Commonwealth Trust. Co.

Commonwealth Trust Co. was a small bank in Union City, New Jersey. Buffett liked that it was “well managed” and had strong earnings power. When Buffett started to purchase the stock, it was selling for $50 per share and was worth $125 per share based on his conservative calculation of its intrinsic value. The stock was earning $10 per share and did not pay a dividend.

Buffett judged that there was very little risk that he would lose his capital. Buffett took seriously the real risk of permanently losing his capital when investing in a stock and, given his temperament, we can easily imagine him taking a pass on Commonwealth if he thought this risk existed.

Buffett liked that the intrinsic value of the company was increasing. If he had to wait for the stock to appreciate, he would get paid to do so. Buffett did not attempt to predict how long it would take to realize the value, saying it could be anywhere from one year to ten years, but that the intrinsic value might rise to as high as $250 per share which would compensate him for the risk. Contrast this to a situation where it might take years for an undervaluation to be corrected but in the meantime the intrinsic value of the company is in decline. For example, this could happen in an industry that looks cheap but is in secular decline.

Buffett often looked for ways to hedge his bets – situations where he could make a mistake on his analysis and still come out OK. He liked that there was some evidence that Commonwealth’s value could be unlocked through a merger. A larger bank owned 25 1/2% of commonwealth and had shown prior interest in acquiring Commonwealth but the merger did not happen. Buffett thought this situation might change.

Buffett also used the Commonwealth example to teach that it is very useful for a stock’s price to stay depressed until a satisfactory position can be built in the stock.

Buffett was paying five times after tax earnings for a business that was expected to grow as much as 7% per year. This gave him a 20% return from the start with a growing earnings yield. I bold this so it cements in your mind the types of situations you should be looking for. It may not happen often, but it is hard to miss if you can purchase a high-quality growing business at an earnings yield of 20%.

Buffett noted that some other purchasers of the stock pushed the price up to $65. At that price, Buffett was not interested in purchasing additional shares or in selling his position. This shows Buffett’s discipline. At $65 per share, Commonwealth was still almost 50% undervalued, yet Buffett was not interested in purchasing more. On the other hand, he was not interested in selling because the security was still materially undervalued.

One additional take away from the Commonwealth case study is the advantage a small investor has over a large institution in establishing a position in an undervalued security, particularly if it is small or illiquid. A small investor can often establish a full position on a down day where there is extreme pessimism in the market such as happened in March 2009.

Takeaways:

  1. Carefully consider the risk of losing your capital when analyzing a stock.
  2. Look for situations where the intrinsic value is increasing. That way, if you have to wait, you’ll be compensated for doing so.
  3. Quantify what you’re willing to pay for a stock and don’t deviate when it goes above your target price.
  4. Learn to calculate your expected rate of return and set a minimum target for yourself, i.e. 15%. Don’t purchase stocks where the mathematical expectancy of their return is below your target.
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