“An investment operation is
one which, upon thorough analysis, promises safety of principal and a
satisfactory return. Operations not meeting these requirements are speculative.” - Benjamin Graham and David Dodd
Time and time again I hear people
saying investing is about exploiting market mispricing. Sophisticated investors
search the globe to find that hidden gem, that scuttlebutt that leads to the earning
beat, the thesis that says "I'm
right, market is wrong". To find market
inefficiency, people look for under-covered companies, spin-offs, bankruptcies,
penny stocks in Kazakhstan…etc.
I don’t dispute that inefficient names may present
better risk/return profiles. But how if you are just trying to achieve some satisfactory
return target? Did Buffett shy away from Coke just because it’s one of the most
liquid and well covered companies in the world? And how about all these people
who made fortunes from Apple, Google, and Microsoft – where’s the market
inefficiency in that?
People forget that the market can
be perfectly efficient and investors can still make money. I’m not talking
about buying the SP500 index. It is conceptually similar though - you’re just
picking up that required return on equity.
It’s easier
to illustrate this with an example. Let’s
say company A disclosed a plan to grow earning at 10% CAGR for next 3 years. The
market takes that and builds the 10% into consensus EPS outlook. Here are
consensus EPS and forward multiples.
The
market assigns a 15x forward multiple to expected year 1 earnings of $1.1, for price of $16.5
per share. Year 2 forward multiple is
thus 13.6x. After one year passed, company achieved
its 10% grow and EPS reached $1.1/share. So everything went exactly as planned
and market was right. Your model would
look something like this:
Mr. Market
now looks at year 2 consensus EPS of 1.2/share. Is it going to put a 13.6x
multiple on it? No, market will assign
the same 15x multiple if outlook has not changed. So price goes up to $18.2 (15* $1.2/share), a
10% gain from the initial $16.5. Even if
company misses earning, say earnings grew at 9% instead of 10%, and multiple
contracts slightly due to lowered growth expectation, you might still make
money.
The point is
there’s nothing wrong with picking up a nice solid return in plain sight. The
blogosphere is full of smallish, speculative names that nobody’s heard off in
search of market inefficiency. Not saying those are bad ideas. On the other hand,
if your goal is 8%-10% return a year and CVS has a reasonable plan to get you
there at a reasonable price, do you really need to say “No, I’m not buying it
because 20 sell side analysts already cover it, and everything’s priced in?”. Or do you say, maybe, just maybe, upon through analysis of industry dynamics, competitors, management strategy, financials..etc, the stock promises safety of principal and a satisfactory return?
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