- As wonderful as a company may be, the price paid for it is the determining factor for investment returns.
- Many companies with great brands have seen their stock prices appreciate while their fundamentals stagnate.
- Buffett has mostly bought at wonderful prices. Keep that in mind when investing.
“It’s far better to buy a wonderful company at a fair price than a fair company at a wonderful price.”
Many asset managers and financial advisors have Buffett’s quote on their promotional materials and web pages. However, more arguments can be made against the above statement than for it. We’ll go through some examples to help prevent you from falling into the trap of paying what the market thinks is a fair price for companies that might not be that wonderful after all.
General Misconception – Investing In A Wonderful Brand Is Enough
By looking at Berkshire’s (NYSE: BRK.A, BRK.B) portfolio, many wrongly conclude that all you have to do is buy good brands and you won’t ever have to think about your investments again. What many omit is that Buffett rarely buys a business at a fair price. When he buys, he mostly buys at wonderful prices. Just think about his American Express (NYSE: AXP) purchase in the 1960s where he put 40% of his funds into AXP while the company was battered by an infamous oil-salad scandal. The scandal and the $60 million settlement made AXP’s stock price drop significantly, right into Buffett’s hands.
Fast forward 50 years, and think about his BNSF Railway purchase in the midst of the financial crisis, or his 50% investment in Heinz in 2013 when the company’s net income was only $18 million. As the economy improved, BNSF’s earnings skyrocketed from $1.7 billion in 2009 to $4.2 billion in 2015 and $3.5 billion in 2016. All things considered, Buffett has already tripled his investment in BNSF.
Figure 1: Berkshire’s purchase of BNSF was made at a great price (2009 – 2016 data). Source: Bloomberg.
In addition to the increased value of the company, BNSF has paid out generous dividends that just 7 years later have already covered for more than 60% of the acquisition price.
Figure 2: BNSF’s net income and dividends. Source: Bloomberg.
As for Heinz, it again looks like “Buffett buying wonderful brands,” but the terms of the deal were wonderful for Buffett. Buffett paid $72.5 per share which would be considered a fair price as it was a 20% premium on the last stock price in 2013. However, in addition to just buying common stocks, Buffett also invested an additional $4.4 billion in equity and got a deal to buy $8 billion of preferred shares with a 9% dividend yield. A normal acquisition at $72.5 can be considered a fair price, but the $8 billion at 9% deal where there is no downside while the upside is unlimited is what makes the Heinz deal another deal where Buffett bought a great business at a wonderful price. BRK currently owns 25% of Kraft-Heinz (NASDAQ: KHC) which has a market capitalization of $110 billion. Buffett’s initial investment of $10 billion is worth $27 after just 4 years, and that’s in addition to the $720 million per year received on the preferred shares that were redeemed at the end of 2016.
Such investments show that while buying wonderful companies at fair prices is better than buying fair companies at wonderful prices, the absolute best way to go is to buy wonderful businesses at wonderful prices. Of course, few among us can make deals like Buffett, but what we can do is avoid mistakes and invest in wonderful brands just because the market’s sentiment or the prevailing theory is to buy wonderful businesses.
Great Brands At Fair Prices Don’t Make The Cut
Let’s take a look at a few brands that are famous and fairly priced but where it’s highly unlikely that an investment would result in the above described Buffett-like returns.
Campbell Soup Company (NYSE: CPB)
CBP is an iconic brand with a portfolio of household names.
Figure 3: Campbell Soup’s brands. Source: Campbell Soup.
However, sales and earnings have stagnated over the last 10 years.
Figure 4: Campbell’s revenue and earnings since 2007. Source: Morningstar.
The only improvement has been in the dividend which went from $0.8 in 2007 to the current $1.32, and that is just because the dividend pay-out ratio went from 38% of earnings to 82%. You might think that as there has been no significant improvement in the business, the stock would have done badly and probably has gone nowhere in the last 10 years. Well, the stock has done extremely well and is up 121% since the bottom of the 2008-09 bear market, and 43% higher from its 2007 peak.
Figure 5: CPB performance in the last 10 years. Source: Yahoo Finance.
The amazing stock performance despite the stagnating business is due to the fact that people think investing in a great business is always a good idea. There is a high probability that recent Campbell Soup investors will get burned in the future.
Not to make this an individual example, a similar story can be told for WD-40 Co (NASDAQ: WDFC) which improved earnings mostly by buying back shares while the stock is up fourfold since 2009 and revenues are flat.
What happens when infatuation with a brand ceases can be seen through General Mills (NYSE: GIS) which lost 20% from its peak just six months ago.
Figure 6: GIS lost 20% as revenues declined. Source: Yahoo Finance.
One of the best things to do in investing is to own wonderful businesses, but this shouldn’t be the only reason for investing in something and shouldn’t be done at any price. Wonderful businesses should be bought when there is a large margin of safety, be it in assets per share, temporarily low earnings, or scandals that people are quick to forget. Such situations happen more often than you might think, just look at 2009, or at what is happening now with retail stocks, or was going on with healthcare stocks in 2016.
Therefore, the same rule applies as for buying cool businesses that we discussed last week: a margin of safety is of extreme importance in order not to lose money.