Yes, price really does matter in stock investing

M2 Capital HoldingsIn this series, we’ve asked Covestor managers: “What is the single most important lesson you’ve learned about being a successful investor, and how do you try to apply that today?”

Author: Patrick McFadden, M2 Global

Covestor model: M2 Global

My most important lesson learned is that purchase price should be a primary focus when investing in public companies.  While this statement may seem trite, purchasing stocks at a deep discount to the present value of our projected cash flows is an essential part of investing that’s actually quite often overlooked.

As important, buying stocks when they are under-priced against a strong fair value assessment can provide investors the peace of mind to remain invested through market cycles. This applies not only to value stocks, but also to growth stocks.

Many market participants speculate on price momentum without much regard to price justification.  We believe this to be a generally dangerous strategy, particularly so in the current (2Q11) precarious macro economic environment, which leaves the market subject to violent momentum swings.

Performing reliable discounted cash flow models requires time and good economic information.  The approach also requires real knowledge about a company and its business.  In many cases we follow a company for years, if not decades.

A great challenge to determining fair prices for stocks is model duration.  We live in a world in which 3-5 years can be greater than a business cycle and company prospects can change due to secular and macro developments over this time period.

Global fiscal and monetary response has transferred leverage and reduced flexibility such that global markets may remain volatile and highly correlated for an extended period.  Clearly, the Federal Reserve has been the keystone player in capital markets since late 2008.  How the Federal Reserve redefines this position, and more importantly the time frame in which they choose to due so, cannot be ignored when building future expectations.

In this environment, we continue to look for contrarian equity investments with compelling price versus our determination of fair value.  We are also looking at combinations of higher yielding dividend paying equities with an aim of providing some price protection while paying out income.