The Perils of Overpaying

Thursday, February 16th, 2017

Hi, I’m Adrian Ezquerro, senior analyst at Clime and manager of the Clime Small Cap Sub-Portfolio.

As an extension of Jonathan’s video last week that reviewed the recent Aconex downgrade, today we explore the concepts of margin of safety and the perils of overpaying.

In the lead-up to the February reporting season, we have seen dozens of companies downgrading profit expectations. The paring back of expectations has been particularly apparent within the small and mid-cap industrial market segments whose prices had generally raced well ahead of intrinsic value.


Figure 1. Small Ordinaries vs ASX100: Since October 2016
Source. StocksInValue
These downgrades have concurrently occurred with a broader rotation of investment capital away from high multiple, growth focused small caps towards the larger end of the ASX spectrum. As a result, the ASX100 has outperformed the Small Ordinaries index by about 10% over the past 4 months.

The results for affected companies have been devastating, with many such companies falling by up to 50% from recent peaks. Among other things, the events of recent months highlight the risk of (1) investing in companies of dubious or unproven quality and/or (2) overpaying for a part share of a given business.

Though clichéd, in many ways our framework reflects key principles espoused by one of the world’s value investing titans, Warren Buffett. These principles have stood the test of time for good reason, in that they are common sense and have contributed to long term investment success.

Before Buffett became Chairman of Berkshire Hathaway, he ran several discrete portfolios under what he termed the Buffett Partnership. In Buffett’s 1963 letter to partners, he wrote:

I cannot promise results to partners. What I can and do promise is that:

  1. Our investments will be chosen on the basis of value, not popularity;
  2. That we will attempt to bring risk of permanent capital loss (not short-term quotational loss) to an absolute minimum by obtaining a wide margin of safety in each commitment and a diversity of commitments.

In simple terms, like Buffett, we seek to acquire a part share in a range of good quality businesses when they are trading at considerable discounts to both intrinsic value and prevailing market multiples. In our view, being consistently diligent on purchases prices increases your probability of long term investment success.

To provide a recent practical example, on your screen now you will note the price chart of Collins Foods, overlaid with our view of intrinsic value. Now let’s imagine we have three different investors, each of whom like the future prospects for Collins but pay varying levels of attention to the margin of safety principle.


Figure 2. CKF’s Margin of Safety
Source. StocksInValue
Investor 1 likes the company’s outlook and although it’s trading above value decides to buy at about $5 per share.

Investor 2 also likes the company’s outlook but decides to wait until he or she can buy with a greater than 10% margin of safety at about $4.50 per share.

Investor 3 likes the stock’s trading momentum and decides to buy at $6.50 per share after noting a big run up in the share price.

Proving that entry prices matter, these investors have since made a pre-dividend return of 16%, 29% and -11% since. Investors in Clime’s Small Cap Sub-Portfolio will be happy to know we have followed a process most alike investor number 2 in this example.

On that note, we’ll leave you today with one final quote from the great Warren Buffett in a letter to his investment partners of yesteryear. Thanks for watching and if you have any questions please feel free to get in touch via our website.

Obtaining value for the price paid

 

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