Two Sides to Value Investing

 | Jun 26, 2014 | 4:00 PM EDT
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Over the years I've learned something very important about investing: An inflexible investor won't last long. And the inflexibility cuts both ways; if you think value only means buying single-digit price-to-earnings stocks or stocks selling below net equity value, you are going to have a very limited method of valuing business. Moreover, you will miss the best investing opportunities.

Similarly, if you believe that value means paying whatever price for growth, it will be a painful exit once the party ends. In 1999, it looked like everything had value. Folks were so enamored with growth. And for a while, it seemed like it was the "intelligent" approach to investing. But it was ultimately painful. 

Consider the following wisdom from Warren Buffett in the 1989 Berkshire Hathaway (BRK.A, BRK.B) annual report:

If you buy a stock at a sufficiently low price, there will usually be some hiccup in the fortunes of the business that gives you a chance to unload at a decent profit, even though the long-term performance of the business may be terrible. I call this the 'cigar butt' approach to investing. A cigar butt found on the street that has only one puff left in it may not offer much of a smoke, but the 'bargain purchase' will make that puff all profit.

Unless you are a liquidator, that kind of approach to buying businesses is foolish. First, the original 'bargain' price probably will not turn out to be such a steal after all. In a difficult business, no sooner is one problem solved than another surfaces -- never is there just one cockroach in the kitchen. Second, any initial advantage you secure will be quickly eroded by the low return that the business earns. ... Time is the friend of the wonderful business, the enemy of the mediocre.

Here is the world's greatest value investor basically saying that "value" and "bargain" are not the same the thing. What makes value is quality, unless you want to build a portfolio based on picking up quick, short-term gains from depressed companies. Even then, Buffett says that the "cigar-butt" approach may not work. And he tells you why: "You might think this principle is obvious, but I had to learn it the hard way..."

In his early years, Buffett was a cigar-butt investor. He picked up little bargains in hopes of picking up quick gains. But he found out very quickly that compounding is the true path to immense investment success. And compounding comes from owning businesses that can continually earn attractive returns on invested capital. So Buffett is not just making an observation, he went through the process and the enormous wealth he's accumulated for himself and Berkshire Hathaway shareholders is proof positive.

Value is not a one-size-fits-all approach. At one point, I thought Chipotle (CMG) was a tremendous value at 22x earnings. Whole Foods (WFM) is also becoming a tremendous opportunity at 26x earnings. Having the flexibility to analyze a company's quality to determine its value is what matters most.

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