I’ve spent a lot of time lately thinking about valuing great businesses. It’s something I’ve personally struggled with as of late, most notably as Microsoft (MSFT, Financial) – a long held position in my portfolio - has seen its valuation continue to march higher. To be frank, its price appreciation has been somewhat uncomfortable for me. The fact that it’s a large position in my portfolio surely doesn’t help in that regard. I’m doing what I can to keep myself honest to ensure that my past success with the stock and my admiration for the business and its leadership (both which I believe are one of a kind) does not allow me to overlook the only question that matters – is the stock undervalued?
As I’ve thought about the appropriate course of action, I have looked for lessons from some investors that I greatly admire. In a recent article, “The Art of (Not) Selling,” I wrote the following:
“I doubt the team [at Akre Capital Management] is completely unconcerned with valuation when looking at an investment. Instead, my sense is that they believe the kind of businesses they invest in – companies like Moody’s (MCO, Financial), Visa (V, Financial) and American Tower (AMT, Financial) - are almost always underappreciated by the market if you’re willing to think of them as investments that you will hold for 10, 20 or 30 years... They must believe that a merely good business is worth something significantly less than a great business. That’s a big idea that I think many investors – myself included – believe. But we often struggle to properly incorporate it into our process. We’re too focused on whether the price-to-earnings ratio is 20, 25 or 30. We let concerns about the price of the asset get ahead of our focus on business quality. We compromise on the latter – and end up looking for decent businesses at “great” prices – when we probably should be more willing to compromise on the former.”
Today, I want to look at something Charlie Munger (Trades, Portfolio) said that relates to this topic:
“Psychologically, I don’t mind holding a company I like and admire and I trust and know will be stronger than now after many years. And if the valuation gets a little silly, I just ignore it. So, I own assets that I would never buy at their current prices but I am quite comfortable holding them… I have a defect. And I just won’t pay 30 times earnings… I have never done that but I have one or two now which are now worth 8 or 10 times what I paid for them and they are still marvelous businesses and are still growing and I just hold them. Many investors I know are like me. I cannot defend it in terms of logic. I don’t defend this logic. I just say this is the way I do it and it keeps me more comfortable to do it this way…”
This part jumps out to me: “I cannot defend it in terms of logic. I don't defend this logic.”
I find that intriguing, because many of us view Munger as the epitome of a rational individual and investor. The idea that he would spot an illogical aspect of his process – and simply accept it – feels wrong. And there’s another problem here: I bet that what he is calling out as illogical has actually worked quite well over his investment career (and as you’ll see in a few moments, Warren Buffett (Trades, Portfolio) has explicitly said as such). It has been a successful strategy for him.
So, the question in my mind isn’t why he would voluntarily commit to an approach he finds illogical; instead, it’s to understand why something Munger considers illogical has actually worked out well.
My thoughts on the subject are that investors can underestimate the value of a great business that has the opportunity to reinvest at attractive returns for decades to come. But, like trying to understand the vastness of the universe, I think it’s tough for people to intuitively appreciate (or accurately predict) the scale of the numbers.
I am not saying that spotting these situations is easy. It’s obviously not. But what I am arguing is that the truly great investment opportunities – those situations that may only present themselves on a handful of occasions during one's life – are worth significantly more than the average business. To me, that indicates that if you happen to find yourself in a position where you think there’s a good possibility you may have one in your grasp, you should do everything in your power to hold onto it. The cost of missing what it offers on the upside can greatly outweigh the risk associated with a higher than average valuation in the short-term.
Assuming we could see the future with perfect clarity, how much is a great business with decades of runway worth? Let’s look at an example. Below is the cumulative growth that would be achieved over four decades at different annualized growth rates. The output is the cumulative change starting from $1.0 per share of earnings in year zero.
As you can see, there are a wide range of outcomes. Growing earnings per share (or any other metric) 10% per annum will result in a roughly 45-fold increase in value over four decades. But at a pace just a few percentage points higher (13% p.a.), the value gain over the forty year period would amount to a 133-fold cumulative increase.
What this next chart shows is the appropriate starting price-earnings ratio in year zero at various discount rates (this assumes the terminal price-earnings multiple in each scenario is 15 times).
As you can see, assuming an appropriate discount rate of 9%, a business that generates low-to-mid teens compounded growth for four decades mathematically justifies a starting price-earnings multiple that is significantly above what any of us would considerreasonable at first glance.
Another Munger quote sums up what these charts show numerically:
“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 6% on capital over 40 years and you hold it for that 40 years, you're not going to make much different than a 6% return - even if you originally buy it at a huge discount. Conversely, if a business earns 18% 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.”
Conclusion
At the 1996 Berkshire Hathaway (BRK.A, Financial)(BRK.B, Financial) shareholder meeting, Buffett and Munger were asked how they thought about Berkshire’s permanent holdings (aka “The Inevitables”), particularly as their valuations continued to reach new heights. Buffett responded:
“Well, there are things that we think there’s no price for. And we’ve been tested sometimes and haven’t sold them… My friend, Bill Gates (Trades, Portfolio), says, it has to be illogical at some point. At some price, you have to be willing to sell something that’s a marketable security, forgetting about a controlled business. But I doubt if we ever get tested on… We really have a great reluctance to sell businesses where we like both the business and the people. So, I don’t think I’d count on seeing many sales. But if you ever attend a meeting here, and they are trading at 60 or 70 times earnings, keep an eye on me."
Next, Munger said:
“The so-called two-tier market created difficulties, I would say, primarily because a lot of people or companies were called tier one when they really weren’t. They just had been, at some time, a tier one. If you’re right about the companies, you can hold them at pretty high values.”
Buffett said:
“Yeah, you can really hold them at extraordinary levels… it’s too hard to find. You’re not going to find businesses that are as good. So then you have to say, “Am I going to get a chance to buy back the same business at a lot lower price? Or am I going to buy something that’s almost as good at a lot lower price?” We don’t think we’re very good at doing that. We’d rather just sit and hold the business and pretend the stock market doesn’t exist. That actually has worked out way better for us than I would’ve predicted 20 or 25 years ago. I mean, that mindset - there’s been a fair amount of good fortune that’s flowed out of that which I really wouldn’t have predicted.”
I’ll close with something my friend Bill Brewster (@BillBrewsterSCG on Twitter) once said, because I think it perfectly sums up what I’ve tried to get across in my past few articles on this topic:
“Traditional value investors understand the role of price mitigating left tail risks. Traditional growth investors understand the ability of the right tail to be longer than traditional value investors appreciate. The marriage of the two concepts is nirvana. Also, hard to do.”
Disclosure: Long Berkshire, Microsoft and Moody's.
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