You May Have Been Looking At the Wrong Places for Investing Opportunities All These While

An interesting thought occurred to me about an hour ago which led to what you’re reading now.

Roughly a month ago on 23 March 2015, I heard someone ask a group of serious investors for their thoughts on commodities trader Noble Group Limited (SGX: N21) after he noticed that the firm’s share price had fallen sharply.

At that time, Noble’s shares were reeling after Iceberg Research, a little-known research outfit, had released a series of scathing reports criticizing the company’s business; from 15 February 2015 (the day Iceberg Research released the first of its three reports) to 23 March 2015, Noble’s shares had lost some 24% of their value.

I did not pay much attention to the question when I first heard it, but the context in which it was asked finally struck a note in my mind earlier today.

Noble had been a business with seriously deteriorating business fundamentals over the past decade even before Iceberg Research had publicly thumbed-down its business. But, the person who asked the question above (let’s call him the questioner) had likely been interested in it because its share price had gone down sharply over a short span of time.

This approach to looking for bargains – sifting through the rubble of shares with falling stock prices to find investing opportunities – is certainly valid. After all, like the investing legend Sir John Templeton once said, “The time of maximum pessimism is the best time to buy.”

But, that approach, for me at least, can be sub-optimal. Here’s why.

From a simple valuation perspective using the price-to-earnings (PE) ratio, Vicom Limited (SGX: V01) was nearly twice as expensive as Noble back then on 23 March 2015. But, the former had vastly better business fundamentals.

Noble and Vicom's valuation

Source: S&P Capital IQ

For instance, whereas Vicom had managed to generate consistent growth in profit and free cash flow over the past decade, Noble couldn’t. In fact, the latter’s track record in this matter had been all over the place. You can see these in the two charts immediately below:

Vicom and Noble Group's Earnings Per Share (EPS) Growth from 2004 to 2014 Vicom and Noble Group's Free Cash Flow (FCF) Growth from 2004 to 2014

Source: S&P Capital IQ

That’s not all. Vicom had generated a great annual return on equity of at least 16% between 2004 and 2014 while carrying a rock-solid balance sheet that has had zero borrowings for the most part. Meanwhile, Noble’s returns on equity have been shrinking over the same time period to single-digit-percentages even as its borrowings have grown. The two charts immediately below plots these out:

Vicom's returns on equity (ROE) and balance sheet figures from 2004 to 2014 Noble's returns on equity (ROE) and balance sheet figures from 2004 to 2014

Source: S&P Capital IQ

If you’re a long-term investor (and I’d argue that most people who buy stocks should be long-term investors), the quality of a business matters tremendously. Here’s how investing maestro Charlie Munger puts it:

“Over the long term, it’s hard for a stock to earn a much better return than the business which underlies it earns. If the business earns 6% on capital over 40 years and you hold it for that 40 years, you’re not going to make much different than a 6% return—even if you originally buy it at a huge discount. Conversely, if a business earns 18% on capital over 20 or 30 years, even if you pay an expensive looking price, you’ll end up with a fine result.”

So, given what Munger has said, if I were the questioner, I’d gladly spend way more time poring through Vicom than I’d do with Noble – simply because the former has had much better business fundamentals. That’s true even when Vicom was more expensive than Noble (using the simple PE ratio yard-stick) back then on 23 March 2015.

If you’ve been spending plenty of time sifting through the rubble of falling stock prices, do note that you may have been looking at the wrong places for investing opportunities. A great investment can stem from a share having a quality business – and that’s true even if the share may not look cheap and would never be among the rubble.

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The information provided is for general information purposes only and is not intended to be personalised investment or financial advice. Motley Fool Singapore writer Chong Ser Jing owns shares in Vicom.