Why it’s far better to buy a wonderful company at a fair price than a fair company at a wonderful price

In Warren Buffett’s 2024 annual letter to shareholders, he called his partner Charlie Munger (who died last November at the age of 99) the “architect” of the present-day Berkshire Hathaway. This is because in 1965, Charlie Munger advised Buffett to stop buying companies just because they are cheap, but instead focus on buying wonderful businesses at fair prices. This advice transformed Berkshire Hathaway into the world-renowned $870-billion company that it is today.

Like Warren Buffett during his early days, a lot of value investors simply focus on buying the cheapest stocks available. After all, cheap stocks provide a significant margin of error and huge capital appreciation potential. However, there are also risks associated with buying very cheap stocks.

Most of the time, there are valid reasons why a stock is cheap. The most common reason is poor earnings growth outlook—either because the company belongs to a bad industry or because it has a lousy product or service. This immediately turns off a lot of investors, which is why stock price is depressed. However, the fact that nobody wants the stock makes it more difficult for its share price to go up.

Cheap companies could also be run by a poor management team. Unless the management team changes, the company might have a difficult time turning around and likewise for its stock to rebound.

Admittedly, there are cheap companies that generate a lot of free cash flow. There are also cheap companies owning assets that are worth much more than their market capitalization. However, unlocking shareholder value might be difficult. Sometimes, the principals of these companies refuse to sell their assets and/or pay cash dividends. Hostile takeovers might also not be possible given the shareholder structure of such companies. Because of this, investors who buy them for cheap valuation get stuck with value traps.

In contrast, good companies have qualities that allow them to sustain their earnings growth over the long term. These could include strong branding, loyal customer base, wide distribution network, low-cost operations and strong management team. These qualities provide good companies with a solid competitive advantage over time. Consequently, even though it might not be possible to buy good companies at a significant discount, investors still make a lot of money since the continuous profit growth allows the share prices of these companies to go up over time.

For example, in 2016, Warren Buffett started buying shares of Apple. At that time, Apple wasn’t very cheap as it was trading at an average price to earnings (P/E) ratio of 11.4 times. However, Apple’s share price continued to go up as profits grew from $45 billion in 2016 to around $97 billion last year. Today, the stock is trading at $170 per share, providing investors who bought Apple in 2016 a compounded annual return of around 26 percent.

Given my years of experience as an analyst, I share Carlie Munger’s view that it’s far better to buy a wonderful company at a fair price than a fair company at a wonderful price. This is the reason why even though almost all Philippine stocks are currently trading at very cheap valuations, we recommend focusing on reasonably priced larger capitalized stocks with good fundamentals that pay cash dividends. Although the price of other stocks could go up more significantly, the risk of getting stuck with a cheap stock that stays cheap is also high. In contrast, buying wonderful companies at a fair price reduces the risk of getting stuck with a losing position for a very long time. INQ