As we have discussed numerous times, the best and easiest way to make money in the stock market is to follow the principles of value investing. Removing noise from the market and focusing solely on the economics of a given business allows an investor to form a clear conclusion about the company.
As Warren Buffet once said,
“Buy on the assumption that they could close the market, and not reopen it for five years.”
Read on to see a real life example of value investing.
Close the Market in 2008…
For investors who watched the market collapse into year-end 2008 and were looking for buying opportunities, finding the best value was imperative. Stock prices had sunk to levels previously unseen, and if you could locate companies that were not only cheap, but also had high quality earnings, the payoff could be enormous. This backdrop of the market in 2008 brings us to one of our favorite companies, Western Digital (WDC).
At the end of 2008, Western Digital was trading at $12/share, down 67% from its high of $39 in June 2008. At $12/share Western Digital had a price to economic book value (PEBV) ratio of 0.8. This ratio implied that the market expected Western Digital’s operating profit (NOPAT) to decline by 20% and never recover. However, at that point, Western Digital had a return on invested capital (ROIC) of 48% and had been growing NOPAT by 42% compounded annually for the past five years.
A company with high profitability and in high growth mode that is priced for zero growth going forward is exactly the type of company value investors dream of.
…And Reopen it Five Years Later
Let’s assume you purchased Western Digital at year-end 2008 after realizing the discrepancy between the company’s stock price and the value of its business. As the Buffet quote states above, “close the market for five years.”
How would your investment have performed? At the end of 2013, five years removed from the market crash of 2008, Western Digital was trading at ~$84/share, an almost 700% upside from when you first invested. This appreciation outperformed the 97% gain of the S&P 500.
Re-evaluate Your Position
At the end of 2013, with your position up an incredible 700%, many investors would advise taking profits. However, year-end 2013, WDC still had a PEBV of 1.1. This low PEBV was the result of Western Digital continuing to grow its business as its stock price rose.
If you decided to hold your position even further based on the knowledge that the market had still not realized the true value of the business, your position would be up another 29% since the end of 2013.
Why Value Investing Makes A Portfolio Impressive
The best investments are often the ones you can make and not worry about. As demonstrated by the case of Western Digital, it is possible to find a company with high quality earnings, low market expectations, strong prospects going forward, and close the market in your mind for a few years. If you did your due diligence, you’ll be impressed with your portfolio when you “re-open” the market to evaluate your positions.
At New Constructs, we provide you the tools necessary to find undervalued companies. Simply looking at P/E ratios during the timeline above would have told you that Western Digital had become cheaper relative to its earnings. We dig deeper, calculating PEBV to quantify the market expectations so you know just how undervalued a company is.
Kyle Guske II contributed to this report.
Disclosure: David Trainer and Kyle Guske II receive no compensation to write about any specific stock, style, or theme.