Warren Buffett became the greatest investor of his generation by following a relatively simple philosophy: buying great companies at good prices.
A look at Berkshire Hathaway Inc. (NYSE:BRK/B)‘s stock performance since 1990 clearly demonstrates Buffett’s success.
That said, it’s harder than ever to find great companies at good prices today. The proliferation of information has made it easier to spot companies that have a durable competitive advantage of some sort, which tends to drive up their stock prices. For example, while I like Amazon.com’s business, the company trades for more than 70 times forward earnings, far more than I’d be willing to pay. Furthermore, Buffett has a big advantage over ordinary investors today. His past success opens up opportunities not available to the general public, such as access to preferred stock deals and private transactions.
Dumpster diving for stocks!
The difficulty of finding great companies at good prices can be discouraging for everyday investors. As a result, I often like to go dumpster-diving for stocks! While great companies are worth more than good companies, mediocre companies, and downright “bad” companies, every company has a value that’s usually not zero (though there are exceptions!). If you can find an adequate margin of safety, you may be able to generate strong returns from owning not-so-strong companies. Don’t believe me? Take a look at this stock chart:
The above chart tracks the performance of four companies — Best Buy Co., Inc. (NYSE:BBY), Research In Motion Ltd (NASDAQ:BBRY), Dell Inc. (NASDAQ:DELL), and Hewlett-Packard Company (NYSE:HPQ) — vs. the S&P 500 since last November. Whereas the S&P 500 has gained nearly 10%, each of these four companies is up more than 50% in less than six months!
You can rest assured that Warren Buffett would not touch any of these stocks, and not just because he does not like to invest in the tech sector. Best Buy Co., Inc. (NYSE:BBY) has experienced stagnant sales and falling earnings for the past year or so, due to heavy competition from Amazon. Dell and HP have each seen their PC businesses cannibalized by Apple Inc. (NASDAQ:AAPL)’s iPad and other tablets. According to a recent Dell proxy filing, a Boston Consulting Group study concluded that Dell is likely to see a $10 billion drop in PC revenue over the next four years. Hewlett-Packard Company (NYSE:HPQ) has also seen disappointing results from most of its other business lines recently, and has experienced significant leadership turnover. Research In Motion was also a victim of Apple Inc. (NASDAQ:AAPL)’s rise, as it went from being the smartphone king to an also-ran in just a few short years. While shares have more than doubled since September, it is nevertheless true that, in two short years, the stock has dropped from $55 to $15.
The big idea
Out of favor “dumpster” stocks can be great investing opportunities, because Wall Street tends to turn against these companies all at once. When problems first surface, analysts are often slow to recognize the severity of the threat. Once it becomes obvious that a company like HP or Best Buy Co., Inc. (NYSE:BBY) is experiencing a significant decline in profitability, analysts rush to cut their ratings and price targets. The result is typically a steep fall in the stock price, which can lead analysts to cut their price targets yet again.
By the end of this process, the stocks have been beaten down so much that value investors can frequently find very good bargains. At their lows last November, Best Buy Co., Inc. (NYSE:BBY), Dell Inc. (NASDAQ:DELL), and Hewlett-Packard Company (NYSE:HPQ) were all trading for three-to-five times earnings. These prices implied that — for all the problems these companies already faced — investors expected the future to be much worse. For the stocks to rally, the companies merely needed to demonstrate that they were starting to stabilize their businesses.
It should go without saying that a “dumpster-diving’ strategy wouldn’t work for companies that are actually headed for bankruptcy. However, HP, Dell, and Best Buy remained profitable in spite of their difficulties. In my analyses of HP and Best Buy Co., Inc. (NYSE:BBY) last November (I wasn’t actively covering Dell Inc. (NASDAQ:DELL) at the time), I found that both companies were trading for well below their long-term valuations.