To illustrate this point, assume a very wealthy businessman offers to sell you an apartment building in the best part of town. The building is in excellent condition, situated on very valuable real estate, and has historically earned $1,000,000 per year. You are obviously excited by the chance to purchase a high quality asset with a very profitable operating history. The businessman informs you that he is going to sell the property to the first bidder willing to pay $30 million or higher.
A few moments later, a local carpenter enters your office and tells you he and his family are moving out of state and want to sell a smaller, medium quality building in an average part of town. After expressing interest, the carpenter tells you the building is in fair condition and brings documents showing that it has earned an average of $175,000 per year. He tells you that he would be willing to sell for $2,000,000. He thanks you for your time and leaves.
Assuming money was not an issue and you had the financial ability to purchase both of the buildings, what would you do? The average investor would probably opt for the high quality building earning one million per year. It is clear, however, that the average building is available on much more attractive terms. The high quality building is going to earn 3.33% on invested capital of $30 million in the first year compared with 8.75% on $2 million invested capital in the average building. An investor inclined to invest in the high quality building would be wiser to purchase a certificate of deposit in a bank earning 4% a year. Not only would he earn a higher rate on his money, but he would avoid the burden of owning a fixed asset, keeping his money relatively liquid in event another investing opportunity arises.
These same facts hold true in the world of stocks and bonds. Excellent businesses such as Coca-Cola, Microsoft, and Gillette are clearly more valuable than most other corporations. In fact, it would be better to pay a fair price for these companies rather than a low price for an average company with average management. However, when shares of these businesses become grossly overpriced, as has happened from time to time in the market, it is lunacy to purchase them. Patience is a virtue; it also happens to be a very financially rewarding.
