Monday, October 7, 2013

Price is what you pay, value is what you get

In my dividend investing, I typically try to focus on the big picture. This means that in most cases I tend to ignore short-term fluctuation in stock prices. This is because short-term prices are usually driven by fear and greed, and might be totally out of line with the underlying fundamentals of a business for extended periods of time.

For example, during the global financial crisis, shares of Coca-Cola (KO) fell from a high of $32 in early 2008 to a low of $19 by early 2009. Nothing had changed fundamentally in the business however, as it earned $1.29/share in 2007 and $1.25 in 2008. Not surprisingly, people still wanted to have a few of their favorite drinks, even during a recession. Therefore, the underlying earnings power was still intact for this global franchise, and the company managed to keep increasing earnings to $1.47/share in 2009 all the way up to $1.97/share in 2012.  Investors who focused on the underlying fundamentals of the business, should not have been worried about the stock price declines in 2008 - 2009. The lower prices should actually be viewed as good entry opportunities.

This is why I focus my attention to understanding the fundamentals of the business I am monitoring. In general, I focus on businesses that sell a product or service that has a loyal customer base. As a result, I try to gain confidence in purchasing a business, whose products/services have lower chances of being obsolete in 10 – 20 years. This is very difficult to achieve, because there could be factors that are unknown today and would not be in my thought model, but which could derail my plan completely. For example, few investors would have expected that asbestos is so bad for people in the 1950s. However, it was bad for people, which led to poor performance by asbestos companies and a several bankruptcies in the US for companies in the industry.

However, if you find a collection of stable businesses you understand, which have durable competitive advantages, and you believe they will still be around in 20 years, you can add the shares if they are attractively valued. Monitoring such enterprises would involve reading annual reports, checking the financial figures there, and even quarterly filings to keep track of major developments throughout the year. Tracking every press release or analyst comment on a company you own however might result in information overload, which would actually be detrimental to your investment results. The thing that will make you the most money is rising earnings per share, which is why you need to focus on areas that could aid the company in achieving that.

In other words, I focus on the real earnings power and underlying assets per share of the company I am purchasing. Over time, this piece of information can provide much more value and wealth to me, than watching the stock price oscillate between a high and a low on a given year.

For example, I firmly believe that people would keep brushing their teeth with the brand of toothpaste they have been using in the past. If you monitor the toothpaste aisle on Wal-Mart (WMT), you can see plenty of consumers pulling their carts to the aisle, looking for their desired brand of toothpaste, and then proceeding on to the next item on the list. Since people are creatures of habit, chances are they would stick with a similar brand of toothpaste for years if not decades. People care about their teeth, and brush them even when there is a recession. Companies like Colgate-Palmolive (CL) sell millions of tubes of toothpaste to consumers throughout the highs and lows of the economic cycle. These millions of repeat purchases result in stable revenues and earnings streams for Colgate. The only problem is that the stock has been slightly overvalued in 2013.

The fact that I ignore short term price fluctuations does not mean that I ignore prices all the time. I only focus on them in relation to what I believe the value of a business should be. I usually achieve that by looking at price in relation to normalized earnings, after evaluating the earnings per share trends over the preceding decade. I then look at trends in returns on equity, revenues, dividends, payout ratios in this order. I use all of this information to estimate whether I have a good chance of receiving higher earnings and dividends over the next 20 years. I add all of this information to make a reasonable estimate of whether the value I am receiving is higher than the price of the company.

To paraphrase what famous investor Warren Buffett says “Price is what you pay, value is what you get”. My investment strategy is inspired by the Oracle of Omaha. Hopefully, this post serves to show that in order to be successful, you need to be able to pay a reasonable price for a sound business with attractive future prospects.

Full Disclosure: Long CL, KO, WMT

Relevant Articles:

Buy and Hold means Buy and Monitor
Seven wide-moat dividends stocks to consider
Warren Buffett on Dividends: Ideas from his 2013 Letter to Shareholders
Warren Buffett’s Dividend Stock Strategy

5 comments:

  1. I agree with your fundamental's view in price. But there has been a significant change in Americans soda consumption and KO is no longer the darling American stock pick. It is now Apple. But things could change, again.

    Watching KO.

    ReplyDelete
  2. Manny,

    Thanks for reading the site and for your comment.

    The point about KO is that it is more than a US soda company - it offers other types of drinks as well. It is also more than a US company - it has operations in as many as 200 countries ( i think that it is not available for sale in five countries or so)

    ReplyDelete
  3. I agree with everything.
    Thanks a million for your Time & Effort in creating awesome article filled with priceless wisdom.

    ReplyDelete
  4. Interesting comment manny. yes apple is currently the darling but the chinese are comming in force with their dmostic high quality brands (albeit android) itching to go global at a fraction of the branded price. I just purchased one of these http://www.youtube.com/watch?v=71xMBTt9lww direct off ebay for a fraction of the price of a branded mobile. It doesn't take a genuis to work out why apple has lost so much market share in china.

    With more phones like these http://www.youtube.com/watch?v=4LzAb1RZp6U (soon to be) flooding the market I predict a big shift in consumer buyer patterns and a drop in apple revenue

    Lester

    ReplyDelete
  5. KO is BUY for long term investment. It has recently released its financial statement. The EPS of KO is $0.54 with an increase of 8% YoY. The total revenue generated by the company in 3Q is $12.05 bn. Its sales had increased globally by 2% but remained constant in Latin America. Due to some operational restructuring in Brazil and Philippine KO had faced decrease in profits, but it is expected that KO will perform better in the next quarter. I have come across these details from: http:// goo.gl/uncE6s

    ReplyDelete

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