A Solid Foundation is Buying at a Low Valuation

All successful investors have two things in common. They are extremely disciplined, and they understand the downside of their investments even more than the upside. 

They look down before they look up. 

“Look down before you look up” is a phrase articulated by Steven Scruggs, portfolio manager at FPA Queens Road Smallcap Value Fund. The phrase is so brilliantly simple, and I wish I would have said it first. I hate Steven Scruggs for saying it first. H/T to John Rotonti and this interview.

Of course, other famous investors have said similar things in different ways. Warren Buffett said, “Investing is all about protecting your downside. The upside will take care of itself” and “Price is my due diligence.”

Most investors forget about valuation in bull markets. All they see is more upside to justify paying up.

I can feel the Graham style value investors nodding your heads in unison. Perhaps even shaking your fists towards the heavens as you’ve watched Mag7, AI stocks, bitcoin, and sh!tcos outperform the last few years. 

Nothing is more toxic than watching other investors outperform you in things you don’t like or believe in. 

But valuation is like a great balance sheet – eventually it matters. 

Speaking of the Mag7. We all remember the famous example of Microsoft (MSFT).

In 1999, MSFT hit a high of $58 per share. It took 17 years to surpass that high even while revenues grew from $19 billion to $90 billion, and EPS grew from $0.71 to $2.56. 

But it’s actually much worse than this. 

If you bought MSFT at $58 in 1999, it would have taken you 21 years to get back to even with the S&P 500 return. 21 years!

Here is another example. 

Over the past 25 years Costco (COST) has grown revenues from $32 billion to $254 billion, and net income from $630 million to $7.4 billion. Costco's stock is up 2100% (13.2% CAGR) over this period compared to 609% for the S&P 500. 

Costco’s Price/Earnings ratio was 20-25 in the 2000’s, 25-35 in the 2010’s, 35-45 in the early 2020’s. Today, Costco is trading at 61x earnings.

I think Charlie Munger would even agree the valuation is a little rich. The crowd loves Costco. It’s a crowded trade. 

If Costco’s PE ratio rerated back to 40x earnings, a reasonable valuation, it would take five years for Costco’s stock to get back to the current stock price. Five years.

In extreme cases a great business can’t even save you from a bad entry price. 

Multiple expansion is a beautiful thing when you buy before the multiple expands.  

No one wants to wait 5-17-21 years to be right. You don’t want this. Your investors don’t want this. Your spouse doesn’t want this. 

It’s better to buy companies before the multiple expands. Before they are discovered by institutions. Before they are priced for perfection.  

By the time everyone calls it a great business the exceptional returns are usually in the rearview. The time to buy is when a company is misunderstood, undiscovered and under-appreciated.

You want to find uncrowded trades. 

Your entry price matters. Valuation Matters. It why valuation is one of the six core skills of stock picking.  

When you buy at a low valuation it provides a better base to grow from. You don’t need as much to go right to make money.  

If you want to find good businesses trading at low multiples you will be focused on unknown or unloved stocks. The intersection of unknown and unloved is microcap. 

The next big winner is a company that is quietly executing under the radar that most investors don’t know about or believe in. 

Many misinterpret investing in microcaps as risky. It can be if you don’t care about valuation and profitability. 87% of 10-baggers in global equity markets started as microcaps and were profitable. 

Multi-bagger investing would be best described as getting a good entry price (valuation) on a small business that can consistently grow revenues and earnings with limited dilution. 

Depending on the industry, companies are valued on Enterprise Value/Sales, Price/Earnings, Enterprise Value/EBITDA, Price/Book or some variant of each. 

To find a 10-bagger first find a stock that can double in three years with conservative fundamental assumptions and no multiple expansion.

What is the key to this?

For a stock to double in three years you need 25% annual organic growth in the denominator of the valuation metric used with little dilution.

Let me give you a couple examples.

Example 1: 

Company X is a consumer products company. They make industry leading food products in a small but growing product category. In this area companies trade between 1-4 EV/Sales. The higher the organic growth rate the higher multiple. If the company is EBITDA breakeven or better, it is additive to the multiple. 

• Company X is organically growing sales 25%.
• Company X is cash flow positive.
• Company X is confident the current growth rate will continue.
• Company X doesn’t need to raise money.  
• Company X is trading at 1x EV/Sales. At the low end of valuation.

Company X is a wise purchase. The equity return should at least match the organic growth rate over a 3-year period. 100% in three years. If the multiple expands it supercharges the IRR. If the multiple expands to 2x EV/Sales by the end of year three, it’s a 300% return in three years.

Heads you win. Tails you win even more. 

Example 2: 

Company Y is a debt free profitable growing company in an unloved industry (Cannabis, Mining, Oil & Gas, Tobacco, etc). All your peers say you’re an idiot for investing in this industry. It’s an uncrowded trade. 

• Company Y is organically growing sales and earnings 25%.
• Company Y is confident the current growth rate will continue.
• Company Y doesn’t need to raise money.
• Company Y is at an 8 PE. 

Company Y is a great setup. You can double your money in three years without any multiple expansion or operating leverage.

If the company does grow 25% for three years in a row, chances are they will show significant operating leverage i.e. 25% revenue growth produces 50% earnings growth. It’s also likely by year two or three the multiple will expand from 8 to 15.

Then all your peers will pile in after it triples and call it a wonderful business.

In both examples, heads you win (no multiple expansion) and tails you win even more (w/multiple expansion). 

A solid foundation is buying at a low valuation. 

Your purchase price matters. Valuation matters. When you combine low valuation with double digit organic growth and a company that doesn’t need to raise money, you get market beating returns. 

Peter Lynch in One Up on Wall Street said,

"These are among my favorite investments: small, aggressive new enterprises that grow 20-25% a year. If you choose wisely, this is the land of the 10 to 40 baggers, and even 200-baggers. With a small portfolio, one or two of these can make a career."

Go find them. 

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