Challenging Buffett: Buying wonderful companies at fair prices isn’t more profitable
Legendary investor Warren Buffett once famously said it’s far better to buy a wonderful company at a fair price than a fair company at a wonderful price. Now one Wall Street firm claims Buffett’s preference doesn’t stand the test of time. A team of analysts at Macquarie Equity Research developed a model to quantify a company’s fundamentals, which helps assess how “wonderful” a company truly is. It then layered a valuation model on top of that to measure if a stock is fundamentally cheap or expensive. To test Buffett’s investment theory, the analysts split “fundamentally cheap stocks” into three categories: wonderful companies at fair price; fair companies at wonderful price; and a mixed group. Macquarie then back-tested the performance of these three groups over the past 30 years across 10 global markets, rebalancing monthly rebalancing. The evidence showed that the opposite is true: buying fair companies at a wonderful price outperforms buying wonderful companies at a fair price. “This result is particularly encouraging for fundamental investors, as it reinforces the effectiveness of focusing on valuation-driven opportunities,” Macquarie said in a recent report to clients. “Had the reverse been true, it might have suggested that other investment styles with narrower opportunity sets are more effective.” Not a clean test While Macquarie’s analysis is interesting, it’s not necessarily a clean test of Buffett’s hypethesis. Buffett’s saying isn’t a quantitative “law,” it’s a philosophy about the margin of safety when investing, and long-term compounding. The investment bank’s quantitative methodology also ignores intangible factors like strong brands, as well as Buffett’s philosophy of durable compounding with low risk of ruin. The late Charlie Munger was widely credited as someone who broadened Buffett’s investment approach early in his career, eventually turning the younger Buffett away from buying dirt cheap, “cigar-butt” companies that might still have a little value left in them, to instead focus on quality companies selling at fair prices.
