Good Companies don’t always make Good Investments
In the 1960-70s, Morgan Guaranty Trust identified 50 stocks that represented some of the exciting growth companies known as the ‘Nifty 50’. Their popularity sparked a shift from ‘value’ investing to a ‘growth at any price’ mentality. In 1972, at its peak, the Nifty 50 PE was 42x vs the broader market’s 19x.
We took the top 10 highest PEs of the Nifty 50 to compare their returns provided the study below over 30 years from end-1971 to end-2001.
|1972 P/E||Annualised Return %|
|Intl Flavors & Fragrances||75.8||5.7|
|Emery Air Freight||62.1||(1.4)|
|Johnson & Johnson||61.9||13.4|
|S&P 500||Overvalued Stocks|
|Average return %||12.0||3.0|
Jeff Fesenmaier and Gary Smith (Department of Economics) Pomona College
How much will you pay for a fruit juice stall?
If someone wants to sell you a fruit juice business, how much will you pay?
You will need to consider the profits on the business and estimate a multiple you would be willing to pay let’s say 3x the forecasted profit. If the intrinsic value is 3x annual profit you probably want to pay 2x profit or less.
This difference between Intrinsic value (sometimes interchangeably called Value) and the price you pay gives you the Margin of Safety. Notice we distinguish between value and price.
Why do you need a Margin of Safety?
Just like in life and selling fruit juice, many things can go wrong. What happens if 2 fruit juice stalls open up next to you, will you be forced to cut prices? And for other things like rising cost of manpower and rental, a margin of safety helps buffer such uncertainties.
Similarly, when we invest in a stock, the price we can observe daily but estimating the value is not so apparent and requires research and understanding of the business. Here we focus our time by not watching stock prices but trying to estimate the business’s value. Intrinsic value typically does not fluctuate as much as stock prices which are driven by ‘fear and greed’. In the short run, prices may bear no relation to the business’s fundamentals. In the long run, price and value should converge.
– Warren Buffett