The Hidden Costs of Going Cheap: Unmasking 'Bargain' Investments

The most expensive purchases that I ever made

I grew up poor. My mother, my grandmother and I immigrated to the U.S. when I was 10. My mom worked very hard to make sure we had everything we needed, but I was not exactly rolling in spare cash.

My coin collection began with some gifts from my mother and father while we were still in Russia. However, once I was in New York, any additions had to come from my own meagre savings. I couldn’t exactly afford some of the nicer silver coins that I hungered for. Instead, I found coin stores that would sell bags of old coins by the pound.

The store strongly implied that there could be very rare coins hiding among the mostly worn-off copper and bronze junk. I fell for that – here was my chance to stretch my money and perhaps find a hidden treasure to get the great coins that I wanted after all, but on the cheap.

Of course there weren’t any valuable old coins in those bags. I understand that now – the store owners would sort the coins and select anything of any value to sell individually. They would then sell the worthless junk by the pound to suckers like me who thought they were getting a bargain. This selection bias is an important lesson that took me well into adulthood to fully understand.

It’s hard to separate the idea of cheap from the idea of a bargain. Cheap refers to a low price, usually in relation to other things in the category. A bargain is something that is priced below what it should be given what it is.

When I was a young analyst at Fidelity Investments over 20 years ago, Will Danoff, the portfolio manager of Fidelity Contrafund, told us a story about his mother. She would buy him expensive cashmere sweaters the cost quite a bit. When he protested about the high price, she told him that “price is forgotten, but value remains.” Her point was that these were really nice sweaters that would last him a long time, unlike the cheaper ones that might be a far worse purchase all things considered.

Unfortunately, my desire for cheapness didn’t end with my unsuccessful buying of bulk coin bags. For a long time, I had the naïve understanding of value investing as only buying things at low multiples of profit. The idea was that if only those profits stayed the same or grew, the returns would be very high without demanding much from the future that hasn’t already been seen in the past.

On the surface, that makes a lot of sense. It even has the added benefit of a potential valuation floor or an extra margin of safety such that even if the business were to deteriorate a bit, we can still make a good return.

So what’s the problem?

The problem is that many statistically cheap stocks have businesses that deteriorate not just a little bit, but quite a lot. They might be managed by poor or unscrupulous management teams that destroy the value of the cash flow stream the company is producing. Or they might have a weak balance sheet unable to withstand even temporary adversity. Like a cheap sweater, they look like a bargain but quickly develop holes that make a fool of the buyer.

When I initially got into wine, I couldn’t tell good from bad, so cheap wine made sense. As my taste evolved, I could appreciate a great wine and tell it apart from a merely good wine and tell the good apart from the average. However, my history as a poor immigrant kid didn’t let me buy the expensive, $50+ bottles of wine even when I could easily afford them. Instead, I was looking for a bargain among the $15 to $30 price range which I was more psychologically comfortable paying.

That led to me buying some of the most expensive wines that I have ever had. How? They usually started as an attempt to find a hidden gem at $25 per bottle, which after a few sips ended up unfinished. I was literally pouring money down the drain. I was paying the equivalent of $200 per bottle for the quarter-glass of that $25/bottle wine.

One of my biggest investment mistakes was buying Sprint soon after it merged with Nextel. I knew it was a third-tier competitor to AT&T and Verizon in the wireless business. I knew that merging two companies with disparate networks would be hard, or at least I should have. I knew the balance sheet would be highly financially levered. However, the stock was cheap and I convinced myself that given the slow pace of change in the industry I had enough margin of safety against unforeseen problems. I was wrong. I did not.

Why did I fear paying a seemingly high price for things? Because it requires a better developed judgement about the quality of what I am buying. A cheap bag of bulk coins that doesn’t contain a gem doesn’t make me question my selection ability – maybe I just got unlucky. A cheap sweater that quickly gets a hole could just be an accident, but what if I pay up for the expensive one and then rip it on something? What if I do spend that $100+ on a bottle of wine only to find it to be a mediocre disappointment, as many $100 bottles actually are?

Buying more cheap things gives me more chances at a bargain. Or so I used to think. In reality, it just gives me more junk or mediocre things and little chance at anything really amazing.

The last 6 years I have gotten into Bonsai, the art of creating potted trees that look giant in miniature. In Japanese “sai” means tree and “bon” means container, so the pot is an important part of the composition. As with most things, there is a range of quality in pots. At the bottom of the range are the Chinese mass-produced pots that cost as little as $10. At the top of the range are works of art made by master ceramicists that can cost over $1000.

When I first got into the hobby, I would buy many cheap to mediocre pots. That made sense – my skill was so low that why invest in better ones? However, as I improved, I would long for some of the beautiful pots I would see on the store shelf. I would always talk myself out of it though – after all, rather than getting a single pot I could get 3, 4 or even 10 pots for the same price.

This week I went to the local Bonsai store where a new shipment of handmade pots by one of my favorite ceramicists had arrived. I spent an hour looking at all the merchandise, including the cheap Chinese pots of which I had many. I sighed and chose 3-4 mid-range pots to take to the register. They were a reasonable trade-off between price and quality.

And then I put them back on the shelf.

I asked myself: “Which pot would I be really disappointed to see gone the next time I am here?” I of course knew the answer. It was the pot that I had looked at on several past trips but never had the heart to buy.

I smiled, picked up just that one pot and calmly paid for it at the register with no regrets about the price. Price is forgotten, but quality remains.

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About the author

Gary Mishuris, CFA is the Managing Partner and Chief Investment Officer of Silver Ring Value Partners, an investment firm that seeks to apply its intrinsic value approach to safely compound capital over the long-term. He also teaches the Value Investing Seminar at the F.W. Olin Graduate School of Business.