A recent Morningstar article warns value investors not to overlook profitability, citing Warren Buffett’s advice to purchase good businesses at fair prices rather than weak businesses at bargain prices.
“Betting that the market has mispriced a stock is a risky proposition,” the article says, explaining that predicting future cash flows is “wrought with uncertainty because the future is unknowable.” Unexpected circumstances—like a pandemic— “throw a wrench into the cash flow generating machinery of businesses…. a task that has proved difficult for some of the greatest investors to pull off even once in a while, let alone consistently.”
The article cites the example of Buffett’s 1975 purchase of textile manufacturer Waumbec Mills, a business that turned out to be cheap for good reason—it had been operating at a loss in what was a deteriorating industry. The experience taught Buffett the important distinction between buying cheap companies and buying undervalued, strong companies, the article reports.
“There is strong empirical evidence to support the argument or investing in high-quality, profitable businesses,” the article notes, citing research showing that profitable companies not only outperform, but also that “current profitability has proved to be a decent predictor of future profitability.”
The article concludes that while value investing works without considering profitability, incorporating this measure “provides additional information about a firm’s expected cash flows. Combining valuations and profitability better isolates differences in discount rates across stocks, which should provide a better signal about which stocks should perform well in the future.”