Why a Great Company can be a Lousy Investment

It goes against popular wisdom, but purchasing shares in great companies is not always sound investment advice.  What is a great company?  Quantitatively, a great company is one which (a) generates extensive cash flow, (b) earns high returns on invested capital, and (c) redeploys cash flow at high returns.  A great company possesses what Warren Buffett calls an “economic moat”, meaning it has a sustainable competitive advantage which allows it to earn attractive returns on redeployed capital.

So, when can owning shares in great companies be a disappointing investment?  The stock’s price is the market’s estimate of future cash flows, discounted to the present at a rate which reflects the uncertainty of those cash flows.  The stock investor in a great company will only earn superior risk-adjusted returns when the company’s future cash flows exceed those expectations reflected in the current price.  For great companies, the stock price often reflects highly optimistic expectations of future cash flows, offering the investor limited compensation for risk.  In the language of value investors, great companies often lack a “margin of safety”.  In contrast, many mediocre companies can be wonderful investments, if the stock price is low enough.

Even more favored are stocks of great companies which are expected to aggressively grow future revenue and earnings.   These so-called “growth stocks” often sell at high multiples of current earnings and cash flows, reflecting the lofty expectations of investors.  While growth may be a component of a stock’s value, it is the most unreliable component, as the future is always uncertain.  One rule of thumb followed by many value investors is to only pay a price reflective of cash flows which the company has currently or historically achieved.  Conservative investors like growth, they just don’t want to pay for it.

Historically, ignoring sensible valuations in favor of overly optimistic expectations has not fared well for investors.  Consider the so-called “nifty-fifty” stocks of the mid-to-late 1960’s.  According to this strategy, an investor would purchase shares in the fifty fastest growing companies, regardless of price.  As measured as a multiple of earnings, the priciest names in this group were trading at 80 to 90 times current earnings.  By the time of the bear market of the mid 1970’s, many investors had lost 90% or more of their money as valuations came crashing down to earth.

Investors should recognize that both investment risk and investment return are functions of price, regardless of the quality of the underlying business.

About the Author:

Matthew DePaola is a long-time practitioner of the deep value investing approach. He cofounded Tortuga Capital after having concluded that few institutional money managers follow a true value investing approach. Matthew has broad experience in business finance and asset valuation, and has engineered the leveraged purchase and recapitalization of several small businesses. Matthew has also spent several years as a financial analyst in the residential real estate development field. He earned his MBA from the University of Florida’s Hough Graduate School of Business and holds a BS in Finance from Florida Gulf Coast University.

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