Can you invest in “crap” and get a better return than by investing in a great company? The answer is a resounding yes. And although, as far as possible, the advice is not to invest in junk but in solid companies, the return on our investment will depend on the price we paid for the shares we bought.
Veteran investor Howard Marks, co-founder of Oaktree Capital Management, knows very well what we are talking about. In 1969, when Marks was at Citibank, the bank and others developed a smart investment strategy that consisted of investing in the 50 highest-quality, fastest-growing companies in the United States. At the time, these included Xerox, IBM, Kodak and Coca-Cola, among others.
The strategy held that if your portfolio contained the best companies, those showing steady growth in sales and profits, it didn’t matter what price you paid, because these companies would tend to rise in value and deliver an extra return through dividends.
In 1973, just 4 years later, the investors who had followed this strategy and bought the “top 50 companies” found themselves with a combined return of -90%. They had bought the best companies, but they had paid more for them than they were really worth, and the market put them in their place.
After this crushing disaster, and with the market falling, Marks invested in mediocre companies, and in the short term they delivered a higher return than the investments of those who went back to the usual companies.
In other words, you can invest in high-quality companies and still make a very bad investment if you pay a high price for them. On the other hand, you can buy a poor-quality asset at a good price and make a better investment, because there are no poor-quality assets if you bought them at a good price.
That is why the moment you buy into a company is crucial for the future of your investment. It’s not about what you buy, but about when you buy and the price you pay for what you buy.
Perhaps one of the biggest mistakes retail investors make is following the usual expert recommendations that push us into blue chips regardless of the price they trade at, while the same experts advise against mid-sized companies. These may not have the sales or profits of the big companies, but at the moment of purchase their price may be so low that it gives us a huge margin of safety on the investment.
And by this we are certainly not suggesting buying bankrupt companies. If we have the chance to buy blue chips at good prices, in the long run that investment will give us peace of mind and steady returns plus good dividends. After all, that is what value investing is about. But as the legendary Benjamin Graham put it: “Price is what you pay; value is what you get.”
Further reading
Featured image: Marcin Wichary from San Francisco, U.S.A., CC BY 2.0, via Wikimedia Commons.
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