The classic investing advice is to “buy low and sell high”. The objective of investing in “Close the Discount” ideas is to buy a stock when it is trading at a substantial discount to a conservative estimate of its intrinsic value and then sell the holding when it approaches this fair value (buy a dollar of value for 50 cents and then selling it later for a dollar). The faster the discount is closed, the greater the compounded performance.
Often, these businesses are operating in cyclical industries and may have mediocre competitive positions or management teams. They therefore “bob around” in the market. Nevertheless, good returns are still possible with such stocks and investors need to be opportunistic and have a relatively active trading strategy.
The future is unknowable, so an assessment of intrinsic value typically results in a range of estimated future cash flows and/or potential asset values. Investors should only buy a Close the Discount idea if the stock appears to be an undeniable bargain based on a conservative assessment of observable facts. This discount to fair value represents the “margin of safety” and makes allowances for potential bad luck or a change to the facts in the investment thesis. We rely on potential catalysts or the market forces of reversion to the mean to drive the stock back to its fair value and generate a decent return.
We will consider buying any asset, if it is cheap enough, on the premise that “reversion to the mean” is one of the most reliable forces in capitalism. For example, we don’t generally own resource-related equities, but we’re always willing to be opportunistic, regardless of sector, if we feel the odds are stacked heavily in our favour. When it comes to choosing between “compounder” and “close the discount” ideas, we are generally agnostic. If someone is willing to sell us a $10 bill for $5 bucks, we won’t complain that the $10 has no “moat”. However, it is important to keep in mind that “compounders” do have an important advantage in taxable accounts as explained here.
(Also see Compounders)