“Price is what you pay, value is what you get.”
That quote, attributed to Warren Buffett, implies
that investors who focus on stock prices are focusing on the wrong thing. Making investment decisions based on where a stock
price has been in the past or betting on where it may go in the future is futile and foolish unless the investor has determined
the value of the stock—or any other security for that matter.
Once value has been estimated, the market price
serves as a gauge as to whether one is getting a good deal on the investment.
Grasping the price-value equation
is critical in making investment decisions and explains the success of long-term investors. The risk that an investor is taking
can be generally determined by the gap between price and value. The higher a price an investor pays relative to (or in excess
of) investment value, the greater the risk. And, likewise, a low price, well below estimated investment value, provides a
cushion against downside risk—what Ben Graham referred to as a “margin of safety.”
The price-value
relationship can also produce some odd scenarios that may seem to contradict widely held beliefs. For example, Treasury bonds,
considered the highest in safety, can be poor investments or even risky investments when purchased at the wrong price.
In fact, today’s record-low yields on long-term Treasury bonds are likely to produce losses for investors in
the future, as an expected rise in interest rates would cause Treasury bond prices to fall. Alternatively, a subprime mortgage
bond can be an excellent investment with nominal risk, as long as it is purchased at the right price relative to its value.
In a recent interview, the eclectic value investor Jim Grant related “that you always want an extreme price.
To me, it’s not so much that a stock is a good investment or a bond is. Somebody said there are no bad bonds, only bad
prices. So we look for things that are mispriced—either on the high side or the low side. And sometimes it is kind of
easy.”
The truly great investors troll in all markets for bargains. Also, price aberration in things like
illiquid securities (which tends to be a turnoff to the mainstream investing crowd) attracts these investors because they
can often find discounted values.
Seth Klarman, another well-regarded value investor, relates that debt (certain
bonds) got much cheaper than stocks during the market calamity. Last year, he bought Ford Motor Co. bonds at 40 cents on the
dollar after his analysis determined the bonds to be worth 60 cents ($600 per $1,000 face value per bond) if we went into
a depression.
Within this simple two-variable relationship, price is presented to us daily. Determining value takes
a bit more effort, but is not an overwhelming exercise. Precision is not required. A range of value will suffice because,
ideally, you are looking for a substantial discount to the estimated value for a margin of safety.
So, let’s
say you valued a stock in the range of $50-$55 per share. You would be interested in buying around $35, but not at $48 per
share. As Grant suggested, the best investments are extreme mispricings.•
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Skarbeck
is managing partner of Indianapolis-based Aldebaran Capital LLC, a money management firm. His column appears every other week.
Views expressedare his own. He can be reached at 818-7827 or ken@aldebarancapital.com.
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