Stories Are Nice. Numbers Are Better

The other day a friend sent me a research report suggesting a stock that had excellent growth potential.

Best of all, the stock was trading at just 15 times earnings, so this seemed like a fair price to the author.

It probably is a fair price, but there was one sticking point: A “fair price” is too high for me.

I do not wish to pay a fair price. I want to pay an unfair price, with me on the better side of the equation.

As much as I might like the idea of growing earnings, I do not want to pay one nickel for a company’s growth prospects. I want to pay a discounted price based on what it earns and owns right now.

It is not that I don’t like future growth potential. The stocks that I have in my portfolio all have excellent growth prospects over the next five years. One of the things that makes us different from other investors is that we are constantly looking for the social, economic and demographic trends that can provide tailwinds for our companies. I love growth but as I said I do not want to pay for prospects.

While that may make me sound unreasonable, it is actually the sane way to invest.

When I have this conversation with other investors, the comment is always made that it must be hard to find a lot of stocks that have excellent growth prospects but can be purchased at a discount to the current earnings and assets.

That is very true. It can be quite difficult much of the time, but it is worth the work and the time involved. Buying a handful of companies at bargain valuations that then grow at a higher rate than Wall Street analysts expected can be incredibly rewarding.

Best of all it gives me more than one way to make money.

If I pay a fair or premium valuation for a company, then my return will be pretty much in line with how much earnings grow while I hold them. However, when I buy the company at a discounted valuation, then I get two ways to make money as I can also benefit from multiple expansion as other investors recognize the potential of the stock.

Let’s look at two different scenarios.

Scenario 1:

I buy Stock A for $10. Stock A is trading at a 20 multiple and has $1 in earnings. If Stock A’s multiple does not change but its earning go from $1 to $2, then I’ve made 100% on my money. I’ve doubled my $10 to $20.

Scenario 2:

I buy Stock B for the same price of $10. It has the same $1 in earnings, but Stock B’s starting multiple is 10 rather than 20.

If Stock B has the same earnings change from $1 to $2 as before, BUT its multiple also goes from 10 to 20, then I’ve made 300% on my money, taking my $10 investment and turning it into $40.

Not bad.

I am aware I have talked about this before, and it is pretty much a certainty that I will talk about it again before too much time goes by.

Buying non-financial companies at low enterprise multiples and real estate and financial companies at discounts to book value create what I call a double compounding potential and can lead to huge returns.

I am a big fan of Charlie Munger’s advice to take a simple idea and take it seriously: Buy good companies cheap and let time and value do the heavy lifting.

It may be a simple idea, but it is the best approach to investing in the equity markets.

Wall Street is a place where the story is often all that matters. The more exciting the story, the easier it is to sell the product to both institutional and individual investors alike.

By keeping your focus on what is hot, popular and exciting, Wall Street can maximize their profits.

For every Amazon (AMZN) there are 99 cases like Pets.Com.

For every Facebook (FB) there are a bunch of MySpaces.

Searching for financially solid companies with the potential for double compounding offers much higher probabilities of success than searching for the next big thing in a sea of fantastic stories.

Stories are nice. Numbers are better.

Tim Melvin

Written By Tim Melvin

As a 30-year veteran of the financial services and investment industry Tim Melvin served as a broker, advisor, and portfolio manager. He’s combined this nearly three decades of experience with a love of value investing in order to help investors worldwide to multiply profits and build their nest eggs. As an avid value investor, Tim...