What should you do if you find that the price or P/E is significantly above or below the historically fair price or fair P/E mark?

"It is better to buy a wonderful company at fair price than a fair company at wonderful price."

In general, if you can buy a quality stock today for a historically fair price or fair P/E, you should probably do so, provided the reward and risk are attractive.

However, what should you do if you find that the price or P/E is significantly above or below the historically fair price or fair P/E mark?

A low price or low P/E is probably your biggest concern, because it suggests that people who are buying the stock today might know something negative about the company that you don't know.

Think about it.  Why would investors pay less for the stock than it has typically sold for?

• Is there something in the news that you haven't heard about?  
• Has an analyst - or have a number of analysts - announced a reduced expectation of future earnings based upon something they know that you don't know?  
• Have you missed something in your quality analysis - or (shame on you!) recklessly jumped over that barbed-wire fence, failing to evaluate quality deliberately enough before moving on to look at the value considerations? 

(E.g. Transmile, KNM).

If the price or P/E is too low - move on to another company and forget about looking at the risk and reward.  You may miss a few good stocks, but you won't have to lose any sleep worrying about being wrong.



If the price or P/E ratio is too high, this tells you two things.

1. The first is that other investors appear to agree with you about the quality issues, because they are paying a healthy price for the stock.  
2. The second is that it may be too healthy a price.  

• You may want to put off buying it until the price becomes more reasonable.  
• Or, it may be worth the premium if the risk and reward are satisfactory.

(E.g. _____________)

Just know that, if you buy a stock whose price or P/E is too far above the fair price or fair P/E, when it later comes back down - which it usually will - the decrease in P/E can reduce your gain considerably.  Your chances of having a superior portfolio are far better if you select stocks for which you don't have to make any allowances.  


As you gain more experience, you'll find that you can make some intelligent exceptions in cases of high or low price or P/E, but for now, the advice for those who are just starting out, don't.

Quality: There are a relatively small number of truly outstanding companies. Their shares frequently can’t be bought at attractive prices.

Investment is most intelligent when it is most businesslike. 
Ben Graham - "The Intelligent Investor"

“There are a relatively small number of truly outstanding companies. Their shares frequently can’t be bought at attractive prices. Therefore, when favourable prices exist, full advantage should be taken of the situation.”
Philip A. Fisher, ‘Developing an Investment Philosophy’, 1980

The moral of this is that only an excellent business bought at an excellent price makes an excellent investment. One without the other just won’t do. 

Investors start from the premise that there is no philosophical distinction between part ownership (i.e. buying shares in a company) and outright ownership (i.e. buying the business in its entirety). All we are looking for is pieces of businesses to buy at the right price.

Warren Buffett put it thus:
 “Stocks are simple. All you do is buy shares in a great business for less than the business is intrinsically worth, with managers of the highest integrity and ability. Then you own those shares forever.”¹ 

Criteria for Stock Selection 


It follows that there are several important criteria that companies selected for investment consideration must exhibit in abundance. Among these are that:

• Their business model is easily comprehensible; 
•  They produce transparent financial statements; 
•  They demonstrate consistent operational performance with earnings being relatively predicable; 
•  They generate high returns on capital employed; 
•  They convert a high proportion of accounting earnings into free cash; 
•  Their balance sheet is strong without unduly high financial leverage; 
•  Their management is focused on delivering shareholder value and is candid with the owners of the business; 
•  Their growth strategy is more likely to rely on organic initiatives than frenetic acquisition activity. 

 Buy when the Odds are in Your Favour 

 Great investment opportunities come around when excellent companies are surrounded by unusual circumstances that cause their share prices to be misappraised. Again as Buffett puts it, “Price is what you pay, value is what you get”.² Having identified a universe of truly outstanding companies, we must wait until their shares can be bought at a price on the stockmarket that is substantially less than their true economic worth. 

References: 

 ¹ Warren E. Buffett, Forbes, 6 August 1990 

 ² Warren E. Buffett, Letter to Partners (Buffett Partnership), July 1966

http://www.sanford-deland.com/pages/quality+of+business

To make sure every $1 investment will generate $2000 in just 30 years ...

Fundamental analysts can have good dreams because they usually sleep well. If you are one of them, you don’t have to be afraid of daily stock price fluctuations. Why care so much for $1 to $2 per day price movements and uncertainties when you can get $100,000 30 years later almost certainly and do nothing? The ‘do nothing’ is what makes you an investor. Don’t you think so? Once you bought the shares, you will only sell them if there are fundamental changes; such as change in management or business model. Otherwise, continue riding on their profits and keep on collecting dividends or bonus issues by ‘doing nothing’.

Doesn’t it sound so peaceful?

"To make sure every $1 investment will generate $2000 in just 30 years, make sure you buy the stock at the lowest price possible."

Valuing a Business

"The critical investment factor is determining the intrinsic value of a business and paying a fair or bargain price."

- Warren Buffett

If you find a good company at a good price, who cares what "the market" is doing?

When buying a great wonderful company, also ensure that the stock was reasonably priced.

Even a great company can be a bad investment if you pay too much for it. 

If you find a good company at a good price, who cares what "the market" is doing?

Nestle revisited

In the year 2001, the after tax EPS of Nestle was 87 sen. and its share price was trading between $19.30 to $21.20, with a P/E ranging from 22.2 to 24.4.

For someone who bought Nestle in 2001, where was the margin of safety of this company?

Margin of safety in a company comes from various sources.  Among these are the qualitative factors which are difficult to quantify mathematically.  Nestle has durable competitive advantage and economic moat.  The only assessment for the investor is to "guess intelligently" what its earnings growth will be over the next few years.  

Margin of safety concept can be applied in two ways.  One that is obvious is buying a company at a big discount to its intrinsic value.  Of course, intrinsic value is not easy to determine and does vary widely depending on the assumptions one makes in deriving this value.  Another method that is not obvious, is the margin of safety that exists too when the present price that you are paying is at a discount to its intrinsic value based on its growth projections, conservatively estimated.

Let's look at Nestle.  In 2001, you were paying 22.2 times for $1 of its after tax earnings.  Was this underpriced, fair price or overpriced relative to its intrinsic value, conservatively estimated based on its growth potential?  Growth projections are at best intelligent guesstimates.  Nestle was projected to grow its business profit at 8% per year at that time.  Therefore in 9 years from 2001, it was projected then to have an EPS of 2 x 87 sen = 174 sen.  

Assuming that Nestle in 2010 had the same PE of 22.2, its share price in 2010 should be 22.2 x 174 sen = $.38.63, or CAGR of 8%.  The average DY of Nestle was 4%.  Nestle paid out virtually all its earnings as dividends.  Therefore, its DY in 2001 based on historical cost was 4% but in 2010, its DY based on historical cost was 8% (dividend paid had also doubled).  This was an average dividend yield of about 6% per year for that period.  Should you have reinvested all the dividends back into Nestle, you would probably be able to compound your initial investment at more than 14% per year.

So, in 2001, Nestle's PE was 22.2x.  Yet, knowing its earning growth potential, conservatively estimated, there was margin of safety even buying at this price, with a reasonable degree of probability.  Using a conservative growth estimate in earnings of 8% per year, its earnings was projected to double in 2010.  Based on this EPS projection, its (future) intrinsic value would be higher and herein was the margin of safety demanded by the value investor.  

Such way of investing may not appeal to some investors.  It is too difficult for them to realise that growth creates value.  One should be happy to pay a higher PE to own a stock of higher quality, better earnings growth, lesser risk and greater certainty of a positive sustainable return.

Buying a wonderful company at a fair price has made those who know how, very rewarding and rich indeed.  There is no reason to change something that has worked consistently over 2 decades of investing.  

Warren Buffett: About Socks and Stocks

"Long ago, Ben Graham taught me that 'Price is what you pay; value is what you get.' Whether we’re talking about socks or stocks, I like buying quality merchandise when it is marked down."

Source: Letter to shareholders, 2008

Read more: http://www.businessinsider.com/warren-buffett-quotes-on-investing-2010-8?op=1#ixzz1oXHwI5c2

Warren Buffett: Wonderful v Fair

"It's far better to buy a wonderful company at a fair price than a fair company at a wonderful price."


Source: Letter to shareholders, 1989


Read more: http://www.businessinsider.com/warren-buffett-quotes-on-investing-2010-8?op=1#ixzz1oXDD3b9D