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You Are Wrong Mr Salmon: Fundamentals-based Investing Works

Ser Jing is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.

On 4 Dec 2012, a finance blogger at Reuters named Felix Salmon posted an article titled ‘The seductive Warren Buffett. A key takeaway of his article that I got was that Salmon did not believe that a fundamentals-based, buy-and-hold investing philosophy can enable professional and amateur investors to beat the market because “all strategies eventually run out of steam.” My response to his article would be an emphatic: “You are dead wrong, Mr Salmon.”

In his article was a complete failure to mention a trait that has enabled fundamentals-based investors to outperform the market – having the conviction to buy stocks at prices below their estimate of intrinsic value when everyone else is selling and then having the patience to hold these stocks for years.  A fundamentals-based investing philosophy, or value investing as it is more commonly known, is not merely a set of tools to analyze a business’s financial statements to decide on its merits for investment. At its heart, it also encompasses a certain mind-set that its practitioners adopt when it comes to the financial markets. Value investors are typically contrarian and patient, and that is not a ‘set of tools’ that can be applied like a simple formula to calculate the Price/Earnings ratio for a stock.  The legendary value investor, John Templeton, sums it up best in his quote -

The time of maximum pessimism is the best time to buy, and the time of maximum optimism is the best time to sell’.

During the financial crisis of 2007-2009, there were many companies with great fundamentals that saw their stock trading at enticing valuations. Some of them, like surgery-robot manufacturer Intuitive Surgical (NASDAQ: ISRG) was selling at $85 per share in March 2009 with a Trailing Twelve Month (TTM) PE of 16.6, while sporting $902 million in cash and equivalents with no debt on its balance sheet. For a company that has grown revenue and earnings at a compounded annual growth rate (CAGR) of 58.4% and 71.6%, respectively, over the last 5 fiscal years, a TTM PE of 16.6 would be a screaming bargain. Besides having a pristine balance sheet, Intuitive Surgical also had a growing economic moat arising from increased patient demands for operational procedures done through their Da Vinci surgical robots.

Coach (NYSE: COH), which makes luxury handbags and leather products, reached a PE of 5.2 on March 2009 when it traded at $11.40 a share. For a company with a rock-solid balance sheet carrying $430 million in cash with only $25.6 million in debt and sporting CAGRs in revenue and earnings of 24.6% and 31.5%, respectively, over the last 5 completed fiscal years, a TTM PE of 5.2 was an extremely cheap price. To sweeten the deal at that time, Coach had a phenomenal return on equity of 48.6%, a measure of the profitability of a business which Warren Buffett particularly likes.

America's favorite iPhone manufacturer, Apple (NASDAQ: AAPL) actually traded at a TTM PE of 14.5 when it hit $78.20 a share on January 2009, its lowest price during the financial crisis. During that period of time, Apple actually had an astounding compounded revenue and earnings annual growth rate of 40.8% and 200%, respectively, over the last 5 fiscal years.  I probably sound like a broken record now, but during that time, Apple had $24.5 billion in cash and equivalents while carrying zero debt on their balance sheet. Furthermore, Apple had just released the iPhone 3G in July 2008 and had a solid growth hook extending a good number of years into the future.

When these companies were trading at their most depressed prices, they were still exhibiting all the business fundamentals that a savvy fundamentals-based investor would have looked out for – a clean balance sheet, great historical growth in revenue and earnings and a high probability of having material increases in revenue and earnings in the future. If a value investor were to have purchased these companies at their lowest prices and held on for less than 4 years, they would have made 635%, 490% and 690% returns on Intuitive Surgical, Coach and Apple respectively based on current prices. That is well ahead of the S&P500’s return of not more than 78% if one were to have purchased the index at the same month as those 3 stocks.

Buying at times of fear and despair is what allows most value investors to outperform the market over the years. Salmon missed the important psychological factor that is an integral part of a fundamentals-based investing philosophy and that truly allows the philosophy’s practitioners to beat the market over the long-term. Value investors recognize that human emotions often cause stock prices to exhibit violent swings that are not reflective of the underlying business fundamentals and strive to take advantage of the value-price discrepancy. That is certainly the case with a certain Mr. Warren Buffett. 

 


serjing owns shares of Apple and Coach. The Motley Fool owns shares of Apple, Coach, and Intuitive Surgical. Motley Fool newsletter services recommend Apple, Coach, and Intuitive Surgical. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. Is this post wrong? Click here. Think you can do better? Join us and write your own!

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