholders with handsome, regular and uninterrupted dividends.  Let us take the example of Gillette.   It produces excellent razors.  One can never foresee a replacement for razors or people not needing a shave, thus endowing permanence to the company’s business.  Thus, Gillette satisfies all the qualifications of an “Excellent Company”.

Now let us examine the price element.  We should not pay a fancy or unrealistic price.  If we do so the “Return On Investment” or “ROI” for the money we have invested will be poor.  However, this is easier said than done.  Today, on 7^th July 2016, Gillette India Ltd. Shares are trading at an unrealistic, “Price-to-Earnings” or “PE” multiple of 63.76 as against the acceptable 10, and a “Price-to-Book Value” or “P2BV” of 20.44 as against the recommended 1.5.  Under such impractical market conditions what can we do? 

No reason to despair.  One can always find a handful of excellent companies whom the market is disfavoring at that time.  We should invest in those companies.  We should also make a list of the other excellent companies but which are expensive.  We should revisit them during large market crashes like the post “Lehman Brothers”.  My own experience shows that even during such extremely depressing times, companies like Gillette will not be available at the idealistic PE of 10 and P2BV of 1.5.  You may find them at a PE of 25 and a P2BV of five to ten, at that time you should BUY.  If you hesitate, you will never get the opportunity to own such companies.  I had vacillated, and let me admit, I do not own any of these good companies.

On the other hand, when people buy shares based on “Tips”, usually given by brokers and the So-Called-Experts, they end up doing the opposite of what Warren Buffett has warned, Buying Fair Companies At Wonderful Price, instead of Wonderful companies At Fair Price.

You Only Find Out Who is Swimming Naked When The Tide Goes Out

What did Warren Buffett mean when he said, “You only find out who is swimming naked when the tide goes out?”

Clearly, he is talking about two things:  Quality of Stock, and Price Paid for Them.

When the share market is in the midst of a “Bull Run”, the market value of your portfolio will certainly cover-up all mistakes made in selecting the company and the price paid for acquiring the shares; every stock in the portfolio shows a blue tick, and a unrealized gain, prompting the lay investor to falsely believe he is a great investor, bestowed with abundant investment wisdom.

No wonder, the seasoned value investor’s portfolio too, is showing significant growth – may be on par with the benchmark index, like BSE Sensex, or surpassing it or underperforming it – nevertheless it’s value has certainly grown.  However, the “value investor”, trained unceasingly in keeping the emotions under strict control, is Stoic. 

In fact, you can observe a distinct deviation in her behavior, either she is very parsimonious in investing in stocks or has given the market a total miss; instead, preferring bonds or other fixed income securities.  On rare occasions you may observe that the value investor had sold shares of a company or two, at handsome profits of course, which had recently gone through some fundamental changes, which are not to the liking of the investor or which are contrary to value investing principles.

On the other hand, our lay and ignorant investor, who is under the false credence of superior investment acumen, is continuing to pour money into the stock portfolio.  Drunk with “Greed” and “Overconfidence”, he might be investing even borrowed money.

The markets are on a roll, in the meantime, lulling the investor community, the so-called “Experts”, media, regulators and political leaders into a false sense of everything-is-going-good feeling.

At last, the time for reckoning arrives!  Some catastrophic Global Event like Lehman Brothers triggers a market crash.  Portfolios world over start bleeding.  Margin Calls and unilateral squaring up of traders’ positions accentuate both the market fall as well as lay investor pain.  Euphoria, which was prevalent, not so long ago is replaced with gloom. 

The tide is going out fast, and you find out who is swimming naked -  who is safe and who getting washed away in the tide.