What is the definition of a great company? A great company generates extensive cash flow, earns high returns on invested capital and redeploys cash flow at high returns. A great company possesses what Warren Buffett calls an “economic moat,” meaning it has a sustainable competitive advantage that allows it to earn attractive returns on redeployed capital.
So, when can owning shares in great companies be a disappointing investment? A stock’s price is the market’s estimate of future cash flows, discounted to the present at a rate that 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 investors limited compensation for their 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 that 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. Although growth may be a component of a stock’s value, it is the most unreliable component because the future is always uncertain. However, one rule of thumb followed by many value investors is to only pay a price reflective of cash flows that the company has currently attained 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 “nifty-fifty” stocks of the mid-to-late 1960s.
According to this strategy, an investor would purchase shares in the 50-fastest growing companies, regardless of price. Measured as a multiple of earnings, the priciest names in this group were trading at 80 to 90 times their current earnings. When the bear market of the mid-1970s arrived, many investors had lost 90 percent 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.
Matthew DePaola is co-founder and chief investment officer for Tortuga Capital, a value-oriented investment management firm based in Fort Myers.