When evaluating potential investments, it’s tempting to focus only on companies with strong fundamentals and solid growth prospects. However, investing based on these criteria alone can lead to disappointing returns. The key to successful investing is understanding the difference between a good company and a good investment.
A good company has qualities like competent management, a sustainable competitive advantage, high returns on capital, little debt, and the prospect for future growth. But a good investment depends on more than just the quality of the business. Crucially, it also requires an attractive valuation relative to the company’s intrinsic value. The same company can be a good investment at one price, but a poor investment at another. This article will explore why investing in good companies alone is an incomplete strategy, the dangers of overpaying even for quality, and how to integrate valuation into an investment process focused on high-quality companies.
Past performance doesn’t guarantee future returns
A common mistake is assuming that companies with a strong long-term track record will continue generating market-beating returns in the future. However, competitive advantages can erode over time and rising profitability tends to attract new entrants. Additionally, high growth in the past leads to high expectations being baked into the stock price. Even quality companies can produce disappointing returns if bought at too high a valuation.
Investors need to think critically about whether past growth rates are sustainable. Competitive forces and the law of large numbers means most companies regress to average returns on capital over time. Future growth potential should be considered, but expectations need to be realistic.
Even the best companies can be poor investments at the wrong price
Buying quality companies at any price is an unsound investment approach. In the late 1990s, many seemingly excellent companies saw their shares bid up to extreme valuations during the tech bubble. When the bubble inevitably burst, even industry leaders saw their share prices decimated along with lower quality companies.
Overpaying for growth puts investors at risk of permanent loss of capital if growth fails to materialize as expected. Meanwhile, low-quality companies can potentially generate high returns if purchased at a sufficient discount to fair value. While business quality impacts expected returns, valuation determines the actual return achieved.
Margin of safety protects against errors in judgement
Evaluating competitive advantages requires making difficult predictions about industry dynamics decades into the future. There is inherent uncertainty in forecasting even for seasoned investors. Insisting on a margin of safety by paying a price at a discount to estimated intrinsic value minimizes the risk of permanent losses due to erroneous analyses.
With a low purchase price cushioning against flawed assumptions, an investment can still generate reasonable returns without every bullish projection being realized. A quality company purchased with a margin of safety helps compensate for mistakes in business assessment and offers downside protection alongside substantial upside potential.
Avoid overpaying, even for excellent companies
The market often overvalues companies with superb track records, dominant franchises, and bright growth prospects. Investor enthusiasm leads to elevated valuations that price in aggressive growth assumptions. Chasing hot stocks with exciting narratives frequently leads to poor timing and buying at peaks.
Beware of anchoring on a company’s fundamentals alone. Prioritize not overpaying versus obsessing over business quality rankings. Insist on a margin of safety and be willing to hold cash when the market offers no bargains. Patience and discipline are required to avoid overpaying, even for elite businesses.
In conclusion, investing in good companies alone is inadequate without also considering valuation. Paying too high a price results in poor returns even for quality companies. Insisting on an appropriate margin of safety and avoiding overpaying is crucial for investment success.