I may be naïve in saying this, but the world of investing baffles me; actually, let me rephrase that – the way that the vast majority of people approach the world of investing baffles me.
One prominent example, and the focus of this article, is intrinsic value. Value investors are intimately familiar with intrinsic value, much like a group of worshipers reciting the Lord’s Prayer. I’ll use the definition from “The Little Book of Valuation”:
“In intrinsic valuation, the value of an asset is estimated based upon its cash flows, growth potential and risk. In its most common form, we use the discounted cash flow approach to estimate intrinsic value, and the present value of the expected cash flows on the asset, discounted back at a rate that reflects the riskiness of these cash flows.”
Those “expected cash flows” discussed cover everything from here to eternity. Considering that the average 24-month analyst forecast error rate in the U.S. and Europe is north of 90% (per a study in James Montier’s “Value Investing”), that leaves a lot of guess-work for any investor looking to employ this approach.
While that may leave things looking quite grim, there’s some solace for the long-term investor: You choose when and if you’d like to play. You can stand at the plate for as long as you’d like, and the umpire won’t bat an eye. With some patience (and the natural vicissitudes of markets), we should eventually wander upon opportunities that are all but a sure thing; in the words of Warren Buffett, “If someone weighed somewhere between 300-350 pounds, I wouldn’t need precision — I would know they were fat.”
But let’s step back for a minute and think about our less patient brethren: How do they approach valuation, or approach the question of future cash flows? I made my opinion on this pretty clear in my recent article, “The Luxury of Thinking Like an Owner” – I don’t think they do. Most of these people (based on the reports I read) are concerned at most with the next few years of earnings, if even that far out. They’ll arbitrarily slap a multiple on their preferred measure of earnings (often just high enough to be at a slight premium to the current market price), and thus conclude that they’ve reached an estimate of “fair value.”
This spits in the face of the definition presented above. If we were going to try and estimate the expected future cash flows of a business, even at the most basic and inexact level, I would point to a few important measures: (1) the expected return of capital to shareholders in the form of dividends and share repurchases, (2) the extent of reinvestment in the business (Capex, M&A, etc.) as well as the source of those funds, and (3) the expected return to be attained on reinvested funds.
I want to make a point clear that I cannot stress enough: The purpose is not exactness. In fact, I would consider any attempt to do so to be an act in futility (again, think of our analyst error rate on a two-year basis). The point of this exercise isn’t to get to a specific number; it is to derive a wide range of values that can be expected to contain intrinsic value under a variety of assumptions (while thinking deeply about the likelihood of those assumptions) – and to then purchase the equity at a material discount to that range of values.
Point number one from above is generally well vocalized by management. Many companies will either have an explicit payout target, or will show some pattern over a period of years. Naturally, the second point is directly related to the first (that which is not paid out is, by definition, retained; if all that is generated is returned, then we must be financing reinvestment some other way).
The third point is where life starts to get interesting. Amazingly, this third step, which is most critical when thinking about future cash flows, is where most of the financial community throws in the towel. Why is this third piece so important? Let’s revisit a recent example:
"I’ve mentioned this quote from Charlie Munger (BRK.B) in the past, and undoubtedly will share it again in the future:
'Over the long term, it's hard for a stock to earn a much better return that the business which underlies it earns. If the business earns six percent on capital over forty years and you hold it for that forty years, you're not going to make much different than a six percent return - even if you originally buy it at a huge discount. Conversely, if a business earns eighteen percent on capital over 20 or 30 years, even if you pay an expensive looking price, you'll end up with one hell of a result.’
Let’s use Charlie’s figures, and assume two companies will end our 20-year forecast period trading at 15x earnings (and reinvest 100% of earnings every year); if we paid 25x on day one for the business with an 18% ROA – meaning the earnings multiple will contract by 40% over time – what multiple of current earnings would you need to pay for the 6% ROA business to end up with an identical return in 2033?
Think about it for a minute and write down your answer; the correct one might surprise you.
Here’s the math: Our first business earned $0.18 on $1 of assets; we’re paying 25x the $0.18 in earnings, or $4.50 per share. Over 20 years, the impact of compounding takes hold in a big way:
In the 20th year, the business earns $4.18 – or 18% – on $23.21 per share in assets. At an earnings multiple of 15x, the stock would be trading at $62.70 per share; in the 20-year period, our shares went from $4.50 to $62.70 – a 20-year CAGR of 14%, and a cumulative return of 1290%.
Now let’s run the numbers for the 6% ROA business:
Our second business earned $0.06 on one dollar in assets; the return on the $0.06 being reinvested back into the business in the second period was also a paltry 6%, adding roughly a third of a penny to the bottom line. We can see that compounding in this example was much less meaningful than it was in the first situation; earnings took 13 years to double, nearly two and a half times as long as in the first example. Assuming that the market would pay a similar 15x for this business in the 20th year, we still need a lot of help to match the 14% annualized return in our first scenario; at 15x the $0.18 per share earned in 2033, the market will pay $2.70 for this business. On day one, you would have needed to pay $0.20 per share – or about 3.5x earnings – to match the returns generated by the first business, which you paid 25x earnings for.
This concept evades market participants who are focused solely on the days and week ahead; they're simply incentivized to avoid (or face the risk of) any recommendations that accept short-term weakness for long-term benefit (as Tom Russo likes to call it, 'the capacity to suffer').
I’ve never read an analyst report that discussed this potent combination of solid fundamentals and time; it doesn’t mesh well with a mind that’s ingrained in a game of guessing quarterly margins. As this example clearly shows, long term investors should focus on finding the truly outstanding businesses, and then watch them closely; there’s serious money to be made by holding on with a great business year after year after year.”
This conclusion should suggest something that I’ve started to consider more seriously as of late: the truly great businesses, the ones that can consistently generate outsized rates of return on their asset and equity, are worth a considerable premium to poor businesses; that relationship may not hold in any given quarter or year, but it becomes increasingly so as one’s time frame is extended.
Analysts have a time frame of (at most) one year, as disclosed in their reports; one can only hope that their compensation is reinforcing their short term focus, driving prices lower and lower on great businesses that are facing temporary headwinds (and creating more opportunity for us).
I look at this set of circumstances and come to a conclusion that I’ve voiced time and time again: Truly long-term investors (in practice, not just by name) are a small group; considering the constant barrage of noise, it can be difficult to remember what truly matters (not surprisingly, the vast majority of people who hold such short-term views – namely talking heads in the media – don’t make money from investing/trading; they make money by keeping viewers tuned in).
At times, waiting patiently can be disheartening, or even boring (three-quarters of the way through 2013, I’ve yet to place a single buy or sell order). But eventually, the tide will turn.
When it does, I think investors should focus on buying great businesses rather than searching frantically for the lowest multiple on current earnings; if we consider the definition of intrinsic value as presented above, this is where the hidden gems are likely to be found.
One prominent example, and the focus of this article, is intrinsic value. Value investors are intimately familiar with intrinsic value, much like a group of worshipers reciting the Lord’s Prayer. I’ll use the definition from “The Little Book of Valuation”:
“In intrinsic valuation, the value of an asset is estimated based upon its cash flows, growth potential and risk. In its most common form, we use the discounted cash flow approach to estimate intrinsic value, and the present value of the expected cash flows on the asset, discounted back at a rate that reflects the riskiness of these cash flows.”
Those “expected cash flows” discussed cover everything from here to eternity. Considering that the average 24-month analyst forecast error rate in the U.S. and Europe is north of 90% (per a study in James Montier’s “Value Investing”), that leaves a lot of guess-work for any investor looking to employ this approach.
While that may leave things looking quite grim, there’s some solace for the long-term investor: You choose when and if you’d like to play. You can stand at the plate for as long as you’d like, and the umpire won’t bat an eye. With some patience (and the natural vicissitudes of markets), we should eventually wander upon opportunities that are all but a sure thing; in the words of Warren Buffett, “If someone weighed somewhere between 300-350 pounds, I wouldn’t need precision — I would know they were fat.”
But let’s step back for a minute and think about our less patient brethren: How do they approach valuation, or approach the question of future cash flows? I made my opinion on this pretty clear in my recent article, “The Luxury of Thinking Like an Owner” – I don’t think they do. Most of these people (based on the reports I read) are concerned at most with the next few years of earnings, if even that far out. They’ll arbitrarily slap a multiple on their preferred measure of earnings (often just high enough to be at a slight premium to the current market price), and thus conclude that they’ve reached an estimate of “fair value.”
This spits in the face of the definition presented above. If we were going to try and estimate the expected future cash flows of a business, even at the most basic and inexact level, I would point to a few important measures: (1) the expected return of capital to shareholders in the form of dividends and share repurchases, (2) the extent of reinvestment in the business (Capex, M&A, etc.) as well as the source of those funds, and (3) the expected return to be attained on reinvested funds.
I want to make a point clear that I cannot stress enough: The purpose is not exactness. In fact, I would consider any attempt to do so to be an act in futility (again, think of our analyst error rate on a two-year basis). The point of this exercise isn’t to get to a specific number; it is to derive a wide range of values that can be expected to contain intrinsic value under a variety of assumptions (while thinking deeply about the likelihood of those assumptions) – and to then purchase the equity at a material discount to that range of values.
Point number one from above is generally well vocalized by management. Many companies will either have an explicit payout target, or will show some pattern over a period of years. Naturally, the second point is directly related to the first (that which is not paid out is, by definition, retained; if all that is generated is returned, then we must be financing reinvestment some other way).
The third point is where life starts to get interesting. Amazingly, this third step, which is most critical when thinking about future cash flows, is where most of the financial community throws in the towel. Why is this third piece so important? Let’s revisit a recent example:
"I’ve mentioned this quote from Charlie Munger (BRK.B) in the past, and undoubtedly will share it again in the future:
'Over the long term, it's hard for a stock to earn a much better return that the business which underlies it earns. If the business earns six percent on capital over forty years and you hold it for that forty years, you're not going to make much different than a six percent return - even if you originally buy it at a huge discount. Conversely, if a business earns eighteen percent on capital over 20 or 30 years, even if you pay an expensive looking price, you'll end up with one hell of a result.’
Let’s use Charlie’s figures, and assume two companies will end our 20-year forecast period trading at 15x earnings (and reinvest 100% of earnings every year); if we paid 25x on day one for the business with an 18% ROA – meaning the earnings multiple will contract by 40% over time – what multiple of current earnings would you need to pay for the 6% ROA business to end up with an identical return in 2033?
Think about it for a minute and write down your answer; the correct one might surprise you.
Here’s the math: Our first business earned $0.18 on $1 of assets; we’re paying 25x the $0.18 in earnings, or $4.50 per share. Over 20 years, the impact of compounding takes hold in a big way:
In the 20th year, the business earns $4.18 – or 18% – on $23.21 per share in assets. At an earnings multiple of 15x, the stock would be trading at $62.70 per share; in the 20-year period, our shares went from $4.50 to $62.70 – a 20-year CAGR of 14%, and a cumulative return of 1290%.
Now let’s run the numbers for the 6% ROA business:
Our second business earned $0.06 on one dollar in assets; the return on the $0.06 being reinvested back into the business in the second period was also a paltry 6%, adding roughly a third of a penny to the bottom line. We can see that compounding in this example was much less meaningful than it was in the first situation; earnings took 13 years to double, nearly two and a half times as long as in the first example. Assuming that the market would pay a similar 15x for this business in the 20th year, we still need a lot of help to match the 14% annualized return in our first scenario; at 15x the $0.18 per share earned in 2033, the market will pay $2.70 for this business. On day one, you would have needed to pay $0.20 per share – or about 3.5x earnings – to match the returns generated by the first business, which you paid 25x earnings for.
This concept evades market participants who are focused solely on the days and week ahead; they're simply incentivized to avoid (or face the risk of) any recommendations that accept short-term weakness for long-term benefit (as Tom Russo likes to call it, 'the capacity to suffer').
I’ve never read an analyst report that discussed this potent combination of solid fundamentals and time; it doesn’t mesh well with a mind that’s ingrained in a game of guessing quarterly margins. As this example clearly shows, long term investors should focus on finding the truly outstanding businesses, and then watch them closely; there’s serious money to be made by holding on with a great business year after year after year.”
This conclusion should suggest something that I’ve started to consider more seriously as of late: the truly great businesses, the ones that can consistently generate outsized rates of return on their asset and equity, are worth a considerable premium to poor businesses; that relationship may not hold in any given quarter or year, but it becomes increasingly so as one’s time frame is extended.
Analysts have a time frame of (at most) one year, as disclosed in their reports; one can only hope that their compensation is reinforcing their short term focus, driving prices lower and lower on great businesses that are facing temporary headwinds (and creating more opportunity for us).
I look at this set of circumstances and come to a conclusion that I’ve voiced time and time again: Truly long-term investors (in practice, not just by name) are a small group; considering the constant barrage of noise, it can be difficult to remember what truly matters (not surprisingly, the vast majority of people who hold such short-term views – namely talking heads in the media – don’t make money from investing/trading; they make money by keeping viewers tuned in).
At times, waiting patiently can be disheartening, or even boring (three-quarters of the way through 2013, I’ve yet to place a single buy or sell order). But eventually, the tide will turn.
When it does, I think investors should focus on buying great businesses rather than searching frantically for the lowest multiple on current earnings; if we consider the definition of intrinsic value as presented above, this is where the hidden gems are likely to be found.
