- We’ll first define what a wonderful business should be and what a fair price would be in relation to general stock market risk.
- We’ll look at price earnings differences among sectors and countries to find places to look for great investments.
- A list of S&P 500 companies with low P/E ratios shows that it isn’t easy to find wonderful businesses at a fair price.
Warren Buffett’s main advice to investors is to find a wonderful business at a fair price. Now with the S&P 500 price to earnings (P/E) ratio of 24.34, that implies an earnings yield of just 4.1% which makes me ask myself, is it possible to find a wonderful business at a fair price today?
I’ll first describe what a wonderful business is, look at what would be a fair price for it, and then look to see if there are any such businesses around.
What Makes A Wonderful Business
- Buffett looks for large companies with more than $75 million in pre-tax earnings. With the current S&P 500 valuation, this would imply a market capitalization of at least $1 billion.
- By “demonstrated consistent earning power,” Buffett shows that he doesn’t trust promises and growth, something that might make it easier to find such businesses as most of the current investing environment is running after promises and growth (hint: Tesla & Amazon).
- The third criterion requires the business to earn good earnings with little or no debt. This means that a wonderful business doesn’t need debt because it has plenty of cash flow to finance its activities.
- The wonderful business has to have good management that knows how to do business in the environment. This criterion goes hand in hand with the earnings power as if past earnings are consistent, the management will probably also be doing a good job.
- A simple business without much technology. Why doesn’t Buffett like technology? Well, the thing with technology is that it can change very quickly and a new player can disrupt the market and leave you with significant losses.
A Fair Price
Determining a fair price is perhaps even harder than determining what a wonderful business is. Nevertheless, my opinion about a fair price is that it has to have an earnings yield that is satisfying in relation to the risk taken and to one’s individual expected returns.
When discussing stocks, people often forget about risk which usually leads to very costly mistakes. A look at the yearly stock market declines since 1980 will show how risky investing in the stock market is even if it might not look so at this moment.
Figure 1: Annual returns and intra-year declines. Source: JPMorgan.
In the last 37 years, the stock market has fallen more than 30% on 5 occasions. This means that we can expect a 30% bear market every 7 years. In order to just cover for such a decline, the minimal return from a stock should be 5% as a 5% return over 7 years mitigates a 30% decline. Additionally, the number of years with declines above 10% were 21 out of the 37 since 1980. On average, the largest of these yearly stock market decline was 13.97% which is a pretty significant risk even if it’s usually just temporary.
In order to mitigate for those declines, I would require an earnings yield of at least 7% over a longer period of time, 10 years. A great tool to use for this is the cyclically adjusted price earnings ratio (CAPE) which uses 10-year average earnings to calculate the P/E ratio. A 7% earnings yield would imply a current CAPE ratio of 14.28 or lower.
Now on to the most daunting task of this article, let’s try to find such a business.
Finding A Wonderful Business
A look at the average sector CAPE ratio for the S&P 500 is already discouraging.
The lowest CAPE ratios can be found with industrials and energy, but those are still above 20. Therefore, the only option is to look at individual companies to find lower CAPE ratios. However, the lower CAPE ratios will probably be a consequence of current distress.
In the table below, I’ve analyzed 24 S&P 500 companies with the lowest P/E ratios to try to find a wonderful business at a fair price among them.
Out of the 24 stocks, some have CAPE ratios below 14 which means that it is possible to find such companies. However, good due diligence is necessary as for example, Kohl’s has a CAPE ratio of 10.6 but its debt burden has been growing constantly for the past 10 years which doesn’t meet the criteria of a wonderful business. General Motors was bankrupt in 2009 and I used only the latest earnings, while companies like Navient are new on the market and lack consistency. Nevertheless, it is possible to find businesses that look wonderful at a fair price, it requires a lot of work and meticulous analysis, but it is possible as it’s likely at least one company in the list above is a wonderful business currently trading at a fair, or even below fair, price.
Another option is to look around the world for cheapness, but such an option requires even more work and research. Nevertheless, a much fairer price for stocks can be found in some countries where the CAPE ratio is below 14.
Figure 4: Global CAPE ratio. Source: StarCapital.
I know investing in Turkey, Brazil or Russia isn’t a walk in the park, but when other options are so expensive, perhaps it’s possible to find wonderful businesses in these countries that are at a fair price.
What many forget in a bull market is that stocks are risky. In fact, they are one of the riskiest investment vehicles out there, and therefore a higher return on investment should be expected. By not forgetting such a simple premise, many can save themselves from the usually high losses that investors suffer in a bear market.
Owning a wonderful business at a fair price mitigates many of investing risks and allows for steady long-term returns.
Keep reading Investiv Daily as we’re always looking for places that offer wonderful investments at a fair price.