Buying a dollar for 50 cents

“This blog talks about how to buy a stock at a discount, its benefits and a case study of my investment in Meta in 2022.“

In my last post, I talked about the early mistakes I made in my investing journey; Overpaying for a company and how it reduced the investment returns even after company performed really well (here).

In this post, I want to take a 360 and talk about the supreme benefits of doing the exact opposite; “buying a dollar for 50 cents” i.e. buying a company at at least 50% discount to its intrinsic value. I will discuss what, why and how. And I will also share the outcome of one of my current investments that I bought at greater than 50% discount to its intrinsic value (META).

“Buying a dollar for 50 cents” Concept:

The idea here is simple. Deep-dive into a business and if it satisfies the quality, longevity and growth criteria (I have talked about these criteria in a book review : here), evaluate the intrinsic value of the business. And then buy the business/stock, only if the current price is at a 50% discount to the intrinsic value.

Why to buy it a discount?

To analyze this, lets consider two scenarios:

1. You are wrong about the business:
In case your the analysis of your business and therefore the intrinsic value proves to be incorrect or business never converges to its intrinsic value, buying at a 50% discount will provide a big margin of safety and protect you from losing your principal capital.

BTW, this happens a lot. Even the greatest investors of all time have a failure rate of 50-60% in stock selection. But practicing “Buying at a discount” saves them losing capital and allow them to move to the next investment.

2. You are right about the business:
If you are right about the business and the business should indeed be valued near your intrinsic value, you get a double bonus. You will earn returns from convergence of stock price to its intrinsic value and increase in stock price due to companies growth.

What will be you returns if you are right?

Well, it depends on many factors, but lets consider the ideal situation. Lets assume that you were able to buy a company that has a intrinsic value of $100, current stock price of $50 and the valuation is expected to grow at 10% for the next 5 years. You will make a 100% return just from the price convergence to its intrinsic value and additional 10% per year for the next 5 years from valuation expansion due to time value of money. So the stock that you bought for 50 would reach around ~161. And that would mean a 200% returns in 5 years even if the company grew by 61% .

(Note: This will be positively affected by contraction and negatively affected by dilution of the outstanding number of stocks)

How it will affect your portfolio?

If you follow the practice of buying at 50% discount to intrinsic value and used the 10% discount rate in your intrinsic value calculation, here is how your portfolio will perform:

At 60% accuracy: Portfolio will be up by 133% in 5 years. Annualized return of 18.4 %
At 50% accuracy: Portfolio will be up by 111% in 5 years. Annualized returns of 16.1%
At 40% accuracy: Portfolio will be up by 88% in 5 years. Annualized returns of 13.5%
At 30% accuracy: Portfolio will be up by 66% in 5 years. Annualized returns of 10.75%

What this shows is even if you hit an accuracy rate of just 30%, your returns will still slightly beat S&P500 returns of ~9.9%

NOTE: I calculated the above returns considering that the failed stocks will provide 0% returns over the 5 years but protect principal capital due to margin of safety. So in case the failed stocks provide some positive returns, the portfolio returns will be even better.

Case study of Meta (Facebook):

This was one of the first stocks where I applied this concept. In 2021, Meta had a 5 year ROE of 25+, profit margin of 25%, Cash reserves of ~$80B. Considering 15% EPS growth for the next 5 years, my intrinsic valuation for the company was around ~$340. So my goal was stock up on Meta if it goes below $170 dollars a stock.

And I had to wait until Mr. Market provided the sudden opportunity, in Aug-Nov of 2022, to buy Meta at as low as 75% discount to its intrinsic value. And even though, I couldn’t get the best deal , I was able to stack up on Meta at around 60% discount to its intrinsic vale; At the average price of $135.

And over the last year Meta stock as converged back to its intrinsic value of over ~$340; Thereby providing a return of ~151%. However, now since it is already around its intrinsic value, I expect Meta to grow at around 10-12% over the next 3-4 years.

Learnings:

– This strategy not only improved the odds of better returns but also improve of the odds of not losing the principal capital. And that in my opinion is the most important thing.

– Being patient is difficult but needed. For this approach to work, one needs to be patient not only for the price to come down to provide a healthy discount but also requires patience for allowing the stock price to converge to its intrinsic value.

– Even though this approach is applied on individual investments, the outcome of this method should be judged at a portfolio level.

– It also requires in-depth understanding of the company and also requires reasonable understanding of how to value a company. So this approach might fail, if the company you are studying is outside your circle of competence.

This approach towards market is difficult, complicated and hard to implement. Therefore, not many are able to implement this approach for long. So it provides a huge competitive edge to the selected few who stay put.

Disclaimer: I still hold position in Meta but this is clearly not a recommendation. Please do your own due diligence.