Cheap is the foundation

Many new investors have been drawn to the years-long rise of the stock markets, and some of them are finding their way to Valuing Dutchman. That's why it's useful to explain how we invest once again. For others, this will hopefully be a welcome refresher.

Two Key Approaches to Value Investing

Our investment style, value investing, can be split into two major approaches. Since many have learned about this style through Warren Buffett, you could even describe it as the Buffett method before Charlie Munger and the one after.

Buffett’s Early Years: The Graham Method

In his younger years, Buffett, like his mentor Benjamin Graham, bought very cheap companies and waited until other investors picked them up again, causing them to return to their intrinsic value.

These weren’t necessarily great companies you'd want to hold for a long time, but purely stocks to buy and sell. On the stock market, there are always shares trading below their value, sometimes even below the value of their tangible assets, and in some cases, below their net current assets (cash, investments, receivables minus total debt).

Often, these companies face underlying problems, which could be due to external factors, things beyond their control, or mismanagement. Sometimes they’re just smaller companies that go unnoticed. As long as the price is low enough and there's a wide margin of safety, you can buy these companies and wait for the price to move back up to the value of their assets.

The intrinsic value of such a company may decrease over time, but thanks to the large margin of safety, you can still often achieve a good return. Sometimes a decline in asset value is already factored into the investment thesis, and the company remains worth buying.

In extreme cases, Buffett calls this the "cigar butt" method: companies that might not be relevant anymore but still have one last puff left.

Typically, these are cyclical companies temporarily facing tough times. It’s up to us to determine if these problems are temporary and if the company can survive the downturn and grow again. This is a contrarian way of investing.

Buffett earned his highest percentage gains by applying this method in his early years. During this period, he paid little attention to the quality of companies.

This investment style requires a lot of time and thorough analysis to avoid value traps. We want to hold only companies where the chance of profit outweighs the risk of loss.

The Evolution of Buffett's Strategy: Quality as a factor

However, this isn't how most people know Buffett. Influenced by Philip A. Fisher and his partner Charlie Munger, Buffett began focusing on buying exceptional companies. Most people now know Buffett as the investor who prefers to hold his stocks forever (buy & hold).

His famous quote that you should look for a castle with a moat full of crocodiles to describe a company’s competitive advantages has become iconic for him.

Buying fantastic companies at good prices has paid off for Buffett. This approach is more relaxed and less intensive than focusing on beaten-down stocks. With such companies, you can invest and then leave them alone for years.

The Role of Portfolio Size

Buffett’s evolution is partly explained by the enormous size of his portfolio, something that's often overlooked. He has said multiple times, including this year at the annual meeting, that if he worked with smaller amounts, he’d once again focus on small stocks to achieve higher returns.

Today, small companies would hardly make an impact on his results because he’s dealing with billions.

The Importance of Price, Even for Quality Companies

However, what remains consistent across both methods of investing is that Buffett only buys stocks when he can get them below their value. Even companies like Apple, he bought when they were cheap, with a price-earnings ratio under 11. Now that Apple is overpriced, he sells.

For Buffett, the price you pay always matters, even though he now focuses on quality companies.

Determining the value of such a fantastic company is often harder. You have to make predictions about future growth and profitability. Even with these companies, the margin of safety is crucial, as the future is inherently uncertain.

If our estimates are too optimistic, this margin of safety can protect us from loss. More importantly, even a fantastic company can be a bad investment. If you overpay by 30%, the company has to grow 30% before you break even.

Make no mistake: during a stock market rally, when everyone seems to be making easy money, expectations become increasingly optimistic, until it inevitably goes wrong.

Recognizing Investment Opportunities Today

As private investors, we have the advantage of being able to buy both fantastic companies and cheap, quirky ones. The size of our portfolio doesn’t force us to focus solely on high-quality companies. The choice is yours.

In times like these, we can no longer buy fantastic companies at a cheap price. These are seldom cheap, except during market crashes.

We now need to look for less obvious quality companies, but even that pool is overfished. Many are seeking quality where it doesn’t exist.

Today, investment opportunities lie mostly in the segment of cheap stocks that are (temporarily) facing issues, but where the price is so low, you’re still making a good investment even if things go wrong.