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COMPOUNDING QUALITY
JUN 22, 2023
87 8 Share
You try to buy stocks for less than what they’re worth.
This also means that growth is always a component of value as it will increase
future cash flows.
Here’s what Warren Buffett has to say about the value versus growth debate:
So in theory, investing is very easy: buy stocks below their intrinsic value.
Most stocks fluctuate with more than 50% every single year.
Via the Valuation tab on Morningstar’s website, you see that Arista Networks
currently trades at a forward PE of 28. Over the past 5 years, the stock traded at an
average forward PE of 29.1.
This indicates that Arista Networks is reasonably valued compared to its own
historical average.
Source: Morningstar
Obviously, looking solely at the current valuation level of a company compared to the
historical valuation isn’t enough to determine whether a stock is undervalued.
You can take a look at these 2 articles if you want to learn more:
That’s why the fundamentals are by far THE most important thing to track as an
investor.
Let’s say that a company called Quality Inc. has the following characteristics:
Now assume that over the next 3 years Quality Inc. is able to double its profit
margin from 10% to 20%.
Due to the fact that Quality Inc. doubled its profit margin (and as a result its
earnings), investors are also willing to pay more for the company. As a result, the
price-to-earnings ratio increases from 15x to 25x.
Can you guess how much Quality Inc.’s stock price would have increased in this
example?
POLL
POLL CLOSED
As you can see, Quality Inc’s stock price more than tripled thanks to the profit
margin increase from 10% to 20%!
This example beautifully shows why your return as an investor can be very
satisfactory if you invest in companies which can improve their fundamentals.
When you are looking for companies which are improving their fundamentals, look
at these metrics:
3. Moat is strengthening
For quality investors, a moat is essential.
When you invest in companies which can widen their moat, your results will be
very satisfactory.
Very recently, Michael Mauboussin has written a new paper about this topic. You can
read it here.
Companies which managed to go from the lowest ROIC quintile to the highest ROIC
quintile outperform all other companies by a wide margin.
This also means that the longer your companies can grow their earnings at
attractive rates, the better.
Via the formula below, you can calculate your expected return as an investor.
Expected return = EPS Growth + Shareholder Yield (Dividend yield + Buyback yield) +/-
Multiple expansion (contraction)
This means that if you pay a fair price for a stock that can grow its earnings per share
with 10% per year and pays a dividend of 2% per year, your expected return is equal
to 12%.
However, there is only 1 possible reason why an insider buys its own stock: he thinks
the stock is undervalued.
And guess what… there is no person who can determine the intrinsic value of a
company better than an insider.
There are multiple studies about this topic and the consensus states that companies
in which insiders are heavily buying their own stock outperform the market over
the next 12 months with 3-6% per year on average.
Via Dataroma you can see which insiders recently bought back their own shares:
Take a look at this article if you want to learn more:
Conclusion
That’s it for the 100th article of Compounding Quality. I am really looking forward
to the next 100 and hope you are too.
If you like this newsletter, please let us know by emailing us, reacting to this post or
by giving a like. Sharing Compounding Quality with friends and family is the
greatest gift I can ask you for.
All intelligent investing is value investing. You try to buy things for less than
what they’re worth.
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8 Comments
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Another Thursday and another treasure of very useful and beautifully presented content.
Thank you, CQ for all 100 pearls of knowledge! As always, I saved your excellent article for
last.
All five reasons to buy shares of a business are very logical and easy to understand. And
yet, so many people fail to stick with them. Speaking from my own past mistakes, it’s not
the complexity of the buying principles that is hard, but rather the discipline to wait and
buy only when all the check marks are present. Most people want to get rich quickly, but
it almost never works out for them. Therefore, it’s important to come to this realization as
soon and as early in life as possible. Then, very good things start to happen.
One more day to get to the weekend, my friend! Summer has officially begun, and I hope
you have a great and sunny weekend. You won’t believe it but, here, it was only 3 degrees
outside when I woke up this morning. Lol!
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Eric Jurado Writes The International Investor Jun 27 Liked by Compounding Quality
Thank you for another knowledge compounding gem! I always learn something from CQ!
What stood out to me in this article, which is also contained in other CQ articles, is the
expected return formula. Brilliant, short, simple, and clear! Please keep it up!
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