This is a popular question among value investors. I’ve heard many value investors talk about why a stock is cheap. I’ll be honest. I don’t think I can explain why a stock is cheap.
There are several areas of investing where I have no expertise. I don’t think I add any value when deciding to sell a stock. Your guess is as good as mine on selling. I don’t think I add value on position sizing. Over time, I’ve decided the best approach is just to make each position the same size. I’ve seen no ill effects from this. And it lets me focus on the buying part. I also have no skill when it comes to knowing when I will get paid. I don’t know what actual catalyst will cause a stock to reach my estimate of its intrinsic value. I have invested in situations where I believed I knew what the catalyst was, what the timeframe for realization was, and what the value realized would be. I’ve always been wrong on this. Usually, I have been too pessimistic on the final price someone will pay for a stock. Unfortunately – when there was an obvious catalyst present – I’ve usually been too optimistic about how quickly that value will be realized.
So I don’t do selling well, or position sizing, or recognizing catalysts. I also don’t think I bring any special skills to knowing why a stock is cheaper than it ought to be. In other words, I don’t think I’m any better at explaining the seller’s rationale for trading his shares for my cash when I buy.
Is this a necessary skill?
It seems like it should be. It seems like – to make a winning investment – you need to know something the market doesn’t. However, I don’t believe that’s true. Because I don’t believe knowledge has much to do with how people invest.
Knowing is usually an intermediate step. Investors incorporate facts into their interpretations of a stock. I don’t think you need to know different facts than other investors. You just need to interpret the same facts differently.
There is one value approach that almost always seems to work for me. And, in a sense, it is based on the idea of a different interpretation of a stock. But it’s not at all based on different facts.
I’m not an expert on why other investors choose to buy and sell stocks. But I have noticed a tendency to focus a lot on reported results. Next year’s earnings are a big concern.
So, using a combination of 3 different facts – facts you’ll often agree with the market on – you may be able to come up with a different interpretation.
The 3 facts I find most helpful in interpreting a stock different are: 1) Owner earnings, 2) Enterprise Value, and 3) What happens in year 4?
Let’s start with the last one, because it’s the most difficult to explain. The market is often focused on what just happened last year and what will happen next year. Analysts and investors are always looking ahead. But, are they often looking more than 3 years ahead?
It’s now 2013. One of the first things I ask when trying to value a stock is what it will look like – assuming a normal environment – in 2017. The reason for this is obvious. The market may put extreme importance on expected results in 2013, 2014, and 2015. But unless these results indicate a pattern that will continue right through 2017, 2019, and 2020 – they aren’t likely to make or break a long-term investment in the stock.
A lot of the value in a stock will come from cash flows after the next 3 years. A lot will also come from cash flows in the next 3 years. But everyone is trying to predict those.
Likewise, everyone is trying to predict what margins, etc will be in an industry environment that looks a lot like today or their expectations for the next few years. Fewer people will be looking at what the net interest margin of a particular bank will be in 2017, what the fuel costs of a cruise company will be, etc.
If you can figure these things out – and you can’t know any of them, you can only make educated guesses – will you know something the market doesn’t?
I don’t think you will. You will focus on something the market is not focused on. But I think your facts will often be quite similar.
I was reading an analyst report recently of a stock that I just analyzed myself. The analyst valued the stock at $50 a share. I valued the same stock at $68 a share. Since the stock trades in the 40s this is a meaningful difference of opinion. The analyst thinks the stock is quite fully valued. He sees no margin of safety. I see an almost 30% margin of safety.
Do we have different facts?
Not really. His report includes most of the same facts I considered important. Some of our future estimates were also nearly identical. For example, he assumes a roughly 2% annual sales increase. I assume a roughly 3% annual sales increase.
There are some differences though. He projects sales growth and margins till 2017. He doesn’t consider either number beyond that.
I can’t disagree with his 2% sales growth estimate for the next few years. In fact, I feel pretty strongly that this stock – which I consider a good buy – actually can never grow its profits faster than nominal GDP. The company does almost all of its business in Europe and the U.S. So, if you predict nominal GDP of less than 4% a year, sales growth can’t be higher than that.
Of course, that estimate is very much focused on the last few years and the next few years. In periods where there was a bit more inflation – in other words, almost any other time in the last century – and nominal GDP growth, sales grew faster than this analyst’s estimate.
I don’t disagree at all with his estimate. I have no basis on which to disagree with an estimate like that over a timeframe like that. Economic growth has been pretty low since the financial crisis. It’s been hard to raise prices. The only way this company makes money over time is by raising prices. So, I have to agree that if nobody is raising prices on anything for the next few years – this company is going to have a hard time creating any profit growth.
So our facts are the same. And I think our opinions – to the extent we have opinions on the same subjects – are actually identical. I wouldn’t disagree with his short-term estimates. They are reasonable. They might turn out to be low. But mine might turn out to be high.
Where do we differ?
In our interpretation. The framework he used was to model out through 2017 and then stop. The framework I used was to ask: What does this company look like in normal times? What would nominal GDP growth look like? What would inflation look like? How much could they raise prices then? Could profits rise faster than sales? And could free cash flow rise faster than profits?
His analysis ended in 2017. Mine really started in 2017. Not because 2017 is likely to be more “normal” than 2013, but because I am interested in “earning power” rather than reported earnings. In a normal environment, how much can this company charge?
The next area where the two of us had different interpretations was price. He used a perfectly reasonable P/E ratio of 15. However, he used a P/E ratio. I think that’s wrong. I think it makes no sense to value a company like this on its P/E ratio.
I use owner earnings. I always do an owner earnings calculation. And I don’t care whether earnings can be reported or not. For example, in this situation the company’s operating earnings would be about 15% higher if you added back amortization of intangibles. You obviously need to add back amortization of intangibles. It’s cash flow the company gets each year. And these are intangibles from acquisitions that don’t need to be replaced.
If you’re focused on reported earnings, there’s a problem with this amortization. It’s going to go on and on for many years. Some of these intangibles are being written off over a period of 20 years. Some were pretty recently acquired. That means – even if the company never acquires another business – it’s going to be taking large amortization charges far into the next decade.
You could look at this from an EPS perspective as a natural source of EPS growth. As intangibles are written off, the amount of amortization required next year declines. So, EPS automatically rises. I think that’s meaningless. Cash flow is the same before and after the write-offs. But reported earnings aren’t the same. Because of the declining intangibles balance, EPS naturally rises without the company doing anything.
It’s a silly observation. But if you are trying to estimate EPS, it’s one of the key inputs for what EPS will be in say 2017. It will be several percentage points higher simply due to a lower intangibles balance that needs to be amortized.
Again, I don’t think this analyst and I disagree on these points. I’m sure he doesn’t view the amortization as a real economic charge. His estimate of free cash flow would be identical to mine. But he uses a P/E ratio. I use an EV/Owner earnings ratio.
This brings me to the last of the 3 perspectives where you can really differ from the market without actually knowing anything the market doesn’t. I only look at a company’s price in relation to its pre-tax owner earnings. And I only care about enterprise value.
A lot of value investors also use this approach. But some folks disagree with me on this one. They feel that it rewards companies that hoard cash. And it punishes companies that rationally leverage up the balance sheet to provide more free cash flow to equity.
I would agree with that assessment in a world of unstoppable inertia. I don’t agree with it in the real world. I don’t agree with it because the capital structure you are looking at is not necessarily what the stock will be a part of when you sell it, nor even what it will be a part of for most of the time you own it. The capital structure is just what it looks like today.
A company with no debt can go out and – without diluting your equity – leverage up the balance sheet and almost double its size overnight. Conversely, an overleveraged business can – without ever risking insolvency – use almost all of the free cash flow you anticipate to pay down the debt in front of your common stock. It can also – if insolvency ever becomes a problem – end up issuing a lot of shares.
Capital allocation is terribly important. I pay a lot of attention to it. But I don’t believe that today’s capital structure tells you as much about future capital allocation as the company’s past behavior, management’s statements, etc.
I especially like to focus on companies that lower their share count year after year. I find this to be more of a predictor of future uses of capital – of what my returns may be in the stock – than simply calculating the leveraged free cash flow on today’s stock price.
That doesn’t mean I won’t buy a leveraged stock. I own Weight Watchers (WTW). It’s very leveraged. But it’s also – at about 9 times my estimate of its pre-tax earning power – a fair price to pay on an EV/Owner earnings basis for what I think is a wide moat business.
Notice that I don’t care what the P/E ratio is (even though it’s low). And I don’t care what next year’s earnings will be. I care deeply about the company’s solvency through the next few years. And I care about what owner earnings will be in a “normal” looking 2017.
I don’t think I know anything the market doesn’t. I do think I may be framing the question a bit differently.
We can all agree that superior knowledge without superior interpretation is not profitable. And superior interpretation without superior action is equally unprofitable.
It may sound like that means the chain of doing something different from the market has to begin with knowing something different. But I disagree. I think you can fork off later in the process. You may know the same facts, but interpret them differently. Sometimes, this can lead you to a different and correct action.