Investing 101 and "Cheap is Good Enough"

The quote “cheap is good enough” comes from a very successful value investor named Walter Schloss. Schloss, along with Warren Buffett, formerly worked for Benjamin Graham, the father of value investing. Graham believed that if you always held low PE stocks with conservative balance sheets, ideally trading close to tangible book value (the balance sheet value of the hard assets, less total debt and preferred stock), then you would do pretty well as an investor. See Concepts page and discussion of Benjamin Graham. High PE stocks aren't cheap relative to trailing earnings. The danger of a high PE stock is that anticipated earnings growth won’t materialize and the stock will tank.

The danger of a low PE stock is that earnings will disappear, the company will go out of business, and the stock will tank (also known as a “falling knife”). Graham tried to address this risk by investing in low debt companies with strong working capital positions — i.e., companies with low credit risk and plenty of money to pay the bills. He also dealt with it by looking for companies trading at or below tangible book value, which gives some downside protection in the event of liquidation. Warren Buffett deals with downside risk by looking for companies with great brands, wide competitive moats or barriers, and highly predictable future cash flows, like Coca-Cola. See Concepts page and discussion of Benjamin Graham and Warren Buffett.

So which of these approaches makes more sense?

Scenario One

A company with a high trailing PE, say 30, is like a guy coming to you and saying, “my business earned $1,000,000 last year, but it’s growing like crazy and should continue to do so, so I’d like you to pay $30,000,000 for it.” As an investor, you should ask whether you’d really be interested in this kind of deal. The initial earnings yield in this scenario is 3.33% (1/30), slightly above the 2.47% yield currently available from risk free 30 year Treasury bonds.

Scenario Two

A company with a low trailing PE, say 10, is like someone coming to you and saying, “my business earned $1,000,000 last year and I’ll sell it to you for $10,000,000.” With an earnings yield of 10% (1/10), well above the risk free Treasury rate, you might be interested. But you’d also want to know if the company is going to be around for a while, so you’d look at whether earnings are growing, flat, or declining, whether earnings are steady and predictable, whether the company has plenty of cash to pay bills, whether there’s a lot of debt to pay down or very little, and what the hard assets of the company are worth after subtracting total debt.

You probably wouldn’t be interested in a company with declining earnings, unless you felt the situation was temporary or the company’s tangible book value was well above the asking price (suggesting you could make a profit by liquidating the hard assets and paying off the debt; this would have to be verified by estimating the fair market value of the hard assets, instead of just relying on the assets’ stated book value). If the company’s earnings were flat or growing, and relatively predictable, you might be interested, since your undiscounted payback period (the time it takes to recoup your initial $10,000,000 investment) would be around 10 years.

To summarize, a Scenario Two company typically has: (1) an unleveraged, low debt balance sheet; (2) a strong working capital position; (3) steady and hopefully growing earnings; and (4) a low price relative to earnings. Investors who are fans of Graham, Schloss, and Buffett generally prefer this type of investment. They’re unwilling to pay a big premium for earnings growth, because high growth rates frequently disappear (often unexpectedly) as competition increases and markets saturate. And it's better if a Scenario Two company isn't facing a low end or new market disruption, a la Clayton Christensen. See Concepts page and discussion of Benjamin Graham, Warren Buffett, and Clayton Christensen.

Low end or new market disruption is often the reason low PE companies go out of business. Amazon has disrupted thousands of brick and mortar retail businesses through new market disruption. Brick and mortar retailers have difficulty matching Amazon’s online, low cost business model. Leveraging its low cost model, Amazon has helped create a vast new market of online consumers who shop at their computer (the new context/situation) instead of shopping at a brick and mortar store. See Concepts page and discussion of Clayton Christensen.

Amazon currently has no meaningful trailing PE, because its EPS for the past 12 reported months is negative. Its forward PE based on estimated earnings for the next 12 reported months is 333, making it a Scenario One stock. Amazon investors seem to believe the company can deliver higher future earnings with no material, concurrent impact on its sales, growth, and ability to compete with other low margin retailers like Wal-Mart, Costco, Sam’s Club, eBay, Target, Alibaba, and Google Express. Applying Michael Porter's five forces, retail industry profits are constantly pressured by: (1) high rivalry (lots of competing retailers doing the same thing -- reselling goods made by others); (2) high buyer power (buyers with lots of information and the ability to comparison shop); and (3) a high threat of new entrants (it's easy to start an online store or brick and mortar store). See Concepts page and discussion of Michael Porter.

The author is not an investment advisor or CFA and readers should consult an investment advisor before buying or selling any publicly traded stock.