Value investing is a spectrum: On one end are the deep-value investors, who want to buy $1 for $0.50 by investing in underrated companies. On the other end are investors like Charlie Munger and Warren Buffett, who will pay a fair price for a company that will increase its value over time.
In this clip from Industry Focus: Tech, Motley Fool analysts Dylan Lewis and John Rotonti talk about the benefits of both styles. Also, they look at what the P/E ratio is and what the number says about a company.
A transcript follows the video.
This podcast was recorded on July 1, 2016.
Dylan Lewis: John, you obviously have a lot of value credentials. You've certainly spent your time honing your investing craft. Can you start a little bit explaining your mentality when it comes to investing and how you think about it?
John Rotonti: Sure. I actually started when I was a freshman in college. I'm 35 now. So it's been a while. I think my strategy has shifted over time. At one point, I was what I would consider a traditional deep-value investor. Now, I've shifted more to focusing on high-quality companies.
I guess, one thing is, there's a value spectrum. On one side of the spectrum, you have traditional deep-value investors looking to buy the proverbial dollar for $0.50. On the other end of the spectrum, you have the Warren Buffett and Charlie Munger style, which is that they're willing to pay a fair price for a great business if they think that business can increase its intrinsic value over time. Using the same example, the deep-value investor wants to buy a dollar for $0.50, and then they'll most likely sell it as it approaches that one dollar value. A quality investor that's willing to pay a fair price will pay a dollar for a dollar of value today if they think that business will be worth two, three, four, or even five dollars down the road.
So there's a nice spectrum there. The deep-value folks, they've been super successful. It works. A lot of them have really generated a fortune for themselves over the years. The quality end of the spectrum works, as well. I'd say the deep-value folks focus more on the margin of safety, and the other end of the spectrum focuses more on the size of the moat, or the competitive advantage.
Over time, I've probably shifted, but I'm definitely always looking for value, for sure.
Lewis: To contextualize that spectrum and the differences there within the value investing niche, within the P/E ratio, I think when you're talking about the deep-value, cigar-butt investing, you're looking more at companies that are relative to the market, pretty cheap. Or, relative to competitors, pretty cheap.
Lewis: Whereas, if you're thinking more about quality businesses, these might be businesses that are trading above market P/Es, but the opportunity there is maybe being undervalued by the market in the eyes of the investor.
Rotonti: That's exactly right. If we just take a step back and think about what the price to earnings ratio is ... I think a good way of looking at it is: how many years would it take an investor to break even, or make back their original investment, if earnings remain constant. If you have a stock price of $10 per share, and earnings per share of $1 per share, that's a P/E of 10, and we assume that earnings will remain at $1 per share, so no growth in earnings, then it would take 10 years to break even.
Lewis: And that's not including time value of money and all that other stuff. A simplified version of that line of thinking.
Rotonti: Really simplified version, exactly right. All else being equal, if you can find two companies of equal quality, and with equal growth and margin profiles, a lower P/E would be better. That's the first thing I'll say. The second thing is maybe that, as investors, we can't examine a P/E ratio in a vacuum. It has to be compared to something, whether it's the company's growth rate, whether it's the company's returns on capital, or whether it's to a market multiple, a pure multiple, or the company's own historical multiple. It's relative to something.
And then, I'll say that companies with higher growth, more predictable growth, so, not a lot of cyclicality in the business, and higher returns on equity, tend to trade at higher P/E ratios, just like you said. The flip side of that is companies with slower or deteriorating growth, cyclical earnings -- not a lot of predictability -- and lower returns on equity tend to trade at lower P/Es. Since I tend to follow companies that are not cyclical and have higher returns on equity, most of the companies I'm actually researching, even for a value investor like myself, tend to have either market or above-market P/E ratios. So yeah, that may come as a surprise, but that's where I'm focusing now.
Then, just for reference, the S&P 500, which is typically thought of as a proxy for the stock market, is currently trading at 24 times its last 12 months' earnings, and 18 times forward earnings. Those are two rough benchmarks I'm using when looking at P/E ratios.