Want To Find Great Investments? Find Mismatches Between Market Perception & Reality

March 27, 2017

Want To Find Great Investments? Find Mismatches Between Market Perception & Reality

  • A great company isn’t always a great investment, while a bad company can be a great investment.
  • In this environment, it’s very difficult to find great investments as only 35% of listed companies are creating value for shareholders.
  • The essence of investing is to find mismatches between the market’s perception and the company’s future.

Introduction

One of the most famous investing quotes is Buffett’s reflection on owning great businesses:

“It’s far better to buy a wonderful company at a fair price than a fair company at a wonderful price.”

In the current market, investors seem to focus only on the “wonderful company” part and totally forget the “fair price” part. Price is the essence of investing, if the price is right and the company is great, even better. However, we’re in an environment where:

a) Consumer confidence has reached its highest point in a decade.


Figure 1: Americans’ consumer confidence has reached 2007 levels. Source: Bloomberg.

b) CEO confidence is also at six year highs. 60% of U.S. CEO’s state that current economic conditions are much better than they were 6 months ago, and 67% of them expect economic conditions to improve in the next 6 months.

c) U.S. payrolls and wages continue to grow at very stable rates.


Figure 2: Change in U.S. non-farm payrolls. Source: Trading Economics.

In such a euphoric and greedy environment where consumers expect to get paid more and more while CEO’s expect to make more and more money, it’s very easy to get carried away and pay whatever price the market asks. It’s important not to forget another quote that goes back to Benjamin Graham:

“Be greedy when others are fearful and be fearful when others are greedy.”

It’s clear to me that the majority are extremely greedy, which means it’s time to be fearful. Owning great businesses is a good way to be fearful, but again, we must never forget about the price because a great business can also be a bad investment and a bad business can be a great investment.

Great Businesses – Bad Investments

A great business is a business that is always increasing earnings, doesn’t use too much capital, and its return on capital employed is higher than its cost of capital. You might think that in the current low interest rate environment that it’s easy to earn higher returns than one’s cost of capital, but the truth is quite opposite. Globally there are 19,960 listed value destroyers and only 10,947 value creators.


Figure 3: Global distribution of cost of capital vs. return on equity. Source: Damodaran.

Only 42.4% of U.S. listed companies manage to have higher returns on equity than their cost of capital as of January 2017. This is, of course, the average for the whole market and is strongly influenced by low commodity prices which make many miners and shale oil producers unprofitable. However, it’s very significant that globally only 35% of companies create value for their shareholders. Does this mean that we should only invest in companies that create value for shareholders? Well, the answer is yes and no.

Everybody would love to invest only in companies that create value for shareholders, but those companies are often priced for perfection. A good example is Microsoft (NASDAQ: MSFT) which has grown its earnings from $1.42 per share in 2007 to the current $2.13, increased its dividend, and bought back about 20% of outstanding shares. However, an investment in MSFT on December 1, 1999 wouldn’t have turned out to be a great investment after all.


Figure 4: MSFT performance since 1996. Source: Yahoo Finance.

MSFT would have been a much better investment if bought in 1996 or in 2009.

If a company is a value destroyer, the price only matters in specific situations. Sears Holdings (NASDAQ: SHLD) had a book value of $72.94 in 2007 while the current book value is -$35.69. The stock price matched the value destruction.


Figure 5: SHLD’s price in the last 10 years. Source: Yahoo Finance.

However, sometimes a value destroying company can be a great investment. Peabody Energy Corporation went bankrupt last year, but investors could have made a killing by buying its stock as short squeezes as revival hopes sent the stock up 20 times in 2015 and three times in 2016.


Figure 6: Peabody Energy Corporation stock price in the last 5 years. Source: Google.

As you can see, there is no rule, good companies can be bad investments while bad companies can be good investments. It all depends on the price of the investment.

Looking at things from a price to value perspective, the current market makes it extremely difficult to find good investments. The only way to find great investments is to look for mismatches. Perhaps the market perceives a company as bad while in fact it’s a good company as some future catalysts will change its faith.

Where To Find Mismatches

Mismatches can be found in any sector or country at all times. With more than 40,000 companies to choose from, I’m sure there are hundreds that will be great investments whatever happens with the market. Even extremely followed companies like Apple (NASDAQ: AAPL) are often mismatches. AAPL’s stock price plunged to $90 last April because the market thought AAPL would never grow again while the company continued to print cash.


Figure 7: AAPL has given plenty of mismatch investing opportunities in the past. Source: Nasdaq.

I think a dedicated investor can easily follow more than 200 companies and with patience, he will individuate a few mismatches every year. Individuating such mismatches should be enough for above average returns.

If you don’t have the time to search for such mismatches, you can always let me do the work for you by subscribing to my new newsletter, Global Growth Stocks.