Having identified a quality company, our next task is to establish if it is trading at a substantial discount to our evaluation of its intrinsic value.
While this may seem a straight forward final step, it is the most critical of decisions that we make. While there are a multitude of great businesses in the sharemarket, many of them generate below average returns for investors. This is due to the fact that the price paid for an investment has a direct impact on the return it generates - no matter how high quality a business may be, if investors pay too much for it, they may very well lose money.
More often than not, great companies trade at a substantial premium to their intrinsic value. However, every now and again, great companies fall significantly due to a minor short or medium term setback which causes its share price to fall significantly. We look for great companies where any setbacks they are experiencing are unlikely to bear any meaningful change to our view of their long term prospects.
There are many reasons why an excellent business might become unloved by the market. The issues could be business related, industry related or simply a result of the economy as a whole. Whatever the reason, we look for great companies whose long term prospects are unlikely to be affected by their immediate situation.
Taking this approach requires a great deal of patience. Opportunities do not present themselves on a daily basis. Accordingly, maintaining liquidity in the portfolio is a sensible idea, so that when an opportunity does present itself, we have the capital available to take advantage of the situation.
Despite the common sense inherent in the value investing approach, we find that it can be challenging to maintain conviction in relation to an investment as the broader market disagrees with our view - generating short term volatility.
We appreciate that the market can be extremely fickle at times, and we accept that we won’t always pick the market bottom. Nevertheless, having watched it generate positive returns for our clients, we are confident in the validity of our approach.