“Finding Value Based on Price”
A great company can be a bad investment. A bad company can be a great investment.
Come again?
One thing is the merits of the company as a business, say from the perspective of its customers, or its employees. Another is the merits of the company as an investment. That, my friends, comes down to price.
See there is a price so high, that even the best company becomes a bad investment. There is also a price so low, that even the worst company may become a good investment.
In the 1980s there existed a type of debt called junk bonds. They were literally called JUNK BONDS. Institutions were generally not permitted to buy them by their investment committees because these debt instruments were issued by companies whose ability to repay was in doubt. Who in their right mind would lend money to a company whose ability to repay was in doubt?
There was also debt called fallen angels. These were bonds that started out as investment grade but had now fallen to junk status. Basically, debt issued by companies people thought could pay, but now had their doubts.
Both junk bonds and fallen angels were shunned by a large part of the investment community. Their logic made a lot of sense. These are bad businesses, we doubt their ability to repay, thus we are not going to buy their debt. This led to junk bonds and fallen angels trading at relatively low prices.
Step in Michael Milken. Michael Milken was a 1980’s Wall Street God. He is the epitome of the 1980s trader/money guy etc. Remember Gordon Gecko, he was partly based on Michael Milken. Michael eventually got into some trouble for insider trading and had to go away for a while. But before all that he revolutionized the buyout business by making access to debt easier and promoting the LBO (leveraged buyout). But even before all that, he made a discovery that went against common belief related to junk bonds and fallen angels.
He realized that a basket of junk bonds, over time, paid more than a basket of investment-grade bonds. Even factoring in that some of the companies eventually could not pay and declared bankruptcy, the price of the junk bonds was so low that they were a superior investment to the bonds issued by much healthier, better companies.
Nowadays no one says junk bonds. Now they are called high-yield bonds. Because they pay a higher yield than investment grade and because it is easier to tell your investment committee you are allocating 10% of the portfolio to high-yield bonds than it is to pitch them on something that starts with the word junk.
People like Howard Marks and his firm Oaktree Capital Management focus solely on high-yield bond investing. Finding value in the mispricing of unwanted investments.
This logic, that a bad business can be bought cheaply enough to be a good investment, also forms the original basis of value investing promoted by Ben Graham. What Warren Buffet later called “Cigar Butt Investing” as he likened it to searching the streets for throwaway cigar butts which you can take one or two last puffs off. Finding value in what others have thrown away.