Price is the Primary Factor of Value, not Quality

I'm sure a lot of people will have their eyes glaze over almost instantly just from the title alone, but some people might agree. I personally think when it comes to value investing, price is the primary factor, not quality. Quality is important, but price supersedes quality in my opinion.

“I am 85% Graham and 15% Fisher” Warren Buffet

What’s the difference between the two, really? Fisher’s scuttlebutt approach has more of an emphasis on qualitative factors, such as competitive advantage, and wonderful businesses with long term compounding potential. Graham has more of an emphasis on quantitative factors, such as using valuation models and focusing more on businesses based on financial statement numbers.

When I read through forums like this sub, the vast majority of individual retail value investors today seem to be the inverse of Buffett’s quote. 85% Fisher and 15% Graham.
Is this a good approach? I suppose it depends on many factors, mostly on one’s own needs and expectations. As Berkshire has grown their capital base larger and larger over the years, their returns have been drawn closer and closer to the average returns of the market. For the last couple of decades, they’ve just about matched the market’s returns.

What this means is that if someone is only focusing on large/mega cap businesses with a Fisher approach, if they have the same level of ability as Warren Buffett and Charlie Munger, long term, they should probably expect to beat the average market return by a few percentage points. This is because the larger and more followed a business is, the less likely it is to be significantly undervalued. If someone concentrated into one booming industry, they may outperform in the short term, but investing based on market dynamics/predictions and not business fundamentals is speculation. Some people may use examples of a large/mega cap stock going up over 100%+ in a year, showing you can get large returns with large stocks, but if someone could consistently pick these out on a regular bases at that scale, they’d be one of the richest people on the planet within 1 1/2 decades starting with $10,000. It is not a realistic example of return potential.

Now that being said, even 2% outperformance is nothing to scoff at. A 2% higher return over 35 year would double your initial investment. However, if someone were to save and invest just $10 more a month, they’d have grown their money more than that 2% outperformance after 35 years.

So in actuality, if an individual is focusing on large compounders, and they are not managing a fund and collecting fees, their time would likely be far better spent focusing on earning/saving more to invest in and index ETF than it would be researching individual stocks.

What if you’re 85% Graham and 15% Fisher Instead?

This type of mental model is vastly different because you compare businesses based on fundamental valuations, while still acknowledging that long term compounders with a competitive advantage is the ideal business type to hold, but it also doesn’t mean wonderful businesses are the best investment, because these types of business are rarely undervalued to any level of significance’.

Instead of being locked onto only focusing on wonderful businesses, this mental model allows you to be far more adaptive with the ability to pivot to different types of undervaluations or even different asset classes all together.
Just for the sake of example; You have two options.

1. A wonderful business, a great brand, competitive advantage, low debt, and compounding earnings. You predict this business will return around a 15% CAGR/year.

2. Junk bonds, normally not touched by most investors, begin having their coupon rate’s increased. First they’re at 5%. Then they go to 10%. Then they go to 20%. Then they go to 40%. Then they go to 80%. Then they go to 160%. Overall the trash bond market has a delinquency rate of say, 20%.

So the question is, comparing the two, if you wanted to buy a basket of the junk bonds, at what coupon rate would you buy the junk bonds over the wonderful business?

“Businesses have coupons that are going to develop in the future too, the only problem is they aren’t printed on the instrument - and it’s up to the investor to try to estimate what those coupons are going to be over time” Warren Buffett

This exact same thing applies to lousy-mediocre businesses. At what undervaluation is the lousy business a better investment than the wonderful business? 30%? 60%? 90%? There is a number, so what is it? This is a prime example of why valuation models and actually valuing business is extremely important for value investing, and why price is the biggest factor of value, not the quality of the business.