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Davidash76 Message

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  • Geoff Gannon 2012-03-06 07:15
    Davidash76: Geoff, thanks for the feedback. When reading, I was tying some of what you were saying to your article regarding how Buffet Value's Growth and how you
    I'm glad to hear that.

    And, remember, when I say something like I'm not able to value Exxon that precisely - that doesn't mean you aren't. Different people have different circles of competence. What is important is knowing where the limit of your circle is. Also, I am serious about erring on the side of things you already own. I am sure you know the companies you already own better than any company whose stock you are about to buy. So, it's a good idea to start from the things you know clearly and move out into new companies, industries, situations, etc. where you see similarities with those already familiar things. Finally, remember that you only need to know how to invest as best YOU can. You don't need to know the right way for someone else to invest. Just the right way for you to invest. So focus on "learning" about investing and "exercises" as being like athletic training. It is only partially about doing the right exercises the right way. It is much more about getting yourself and keeping yourself in peak condition as an investor. Warren Buffett and Charlie Munger are good examples of this. But so was Walter Schloss. It's a personal, practical journey about finding the approach - and sticking with the approach - that works best for you. Everybody does it a little differently. So don't get hung up on what's right and wrong. Focus on what works for you.
  • Geoff Gannon 2012-03-05 08:39
    Davidash76: Hi Geoff, I'm doing some quick valuation exercises on some of the stocks I own based on the methods you detailed in your past post (Microsoft and Exxo

    It depends on what you are looking for. The Buffett/Munger Bargains Newsletter picks a stock every month. So, it HAS to compare its pick to the market by default. You always value the stock you are considering buying against the next best alternative. In the case of the newsletter, the next best alternative is always another stock. I could've done a long analysis comparing WAT to every other possible pick - or at least the other top few candidates. Basically, Waters was safer than the alternatives that were cheaper than it. And it had more long-term upside than the stock that were as safe as it was (which were very, very few stocks). So that's why the Buffett Munger Bargains Newsletter uses current market valuations to justify its picks. Because it HAS to make a pick. The next best alternative is always another stock - because newsletters keep making picks regardless of the market environment.

    Do you have to keep buying stocks regardless of the market environment? That's up to you. Your next best alternative could be holding cash.

    However, since you are talking about doing valuation exercises on stocks you already own - I would suggest using the current market valuations. You should sell stocks you already own only because you have a better idea to invest in or because they are clearly overvalued. If you decide they are overvalued using the 14.88 Shiller P/E (geometric mean - GuruFocus uses a different average approach and gets 16x) then you are really not saying those specific stocks you own are overvalued. You might as well just be saying the market is overvalued. I don't think - and a lot of people disagree with me here - that you should sell the shares of companies you like and are familiar with simply because they have risen along with stocks generally.

    So, my own feeling is that you should always err on the side of inactivity. The bar for buying should be set high. And the bar for selling should be set high.

    All valuations are ultimately relative. Even the Shiller P/E approach is basically using long-term interest rates over 100+ years. It's just doing it indirectly. In the long-run interest rates (especially the longest dated - 30 year+ corporate bond rates) help determine the value of stocks by either offering attractive or unattractive returns and being an alternative to stocks.

    So, I think you can - for the purposes of just doing an exercise - always value the stock both ways and consider the band between the roughly 15 times historically normal P/E and the current 22 times Shiller P/E to be the band of possible intrinsic values for the stocks you are looking at. In other words, if their earning power is $1 a share, you should understand that means they are neither definitively worth $15 or $22 but rather they are worth something in the $15 to $22 range.

    As for your buying and selling decisions, I would suggest you use the lower Shiller P/E (the long-term average of 15) for your buy decisions and today's higher Shiller P/E of 22 for your sell decisions.

    Don't use the same number for your buy and sell decisions. This is just an invitation to overprecision and overtrading. Be less precise. And more patient. When in doubt, stick with what you know. Be slow to sell good stocks you own. And be slow to buy new stocks you've never owned.

    Personally, I do not focus on intrinsic values. I focus on the returns I think are possible in the stock and a conservative calculation of what I think the stock is clearly worth more than. Ideally, I try to find a stock that I think offers safety in the sense that if I know it is worth more than 2 times book value, and I pay 1.3 times book value - I am getting the stock for less than it is worth (even though I don't know exactly what it is worth, I know I paid less than intrinsic value). And then I want to see a reasonable way over a period of the next 10 years for me to receive an adequate return.

    These are my criteria:

    1) Price clearly lower than value
    2) Acceptable return over 10 years (10% a year)
    3) Better than alternatives

    I use 10% as my minimum acceptable expected return over a 10 year holding period. For me, even if interest rates are at 4%, I would prefer to hold cash and wait for an opportunity I think can return 10% than ever invest in something that only has single digit return potential.

    For alternatives, I look at the other stocks I might buy. But even more than that, I focus on the stocks I already own. Would adding to them be a better use of my cash? This can be hard because sometimes there is an uneven comparison in terms of safety and return. Sometimes a company I like less has a share price that is so low its potential to offer very good annual returns over - say - 3 years is hard to pass up.

    But I try to stay focused on the investments where:

    1) Present day undervaluation is most CLEAR
    2) Acceptable 10-year returns (10%+) are most likely
    3) Safety is highest
    4) Business quality is highest

    Also, remember that valuation tools are general tools. Not specific tools. I've talked sometimes about companies like DNB, CEC, and BDMS. Their capital allocation policies alter my views of their intrinsic value. Because I think the likelihood of adequate returns in those stocks is increased by their policy of not over doing reinvestment in their own operations but instead buying back their stock, paying dividends, etc. This is why Warren Buffett values IBM so highly.

    So, using the kind of approach I used in the Microsoft and Exxon examples is just a starting point. In essence, that only values the free cash flows. It does not value the uses to which management will put those free cash flows. If the use is poor, the stock's earning power should be valued at less than $1 for every $1 of expected free cash flow. If the use is good, the stock's earning power should be valued at more than $1 for every $1 of expected free cash flow.

    Investing involves the valuing not just of capital but of the return on that capital and then the subsequent return on that return on the original capital - and so on. This is critical. And it alters the valuation of companies like Waters in important ways.

    If Waters used its capital differently, I never would have said 19 times earnings is an acceptable price to pay for the stock. Nor would Buffett have bought IBM.

    Once you get beyond the exercise stage, keep this in mind when actually applying your intrinsic value estimates. A company is more than its future cash flows - it is the uses to which that cash will be put.
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