Part 3 - Fallacy of Owning Quality Companies At Any Price
by Saket Mundra
The price/value conundrum lies at the heart of investing – an activity that we deem to be “deceptively simple”. How else could one explain a security that is deemed to be under- and over-valued at the same time by different market participants? We believe that the basis of all investing lies in the divergence and convergence of the price and the intrinsic value of a business. Warren Buffet, the Oracle of Omaha and one of the most successful investors in the world, often refers to a “fair price” for a stock. But what, exactly, does he mean by this? Is it an absolute number or a relative concept?
After sharing with you our thoughts on “time horizon” and “quality companies” in the first two parts of this series, we wrap up with our views on “price” and “intrinsic value”. In doing so, we touch upon the beliefs and objectives of various market participants and the common pitfalls amongst various valuation methods. We conclude with a discussion of how we traverse this complex topic in order to create wealth for our clients. We believe that a deep understanding of what constitutes “value” is the foremost prerequisite for becoming a successful investor. While the essence of how investing works is widely known amongst seasoned investors, ambiguity in the interpretation of “intrinsic value” separates great investors from the rest.
Defining “Price” and “Value” and the Myths that Lead to their Divergence
“If the market is truly a game, it will be possible to have the game without any intrinsic values at all.” – The Money Game
With the advent of behavioral finance, there is a growing body of evidence warning us of the pitfalls of assuming rational behavior by market participants at all times. Inspite of all the work done so far, we believe that little has been said about why the participants behave in the way they do and the role that their objectives play in promoting this behavior. Any rational set of individuals wouldn’t engage in the equity markets unless they truly believed that they can generate better returns than in other asset classes and/or beat the other market participants. In our view, it is this belief, whether justified or not, that forms the very foundation of the market - how else could one explain the momentary changes in prices of securities? While this belief could be true some of the time, it could also cause the market participants to become delusional at other times. When one acts based on existing beliefs in presence of contrary evidence, irrational behavior and decisions follow. Combined together, these rational and irrational decisions of market participants manifest in the form of the “price” of a security at a given point in time. On the other hand, “value” is deemed to be an objective and rational assessment of a business and its worth.
Next, we address the issue of the objectives of various market participants which highlights the next level of challenges and ambiguity in determining the value of a business. Does a pension fund value a business in a similar manner as an individual investor? Do they have the same time horizon, the same risk tolerance; the same return expectations? Differing inputs for these variables might result in differing perspectives on the value of the business. What this suggests to us is that even a group of the most seasoned investors could only, at best, come up with a range of values for the business, which is nothing more than a reflection of the range of their circumstances and objectives.
In light of this, how do we, as investment managers, identify what might be a “fair price” and what might be the true “intrinsic value” of a particular business? And if one doesn’t find this challenging enough, the limitations of various methods employed to determine value compound the problem further.
The Methods and their Madness
The methods employed by the broader markets might be varied but they all evolve from the same baseline – the true worth of the profits/free cash flow of the business. Despite the advances that we have made in getting the semantics of valuation methods right, they at best reveal estimations of value and are broadly influenced by the context in which the market participants are operating. For illustrative purpose, let us think about valuing Proctor & Gamble as of today using the prevalent “Discounted Cash Flow” (DCF) method at two different times – 2007 and 2015. How do we determine the right discount rate for these periods? in 2007 the fed funds rate (risk free rate) was closer to ~5% while in 2015 it was ~0.25%. Using these two numbers as inputs will result in two extremely divergent values for the same business, even though we used the same method. Which value is more accurate, or does either have any merit?
A wide variety of market participants are skeptical when it comes to the widely prevalent use of DCF, and for valid reasons given every model is a “garbage in – garbage out” exercise. Consequently, some of them prefer a multiples-based approach to deem the value of a business under the pretext that it seems less error prone and simple. The flaw in that line of thinking arises from the fact that the multiples and the DCF are one and the same thing – they reconcile. The only difference between the two is that one is explicit in the assumptions, while the other hides those assumptions implicitly. Our team cautions each other all the time to not fall into this pitfall. After all, “a dollar is a dollar is a dollar” irrespective of the choice of the method employed.
At times, participants put too much emphasis on the relative multiples of a security when compared to its historical multiples and to its peers. We wonder if it is wise to do so without proper context. For example, we all know the outcome of buying the cheapest technology stock relative to its peers in 1999 – those investments were generally disastrous. Similarly, when participants buy a security because the current multiple is much cheaper than the historical multiple, they fall into the same trap. Implicitly, they assume that the historical multiple reflects the true value of the business – which may or may not be true. Maybe the business prospects have changed or maybe the historical multiple was inflated – in either case, participants err.
While most of these flaws when valuing businesses are well documented, some errors are repeated time and again. How else could one justify any boom or bust in the markets? Seemingly small flaws applied consistently and coupled with herd mentality can lead to disastrous outcomes.
Seeing “Value” as a Fluid Concept Dependent on the Business and the Economic Context
As philosophical as it may sound, we believe that “value” is a fluid concept which is impacted by the business and economic context in which the business operates and is therefore valued in. A valuation exercise that doesn’t incorporate the business and economic context could fall short of acknowledging the new realities of the world and is likely to reflect only partial truth.
It may be worthwhile to elaborate on what we mean by business and economic context respectively. All of us can agree on the assertion that the fundamentals of a business evolve and change continuously – this change adds to the uncertainty of the valuation exercise. If one fails to incorporate how a business changes and evolves when valuing it, results are bound to be erroneous. Apple is a fine example. Over the last 10 years, the company’s business and its prospects have changed a number of times. If we refer back to the range of values that most investors came up with 10 years ago, it would be nowhere close to Apple’s current price or today’s estimates of Apple’s intrinsic value. One might argue that Apple is a bad example given the rate of change in its business and industry - but when we look around, we find plenty of evidence of this phenomenon in industries as ‘boring’ as utilities. With the availability of low-cost shale gas in the US, hasn’t the value of various utilities changed?
Now, moving on to the dependency on the overall economic environment and the role it plays in valuing a business. Economic and external variables can seep into the valuation in a number of ways, such as a change in the fortunes of an industry. Chinese companies come to mind as we talk about the overall economic context. As the Chinese economy has been evolving from an investment-led to a consumptiondriven model, the fortunes of various businesses and thereby their value has evolved. Consumptionoriented business, such as Tencent and Alibaba, have seen a substantial increase in their intrinsic value given the shift in the economic backdrop when compared to ‘old economy’ businesses, such as a utility company like Dongfang Electric.
Another example of economic context finding its way into valuation is use of an appropriate discount rate. In this vein, we often find that even when market participants agree upon the profitability/cash flow generation of a business, they may vary widely in the discount rate that they use to value the business. Shouldn’t investors across various asset classes, who have different return objectives, use different discount rates? In our opinion, they should. Since the economic crisis in 2008-2009, this phenomenon is very evident in the asset allocation calls of various investors. During this period, the fixed income investors have essentially crowded out prudent investors from stocks that are perceived to be defensive in sectors such as utilities, staples and REITs.
If we go one step further, how does one reconcile usage of different discount rates over different periods of time for valuing the same underlying business? This question is very relevant today as the Fed has started raising rates in the US. In a nutshell, it is fair to say that a number of “unknown and unknowable” factors influence the estimate of value at any and all times, which makes it a rather fluid concept.
Flexibility – an Underrated Trait of a Consistent Investing Philosophy
A lot has been said about how a consistent investment process and approach is essential for successful investing. What we feel is extremely underrated is the flexibility to incorporate relevant context with regards to the environment one is operating in, while following a consistent set of investment principles. In trying to value any business, we rely upon our investment philosophy for guidance to navigate the complexities. What that means is that we try to “Seek the Truth”, which entails thinking differently, being aware of the limitations of various methods and tools as well as our own biases. We astutely think about our own objectives, time horizon, and the environment that we are operating in.
In practice, the mental model that we find extremely useful is inversion, which helps in gauging what’s implied in the current price and the Street’s consensus estimates. This exercise not only requires an in-depth understanding of the business, but a mindset to use valuation tools in a different manner. For example, one of the primary reasons we build DCF models is to understand numerically the strategy and the levers of a business and the variables that matter most. It allows us to understand the sensitivity and sensibility of variables reflected in the price and estimated value of the business. Often we are able to find variables that don’t seem to make a lot of sense. For example, if a company is priced to grow at 10% compounded forever, we may steer away as that seems very unreasonable to us. On the other hand, we have owned companies in which the market prices negative growth forever, an outcome which we deem to be unlikely in cases that otherwise meet our investment process. A fine example of this was our investment in DirectCash (TSX:DCI), where we bought the stock at a price that reflected steeper decline in the business than we believed was fundamentally possible.
In many cases we try to understand macro variables implied in the price and expectations. As an example, if we use consensus growth and margin for the business, we can estimate the discount rate reflected in the price and estimated value. To verify our thoughts, we consciously try to reconcile the multiples and DCF – which gives us a broader perspective and helps us to eliminate, or at least mitigate, our own biases. When it comes to multiples, we tend to think in terms of payback periods for our investment. In a vast number of stocks and sectors today, it seems that it will take about 25 or 30 years to just earn our original investment back, let alone make any kind of measurable return. By employing a combination of models together in a different manner, we become more aware of the potential pitfalls, implied expectations and a sensible range of valuation.
Finally, all else being equal, we think about the “value” as a range that encompasses sensible business variables and economic environment overlaid with our objectives and time horizons as investors. It follows then that, to us, Warren Buffet’s “fair price” is one that gives us a reasonable margin of safety and enables us to fulfill our return objectives. We must reiterate that flexibility in use of various methods and approaches, while remaining true to our investment process, forms the key tenet of how we arrive at a fair price and intrinsic value. We believe that to invest successfully in the ever-changing world, it only makes sense to use a plethora of scenarios, methods and approaches that are relevant to the situation at hand. This approach of arriving at fair price and value has helped us navigate the complexities of the market in a rational way and we are confident that it will continue to do so.