“It’s much better to buy a wonderful business at a fair price than buying a fair business at a wonderful price. “
We all are too familiar with the above quote from Mr. Buffett. My experience has certainly reinforced my preference in buying wonderful businesses at a fair price than buying a fair business at a seemingly attractive price. A lot has been discussed on why that is the case so I won’t be repeating what most of you already know. In this article, I want to touch on one subtle point about the advantage of buying wonderful businesses at a fair price, or at even a higher than fair price from the human side of investing perspective – the confidence level you have with the quality of the business impact your investment decision making, especially during adverse periods of time. In my opinion, this confidence level matters enormously, especially when you have two businesses of different qualities sharing the same expected rate of return profile.
Let me use a pair of stocks to make my point.
The recent drop in energy price provides plenty of candidates for fair businesses selling at seemingly wonderful prices. Even some better-than-fair businesses are cheap. Such is the case for National Oilwell Varco (NOV, Financial). Plenty investors assign National Oilwell Varco (NOV) a wide-moat rating because it is the dominant player in the market it serves, with a nickname of “No Other Vendors.” I think it is a good-enough business but not a wonderful business because its future depends a lot on where oil price will be down the road, and nobody has the crystal ball on oil price in the future even though plenty of people claim they do. National Oilwell Varco’s stock has dropped to 52 week low, typical among energy related companies. It is trading at 10 times TTM earnings.
Another stock that has been hovering around 52 week low is Discovery Communications (DISCA). This is without a doubt a wonderful business. It has enormous pricing power (3-5% annual price escalators) embedded in its contracts with content distributors due to the unique content it creates. The business enjoys vertical integration and universal appeal of its content. Its destiny is not dependent on things they have absolute no control at all. I can go on and on about the wide moat of Discovery but for the purpose of this article, enough is to know that it is a wonderful business trading at 17-18 times TTM earnings.
Let’s say you own both National Oilwell Varco (NOV, Financial) and Discovery Communication 52 weeks ago and now you are sitting with a paper loss of about 25% for both stocks. Let’s also assume that your expected forward return of at this price is 15-18% for both stocks. In other words, let’s assume both stocks are cheap.
I’ve had discussions with owners of both stocks recently and most of them told me they think the stocks are cheap. Then I asked all of them one question: Would you be willing to add significantly to your position at this price level? Most NOV owners’ are less willing to add significantly to their positions because even though they think the stock is cheap, they are worried about further drop in oil prices or an extended period of “cheap oil” at the current prices. In contrast, DISCA owners are significantly more willing to double down on their positions because their confidence stems from the inherent favorable business economics of Discovery Communication, which will likely to help grow the fundamentals of the business both domestically and internationally in the next few years.
I found the divergence in answers extremely interesting because this is a good example of “in theory, there is no difference between theory and practice and in reality, there is.” Now let’s put aside all the things that we don’t know and just assume that 5 years later the stocks of NOV and DISCA would offer the exact same total returns from today if you can hold them through. Based on my observation, I would bet that there will be a lot more DISCA shareholders than NOV shareholders who can actually hold the stocks throughout the 5 year period. The key difference – the confidence level in the quality of the business.
Why does this matter? Obviously there are more than one answer but here is what my answer is. We all agree that it is important to stay rational as an investor, even during panic times. If you own shares of lousy businesses, fair businesses, or even good businesses such as National Oilwell Varco (NOV, Financial), you are much more likely to face panic times than shareholders of wonderful businesses such as Discovery Communication. Because we are more likely to make irrational decisions in a panic mode, we are more likely to commit a mistake with non-wonderful businesses. But on the other hand, if we own wonderful businesses such as Coca Cola (KO, Financial), Berkshire Hathaway (BRK.B, Financial), or Discovery Communications (DISCA), we are less likely to find ourselves in panic mode and therefore, more likely to stay rational.
Now let’s revisit Mr.Buffett’s wise words. It may seem pretentious for a young and relatively inexperienced value investor to add anything to his holy wisdom but heck, I’d like to end this article with a modified version of the quote from the Oracle at the beginning of this article. If this makes me look dumb and stupid, at least I have given the readers something to laugh about anyway.
“It’s much better to buy a wonderful business at a fair price than buying a fair business at a wonderful price, because doing so helps us stay rational.”
