Realization-of-value problem

What kind of business do you want to own? Investors out there know that identifying what to invest in is a mind-challenging event. There is no better reward than seeing our money appreciate based on our own decisions and conviction. We are taught by the grandmasters (Buffett, Fisher) that one should only invest in businesses that have superior economics and selling for the right price. But what is a desirable purchase?

There is no business that is perpetually bad. Stock prices do not go down forever. With that in mind, most businesses were possible candidates for investment as long as they are selling at a bargain price. Through calculations, one could find out the intrinsic value of any business and if their stock price falls below that value, we should buy it to add into our portfolio. In this way, we wouldn’t be too concerned with the nature of the business we are buying. Simple isn’t it. A portfolio of such stocks can be built up based on the belief that someday the price will rise to or above the stock’s intrinsic value.

However, investors with this investment strategy will face the realization-of-value problem. In short, what do you do if the stocks you bought continue to sell below their intrinsic value for many years? The magnitude of returns depends on time. If the realization of value doesn’t occur, every year that one waits, the projected annual compounding rate of return diminishes. And if it takes longer than a few years, one could even end up with an annual compounding rate that may be less than what one could get from bonds or other financial instruments.

In reality, many companies were incapable of being analysed and their intrinsic value could not be determined. Quantitative reasoning, though reflective of the quantitative side of a business, does not fully articulate what is happening in the business. Stable earnings may allow one to place an intrinsic value on a business, but they will not always indicate the nature of the business’s underlying economics.

One solution to this problem would be to identify a near term catalyst which will move the stock price up north, and to insist on a bigger margin of safety before the purchase.