Bill Ackman Thinks This Factor Is Even More Important Than Valuation For Long-Term Investments

Bill Ackman has built a portfolio of stocks that he believes currently trade at very compelling valuations. The head of Pershing Square (NYSE: PS) has built a strong track record as a long-term buy-and-hold value investor. But some of his top holdings today wouldn't be considered value stocks by most.

For the most part, the stocks in the portfolio have valuations around the S&P 500 average, or in some cases, much higher. That's because valuation isn't the most important factor for generating long-term returns, Ackman explained in his recent letter to shareholders. While valuation should always be a consideration, strong and sustainable earnings-per-share growth is even more important, Ackman says.

He explains his thesis with simple math, and while it opens the universe of so-called "value stocks," it follows the same ethos as the father of value investing, Ben Graham, and Graham's most well-know pupil, Warren Buffett.

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The factor that matters even more than valuation

Ben Graham is quoted as saying that in the short-run the stock market is a voting machine; in the long run, it's a weighing machine.

The earnings multiple the market assigns to a stock is emblematic of how many market participants are "voting" for it. In the short run, the number of "votes" a stock receives can significantly impact its price. Ackman points out that a company could grow its earnings 5% quarter over quarter (a 20% annualized rate), but if the earnings multiple is compressed by 10%, the stock price will drop 5.5%.

Over the long run, however, strong earnings growth will overcome contractions in earnings multiples. Even if the stock market pushes a stock's earnings multiple down by 50% over a decade, if the company grows its earnings at a 20% compound annual growth rate over that period, the stock will return roughly 12% per year.

Ackman explains that Pershing Square's primary focus is on companies that can grow earnings at a high rate over the long run. "We have chosen to invest in businesses that have relatively high rates of EPS growth because, for among other reasons, the longer the investment horizon, the more our returns will be driven by the company's EPS growth, and the less they will be affected by the potential change in the multiple that investors assign to those earnings," he wrote in his letter to shareholders.

On the other hand, focusing exclusively on undervalued businesses won't provide the same long-term returns. Once the market corrects itself and fully values the business, a company with slow underlying earnings growth cannot continue to compound at an attractive rate. The stock's total return will ultimately reflect the business's overall earnings growth.

Buffett did the same thing

In his early days, Warren Buffett used to buy companies with stocks trading below their book value. Even if the companies were dead in the water, he'd eventually see a return, even if the business was merely sold for parts. That worked at a relatively small scale, but it also resulted in significant portfolio turnover. Charlie Munger convinced Buffett that it's much better to buy a wonderful business at a fair price than a fair business at a wonderful price.

That's ultimately led Buffett to make some investments many wouldn't consider "value investing." For example, he recently initiated Berkshire Hathaway's position in Alphabet, a stock Ackman once owned as well. Buffett's retort: "All investing is value investing," he said, echoing Munger at Berkshire's 2019 annual meeting. "All the same calculation goes into it, whether you're buying some bank at 70 percent of book value, or you're buying Amazon at some very high multiple of reported earnings."

Investors should be looking for "wonderful businesses trading at a fair price." If they can get an even better-than-fair price, so much the better. A company that can grow earnings at a high rate and that's currently out of favor with the market could be a very big long-term winner for investors. But those only come along once in a blue moon. For investors looking to deploy cash today, finding a business that's capable of growing earnings at a 15% to 25% rate over the long run that trades for an earnings multiple between 20 and 25 times expectations is going to produce excellent results. Ackman's portfolio is full of examples of stocks you could buy today with excellent long-term growth prospects.

Adam Levy has positions in Alphabet and Amazon. The Motley Fool has positions in and recommends Alphabet, Amazon, and Berkshire Hathaway. The Motley Fool has a disclosure policy.