Value vs Price

Buffett did not become a billionaire by investing only in good-quality companies – he bought them at a discount to Intrinsic Value.

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/EAnnualised Return %
Polaroid90.7(14.7)
McDonald’s85.710.5
MGIC Investment83.3(6.8)
Walt Disney81.69.0
Baxter Travenol78.510.1
Intl Flavors & Fragrances75.85.7
Avon Products65.46.0
Emery Air Freight62.1(1.4)
Johnson & Johnson61.913.4
Digital Equipment60.00.9
   
 S&P 500Overvalued Stocks
Average return %12.03.0

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

Melvin Tan

Melvin joined DCG Capital in 2011 and is a portfolio manager with more than 13 years of experience in investment management.

Previous experience: Lion Global Investors, Technology and Telecommunications; Straits Lion Asset Management, information technology portfolio implementation; Avanade Asia, software engineer.

Academic and post-graduate qualifications: Bachelor of Engineering (Honours), National University of Singapore; CFA® charterholder.

Teck Jin Tan (“TJ”)

TJ joined DCG Capital in 2014 as an investment analyst with more than 8 years of experience in investment management.

Previous experience: Target Asset Management, Greater China equity; Deutsche Bank, Hong Kong, macroeconomics and equity strategy; Singapore Police Force, securities fraud.

Academic and post-graduate qualifications: Bachelor of Engineering (Honours), Master of Engineering, Cambridge University; MBA, Columbia University; CFA® charterholder.

William Toh

William joined DCG Capital in January 2019. He has more than 25 years of investment experience.

From 2007 to 2018, he was the Chief Investment Officer of New Harbour Capital Partners and Lead Portfolio Manager of the New Harbour Asia Fund. Prior to that William was the Chief Investment Officer of Asia General Holdings responsible for managing the insurance funds of Asia Life Assurance and Asia Insurance (2001-2006). He started his investment career at GIC in 1981.

William is an Independent Non-Executive Director of Mapletree Industrial Trust Management Ltd and also serves on the investment committees of several Mapletree property funds. He is Chairman of the investment committee of the Methodist Church of Singapore (since 2013) and a member of the investment committee of Singapore Bible College (since 2008).

William studied at the University of Tasmania, Australia on a Colombo Plan Scholarship and graduated with a First Class Honours degree in Mathematical Economics. He also attended the CFA Investment Management Workshop presented jointly by CFA Institute and Harvard Business School.