In a recent interview with Consuelo Mack of WealthTrack (link), Jean-Marie Eveillard of First Eagle Funds said something that I’ve heard many times before – and something I have a tough time understanding. I figured it’s about time that I put my thoughts on this topic in writing.
When discussing the different types of value investors, Mr. Eveillard had this to say about Warren Buffett (Trades, Portfolio):
“[Buffett] introduced the qualitative in a major way. What I mean by that is that he was looking for businesses that had a sustainable competitive advantage; businesses that were likely to be as successful ten years down the road as they were today.”
Digging deeper into the Buffett approach to investing (specifically the long-term, buy-and-hold strategy that he’s widely known for), Mr. Eveillard then made the following statement:
“A key question, if one adopts more or less the Buffett approach, is if the stock moves to what you think is the intrinsic value of the business, does one sell automatically? Some value investors say ‘yes, you have to sell, because it is fairly valued now.’ My point is, if it’s modestly overvalued or moderately overvalued and if you think you have a business that is really compounding, that creates value successfully over the years, you’re probably better off holding on to it – and accept the fact that maybe for awhile the stock does not go up, as the profits have to catch up with the price of the stock…”
Let’s assume that taxes have no implication in the discussion; what possible justification is there for holding on to a stock that is overvalued – even modestly or moderately?
The crux of the problem, from my perspective, comes from the bastardization of “intrinsic value” (“fair value”). Based on how it’s used, it clearly means different things to different people. On Wall Street, “fair value” is almost always defined (in practice) as the product of a forward earnings / EBITDA estimate and a multiple (which may be based on an industry average, a trailing average for the company, or chosen arbitrarily). In the case of historic, company-specific multiples, this approach assumes that what Mr. Market has said in the recent past is worth listening to, despite the fact that you’re now assuming he’s being irrational. For a recent example of the kind of trouble this can get you in, go back and look at large cap blue chips that spent the decade to 2008 / 2009 in a constant state of P/E compression (from 40x or more to the mid-teens or lower); that’s just one example of the many shortcomings of that approach.
(Side question: I wonder how many analysts thought Coca-Cola (KO, Financial) was worth 25x earnings or more in 2000 – I would bet every single one; for that not to be the case, an analyst would’ve needed a price target 40% or more below the actual stock price at the time. Today, how many analysts think KO is worth 25x or more? According to the Wall Street Journal, none of them.)
I’ve argued in the past for a different approach: I think “intrinsic value” makes the most sense when thought of in terms of required forward rates of return; these return requirements set the discount rates in our calculation. I’ll quote Seth Klarman (Trades, Portfolio), who put it better than I can:
“A discount rate is, in effect, the rate of interest that would make an investor indifferent between present and future dollars... The appropriate discount rate for a particular investment depends not only on an investor's preference for present over future consumption but also on his or her own risk profile, on the perceived risk of the investment under consideration, and on the returns available from alternative investments.”
So let’s return to Mr. Eveillard’s two options: sell when a stock reaches the upper bound of “fair value” – which I’ll define as the lower bound of our acceptable rate of return - or continue holding on to the stock?
After adjusting for the impact of taxes on realized gains, the argument for holding a stock beyond “fair value” –Â where it is no longer justified in our calculations – seems weak. Is that what Mr. Eveillard is advocating –Â holding on to stocks that will earn inadequate rates of return? Would he keep holding a stock priced to return 7% per annum if his requirement was 10%, simply because it’s a great business? Where does the quality of the business – great or crummy – have any impact in that calculation? The numbers in our calculation already account for the quality of the business in their forward estimates. I don’t think that’s a very compelling argument – and considering how much smarter Mr. Eveillard is than I am, that likely suggests I’m thinking about this incorrectly.
I think the real issue is one of different time horizons – more specifically, the impact that business quality has on intrinsic value over time. When someone says that a business has reached / exceeded fair value but they’re still holding on because it’s a great business, what I really hear is that it may appear expensive at first glance, but the fundamentals actually justify the current valuation (if not higher). Said differently, the stock isn’t actually overvalued – it just appears so on simplistic measures of intrinsic value like the current P/E versus the market multiple.
I don’t think Mr. Eveillard purposefully holds investments that he believes are overvalued because they are great businesses; I think the more accurate statement is that great businesses with a visible future over the coming 5+ years are consistently mispriced relative to the market as a whole / average business. In his comments, I think Mr. Eveillard’s justification for holding the businesses that are “really compounding” is an example: that business, which is expected to generate better than average returns on invested capital and earnings / FCF growth in the coming years, really isn’t overvalued – it just appears so by the rudimentary / conventional approaches of valuation that many rely upon singlehandedly. Clearly he thinks the long term forward rates of return are still attractive – otherwise he wouldn’t have any reason to keep holding the stock.
I'm hoping that my thought process is on this is at least somewhat coherent.
As always, I would love to hear your thoughts –Â particularly if you find errors in my logic.
