We recently sat down with a group of individual investors to talk about Crocs (Nasdaq: CROX). The stock has been on our watch list, and with its recent precipitous drops, it is now trading not only well off its highs but also below its IPO price in February 2006.
There things to like about Crocs, such as its strong balance sheet, patented croslite material, rapid sales growth, and diversifying product line. But there are also things not to like about it, including ballooning inventories and accounts receivables, insiders cashing out, and serious fad potential.
So our conversation about the company's suitability as an investment quickly devolved into a debate about the aesthetics of the company's core clog:
"It's ugly."
"No, it's not."
"Yes, it is."
"No, it's not."
You get the point.
Deep breaths
But look: An investment's potential depends on only two things ...
- The quality of the company you're buying.
- The price you're paying for it.
Now, the quality of a company's product is certainly part of determining the quality of the company, but it won't make or break an investment thesis. If you focus on the product because that's what you know, then you know just enough to be dangerous.
Peter Lynch is often reduced to his "buy what you know" maxim, but Lynch himself was adamant that "liking a store, a product, or a restaurant is a good reason to get interested in a company ... but it's not enough of a reason to own the stock!"
Take Anheuser-Busch (NYSE: BUD), for example. We -- like many amateur alcohol connoisseurs -- don't hold its products in the highest regard. But even though Budweiser isn't a very good beer, that hasn't stopped Anheuser-Busch from being an absolute powerhouse of an investment over the years.
With a superior distribution system, economies of scale, and a variety of brands that generate gobs of free cash flow, Anheuser-Busch has returned 12% annually over the trailing two decades -- enough to turn a $5,000 initial investment into nearly $50,000 today.
Contrast that experience with what you would have gotten investing in Ford (NYSE: F) in 1988 -- which back then made the totally awesome Thunderbird. A $5,000 investment there would have trailed the market and returned just 3.1% annually.
Had you decided that General Motors' (NYSE: GM) Corvette was the cooler product, you would have done even worse. You would have earned just 2.4% annually over the trailing two decades.
More where that came from
And let's be clear: These situations are not unique.
Sirius Satellite Radio (Nasdaq: SIRI) -- a company with a fantastic product, by all accounts -- has absolutely incinerated investor capital over the past 10 years. You'd also have been sunk by Saks (NYSE: SKS), which offers an unrivaled high-end shopping experience. And even Callaway Golf (NYSE: ELY), whose Big Bertha drivers were the best on the market for quite a while, would have been among the worst investments you could have made.
These companies all offered superior products, but they failed as investments because they faced onerous debt loads, an inability to make money, and loads of competition.
The things to remember
Again, when it comes to investing, two things matter:
- The quality of the company you're buying.
- The price you're paying for it.
Now, these two points open up a ton of other questions, like the obvious ones: "How do you define quality?" And "What's a good price?"
"Quality" is equal parts subjective and objective -- subjective because you'll want to understand a company, its products, and its relationship with employees, customers, and competitors, and as for the objective measures of "quality," take a cue from master money manager Ron Muhlenkamp. He looks for returns on equity (ROE) above 14% and accelerating sales growth relative to a company's peer group.
A good company is easier to find than a good price is. As Muhlenkamp has said, "We always want to own good companies, but we believe you can turn a good company into a bad investment if you pay too much for it." One quick measure that Muhlenkamp looks for is a price-to-earnings ratio below ROE.
Come on down ...
A recent study of wine drinkers found that when they drink cheap wine that they're told is expensive, they like it more than expensive wine that they're told is cheap.
In the markets, this happens all the time. Investors are lured to buy a "cheap" stock simply because the price has fallen ... even though, as we preach and practice at our Motley Fool Inside Value service, price and value are independent of one another.
In fact, once we drill down on a quality company at Inside Value, we spend all of our time obsessing over a good price. We demand a hefty margin of safety, so that even if we're wrong, we've still minimized the downside risk. This way, we position ourselves to profit for the long term by buying quality at good prices.
That tack has happily put Anheuser-Busch in our portfolio, even as we continue to drink and recommend Fat Tire Amber Ale, Lagunitas Pils, Bluegrass Bourbon Barrel Stout, and many other beers long before we'd touch a Budweiser.
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Neither Tim Hanson nor Brian Richards owns shares of any company mentioned. Anheuser-Busch is a Motley Fool Inside Value recommendation. The Fool's disclosure policy is happy to accept free samples from any brewery wishing to be included in this article, though not kegs ... since we can't accept gifts valued at more than $25.
