Statistics cannot be any smarter than the people who use them. And in some cases, they can make smart people do dumb things.”[1] – Charles Wheelan
A lot of the questions we get are based on how we value a company. As investment managers we think this is the most important task we have as allocators of capital. The ability to get reasonably close – not perfect – valuation of a potential investment is the predominant driver of our long-term success or failure. Yet it is by far the area where – to Wheelan’s statement – smart people make some of the dumbest mistakes (including ourselves).
Valuation methodology: Art, science or voodoo?
I want to be completely upfront. Valuation is part science, part art and part druidic mysticism. There really isn’t any perfect way to value a company. There are simply too many moving parts, too much prognostication and frankly too much guessing. But that doesn't mean the process isn’t worth its weight in gold. At Nintai, we believe the process goal is clear: is the stock – representing a share of the business – trading at a discount to future earnings discounted back at a reasonable rate. To achieve this relatively simple goal, it takes a considerable amount of time and requires an extensive amount of research, industry expertise, and creative or flexible thinking. By the latter we mean the ability to see the data from multiple angles and make connections where there may appear none at first.
Because of the level of time and detail required we don't value that many companies per annum. Our investment criteria (see our article "Our Investment Strategy And Portfolio Selection” found here) generally leaves us with a pool of roughly 100-125 companies each year. Since 2000 we've probably fully valued roughly 250 companies and revisited these between 5-7 times since their initial review.
Valuation goals
When we finally choose one of the candidates we are going to fully investigate, we look to achieve comprehensive knowledge in four (4) major categories. These are:
- Estimated Fair Value of the Company per Share
- Capital Allocation Skills of Management
- Financial Strength of the Company
- Long Term Prognosis of Corporate Moat
Estimated fair value
We look at the calculation of fair value slightly differently than most. First, we see the process as far more than discounted free cash, margins, etc. We take a holistic approach utilizing all components of the financials including the income statement, cash flow statement, balance sheet and 10-Q/10-K guidance. We feel all these components can have a direct impact on valuation. For instance we believe movement (either positive or negative) in shares outstanding on the income statement can either reduce or increase risk and thus impact valuation. An example is Expeditors International (EXPD, Financial) that has decreased shares outstanding from 223M in 2005 to 194M in 2014. This has increased the valuation by both reducing total shares as well as decreasing risk through share repurchases. Similarly the usage of both short- and long-term debt can increase risk and impact valuation. An example of this was Cognizant Technology’s assuming $700M in short-term debt and $938M in long-term debt in 2014. While the use of debt made sense from a business perspective, from Nintai’s valuation methodology, this raised its balance sheet risk and lowered valuation.
This holistic approach can be very complex but we believe it serves two goals: first it makes us see connections where we might not see either risk or reward without it and; second it allows us to keep a constant eye on the downside. We are happy to see potential advantages during this process and still not invest, but unpleasant surprises will usually stop the valuation process dead in its tracks and ultimately take the company entirely off the watch list.
Capital allocation skills
We simply won’t invest in managements that are not exceptional capital allocators. Our valuation process evaluates long-term capital allocation rates (10 years), specific returns on acquisition and divestments, return on assets (10 years) and return on equity (10 years). Each of these evaluations is assigned a risk assessment level that directly impacts valuation. For instance, high return on capital through extraordinarily difficult times such 2008-2009 is worth more than relatively more normal periods such as 2004-2007. We feel great allocators make a larger impact on valuation during rainy days than any other time in their tenure. In general, we look for companies with ROIC of roughly 15% annually for the last 10 years. In Nintai’s model each 5% increase beyond that threshold will increase valuation by roughly 1%.
Financial strength
The ability to have access to capital – either by tapping cash on the balance sheet or through the capital markets – plays an enormous role in our valuation methodology. We think rock solid balance sheets are simply worth more than those that are not. This means we miss quite a few opportunities, but we believe it is the number one reason we have outperformed in the long run by evading the short-term capital market panics such as 2008-2009. The difference between a pristine balance sheet and one heavily leveraged can impact the valuation by +/- 10% in our model. As we mentioned, CTSH made the decision to access the capital markets in 2014 and raise a total of $1.6B. This decision – in isolation – reduced CTSH’s valuation by roughly 6% in our valuation model.
Prognosis of moat
We want to invest in compounding machines. We’ve often stated we love to have management do the heavy lifting for us. Management’s ability to find profitable and growing niches they can dominate is our dream scenario. We see this frequently in duopolies or industries that have several large leaders and many smaller competitors. In our model one tool we use to assign risk is in both the amount of market share and the movement of such market share. Companies with high existing market share as well as actively taking additional market share will have the greatest positive impact on valuation. Paychex (PAYX, Financial) and Automatic Data Processing (ADP, Financial) are examples of this duopoly model and see significant increases in fair value from these characteristics.
Conclusions
Getting to an approximate valuation is a very difficult and demanding process. It should focus on measuring things that you think will drive long-term valuation of your investment. Equally – if not more – important, it should build in processes that constantly check for downside opportunities. We cannot stress the importance of this enough. We believe far too many investments are made by not fully understanding all the issues, relationships, and interactions that can lead to truly horrific losses. As Mr. Wheelan said, our data is no better than the brains and learning we apply to it. At Nintai we have a monthly review of the valuation process to both check on performance as well as update from learnings we’ve gleaned over the past 30 days. With this process in hand, we believe you can build a base of attractive investments that meet your personal investment methodology.
As always we look forward to your thoughts and comments.
[1] “Naked Statistics: Stripping the Dread from the Data,” Charles Wheelan, W. W. Norton & Company; January, 2013
