Probably the largest aggregate losses are suffered by people who invest overenthusiastically in a basically sound company. — Ben Graham
I was reminded of Graham’s quote after hearing something Joel Greenblatt said at a recent conference:
I’d like to own a great growth company that’s gonna continue to grow forever and there are some extraordinary companies out there that will continue to do well. I would say…people think there are a lot more companies that rhyme with those few companies that can do that, then there are, in reality. There probably are a few great businesses like that, and I’m not gonna argue that they’re great — I have to figure out which one’s they are first — but there will be some winners. And you’ll know their names because they won.
Sometimes the market views stocks through rose-colored glasses. It prices companies as if they’ve built an impregnable moat around them and they already won. Really, it’s an illusion.
Greenblatt’s comment stems from Warren Buffett’s “wonderful companies at fair prices” strategy. His “wonderful companies” have moats that protect their growth and earning power from competitive forces.
But companies with moats are rare because capitalism breeds competition. High profits attract competitors, competition eats into profits and growth, losses cause competitors to fail, which allows for high profits for survivors. It’s a vicious cycle.
The result is the force known as mean reversion in stock prices. So highly profitable, fast-growing companies slow down. Their once high flying stocks must adjust to the slow growth reality, causing the stock price to fall (mean reversion also pushes undervalued stocks higher as companies forgotten and left for dead prove to be not dead).
Of course, a few rare companies exist with moats that fend off competitors and don’t fall to the force of mean reversion. They grow at exceptionally high rates over a long period of time and their stock prices tend to reflect it.
Buffett wants those rare companies…along with everyone else that’s piled into the same strategy. There’s only one problem. Most of us are a poor judge of moats.
One mistake is thinking an average business at the peak of its cycle is a wonderful business. It’s hard to get the full picture of any new company that only has the good times of its business cycle on its books because there are no bad times to judge the good times against. Graham preached about being wary of companies without a long enough history of earnings for this very reason.
In addition, old companies experiencing a longer than normal period of good times are at risk of overenthusiastic prices too. Investors make the mistake of extrapolating profit and growth trends rather than anticipating the turn caused by mean reversion.
That gets to the issue of what’s a fair price. How much wonderful (and then some) is already priced in? A better question might be: how many investors even ask that question? Or are they too busy taking cues from price action (high price = high quality, right)?
Graham warned of these numerous mistakes that lead investors to see “wonderful companies” everywhere:
The successful purchase of growth stocks requires two rather obvious conditions: First, that their prospect of growth be realized; and, second, that the market has not already pretty well discounted these growth prospects. — Source
Many mistakes have been made in buying growth stocks on the theory that the future will duplicate the past. — Source
My experience teaches me that by far the largest losses have been sustained by investors through buying securities of inferior quality under favorable general conditions. — Source
A hot stock, like a hot stove, should be handled with care. — Source
The psychological mood of people changes more drastically than anything else in finance. Human nature changes least of all. — Source
The point is, Buffett’s “wonderful companies at fair prices” is an exceptional strategy, made more difficult by the rarity of “wonderful companies” and “fair prices,” by its rise in popularity, and by human nature.
- Value is Dead, Long Live Value (pdf) – OSAM
- Investor Memory and the Momentum Effect – Klement on Investing
- Why History Gets Stuff Wrong All the Time – A Wealth of Common Sense
- The Investor’s High – Your Brain on Stocks
- Paradigm Shifts – R. Dalio
- All about Direct Listings – a16z
- Global Investor Study 2019 – Schroders
- Amazon’s Business Practices Harm American Consumers – Medium
- The Streaming Wars: Its Models, Surprises, and Remaining Opportunities – REDEF
- 50 Astronauts, in Their Own Words – Washington Post