Stock Selection: The Importance of Opportunity Cost

Friday, Apr 27 2012 by
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Stock Selection The Importance of Opportunity Cost

Warren Buffett and Charlie Munger's annual sessions at the Berkshire Hathaway AGM are, of course, legendary. It's because they are so filled with pearls of investment wisdom that such hordes make the trek to Omaha each year. One idea that stands out amongst the many is their emphasis of using opportunity cost as a filter. As Munger observes in Poor Charlie's Almanack"Intelligent people make decisions based on opportunity costs - in other words, it's your alternatives that matter". 

When Opportunity Knocks

The central idea is that the real cost of any purchase you make isn’t the actual dollar/pound cost. Rather, it’s the opportunity cost — the value of the investment you didn’t make, because you used your funds to buy something else. To illustrate this, in the 1998 Shareholder Meeting, Buffett explained that, the first question he & Munger ask themselves when looking at a potential investment is: 

"Would we rather own this business than buying more Coca-Cola or more Gillette?". 

Buffett calls businesses like Coca-Cola and Gillette the Inevitables because, not only do they have superior economics and growth prospects far into the future, but also their prospects are highly certain - if you do your homework, you can develop rational conviction about their future. "No sensible observer.. questions that Coke and Gillette will dominate their fields worldwide for an investment lifetime". 

Because you have the opportunity to purchase these kinds of investments, they argue that you can use this as a filter to automatically eliminate the other 98%. We should want companies which get as close to perfection as possible, or we should figure we'd be better off buying more Coke. Buffet notes that, if every management, before they bought a business, said - "is this better than buying in our own stock or even buying Coca-Cola stock?", there'd be a lot less unsound deals done.  

Introducing the fastest way to compare stocks on the Web....

It is with exactly that kind of thinking in mind that we're now released our new Stock Comparison Tool. Too often, it seems that investors get caught up by a stock idea they may have stumbled upon, without taking the time to examine the opportunity cost of that investment, versus others that may be available in the market.

Struggling to decide if one company is a better…

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Disclaimer:  

As per our Terms of Use, Stockopedia is a financial news & data site, discussion forum and content aggregator. Our site should be used for educational & informational purposes only. We do not provide investment advice, recommendations or views as to whether an investment or strategy is suited to the investment needs of a specific individual. You should make your own decisions and seek independent professional advice before doing so. Remember: Shares can go down as well as up. Past performance is not a guide to future performance & investors may not get back the amount invested. ?>


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7 Comments on this Article show/hide all

marben100 27th Apr '12 1 of 7
6

I'd very much like to endorse Stockopedia's comparison tool, which I have only recently stumbled across.

This approach goes back to well before Buffett & Munger, with excellent examples of the technique in Graham's "Intelligent Investor". I completely agree with Ed's comment that:

Too often, it seems that investors get caught up by a stock idea they may have stumbled upon, without taking the time to examine the opportunity cost of that investment, versus others that may be available in the market.

This has very much been a (bad) feature of my own investing approach. I find that I am constantly bombarded with investment ideas - and many thanks to those offering those ideas! Few of them pass my investment filters - but sometimes that's just because I don't find time to do the necessary analysis.

What I have to hold my hand up to not doing thoroughly enough is sector comparisons. Am I investing in the best company of its type? Without good tools that's very hard & time consuming work.

In the niche software sector, I have been (and am) a long-time investor in Brady (LON:BRY) , Europe's leading supplier of commodity trading software . Roger Lawson recently reported on the AGM of EMIS (LON:EMIS) , a supplier of systems for UK GPs (ShareSoc members can read Roger's AGM report here). So, having recently discovered S'pedia's comparison tool, thought I'd do a side-by-side comparison of Brady and EMIS. See for yourself!

It's great having all the key quantitative factors side-by-side. From the figures, my conclusion is that EMIS looks like a safer, more "boring" investment, with modest growth, whereas Brady is more of a GARP play. Of course, boring is good, but I have considerable confidence in Brady's sector and management. The latter have done an excellent job of growing the business profitably since they were installed in 2007.

I also note that when you retrieve the stock report for a company, it lists comparable companies.. So, why not run the comparison to see whether there might be a better opportunity in the sector? Now that it can be done so easily, I'll certainly be doing so in the future. Might unearth some less well-publicised gems. ;0)

Just one final caution, however, whilst the tools are invaluable, I do feel that you have to dig a bit deeper before investing hard-cash. How sound are the forecasts you're relying on to arrive at ratios? Are the figures distorted by adjustments or non-obvious factors that make them appear better or worse than they really are? What is the newsflow saying?

Cheers,

Mark

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Isaac 27th Apr '12 2 of 7
1

We welcome any feedback!

The purpose of this article is to sell Stockopedia's tool. OK. - To serve that purpose I think the most important aspect is the screenshot.

However what I find disappointing is the screenshot is tiny, compared to the rest of the text  and therefore making it more difficult to read. I would have thought this should be bigger if anything so it stuck out like a sore thumb.

To improve the tool futher I would indicate the total number of ticks each company has, e.g.Shell has 9 compared to BP's 6 so instantly Investors know from a mechanical perspective which company looks better.

I would go one step further and put a weighting on the relevance of each criteria, e.g. a growth in Shell's earning compared to BP is probably more valuable then Shell having a larger market cap compared to BP.

 

If you want more readers to take up the tool then speak to Robbie Burns, Invite him to use your tool for his investment screening, ask him for feedback. If you can get him to endorse it then offer his readers a discounted price to take up the screener in return for him advertising it on his website.

He has a strong following so with his endorsements it should be easier to sell.

And finally once you have a larger uptake reduce the costs which in turn will feed on itself and encourage more readers to take up the service as more and more people endorse it.

Cost of data = Fixed so more users = lower subscription costs which in turn means more users etc.

 

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Isaac 27th Apr '12 3 of 7
1

I love Shell btw, I think it could go to £30 at somepoint IMO.

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Dave Brickell 27th Apr '12 4 of 7
3

Hi Isaac, you can see the full set of comparative data for those three companies on the Compare page itself (Toolbox -> Compare Stocks from the menu):

http://www.stockopedia.com/compare/

Other companies are locked out, though, as it's part of our data contract that we can only display the info to paying subscribers. What we can offer is "tasters" like this but we do also offer a two-week no obligation trial that can be cancelled at any time, so it's pretty frictionless to check out the tools, screens & data-set if you're so inclined.

Thanks for the other comments - all noted.

Cheers,

Dave

Website: Stockopedia PRO
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Mid Herts 28th Apr '12 5 of 7
2

I think you have chosen a very odd group of companies to compare. BP and Shell are quite similar but Tullow is entirely different. It is much smaller and at a totally different stage of development. The rationale for investing in Tullow is that it has recently discovered and only barely started to develop very large new fields in relation to its size. Of course it may now be that this is fully reflected in the price you have to pay for the shares. However, I suggest that you could have run a similar screen at any time over the last six years or so that I have owned Tullow and at a quick glance just discarded it. Result Tullow share price up 7 times; BP and Shell barely changed. I know you will say that screens are only a starting point but it does not help if you are starting from the wrong place.

I suppose screens are quite helpful in comparing the kind of large established company with good moats that you mention at the start of this article. (But they are not immune from discontinuities...) However, star investments sometimes come from the exploitation of new ideas (plenty of failures too I admit). Consider Apple, Microsoft etc.

Investing is difficult isn't it.

MH

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Edward Croft 28th Apr '12 6 of 7
1

In reply to post #65594

Isaac - the compare tool isn't really designed as a screener - its just a quick way to test the vital statistics of few stocks at the same time - I've thought about adding a score on that page, but it doesn't make sense there as its not designed to show outright which stock is best.

The checklist tool is the one that's more flexible for zeroing in on a single stock against specific strategies - e.g. check out Shell vs. Naked Trader criteria here... have unlocked the page for you today. http://www.stockopedia.com/checklists/naked-trader-esque-screen-164/?ticker=RDSA&auth=32fcfa7a57ddac6bf66f0df3cf3903f8

There's certainly an argument for creating a mashup of those two tools though. i.e. comparing different companies against a different screen's criteria at the same time. Will have a think.

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snickers 3rd May '12 7 of 7
2

ok here's my mashup of your comparison tool, a universe of companies.. tech-manufacturing sector. right and down are good, and bright and colourful are good. it's a attempt to get 5 or 6 dimensions, debt, quality, red flags, value, growth, into a 2d graph..


xpp are a good firm.. oxig are quality.. sprp i want to know more about - they appeard at a Mello Monday i think. i've never attended one, but.. if anyone wrote it up it's not on the website.. pfl are not so shiny if i recall.

..i'm yet to take the plunge on the strength of this code. too much information and relativism, even if it isn't shot through with math errors. so i'm slightly drawn to terry smith's methodology: "do they make toothpaste?".. but then where's the interest? i want Romance in my investments.

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