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Thomas Macpherson
Thomas Macpherson
Articles (109)  | Author's Website |

Value Investing and Relativity

Sometimes value depends on where you are standing

August 29, 2017 | About:

Value investing, as Bruce Greenwald says, is a big tent. Everyone under the tent, including us, ascribes a range of values to something and wants to buy it as some level of discount to that." - Adam Weiss

In 1892, Hendrik Lorentz introduced the idea of “local time” or the relativity of simultaneity. In this theory, the notion of two events being “simultaneous” is shown not to be an absolute truth, but rather is relative to the observer’s location. For instance, if two guns were fired, to Individual A it would appear Gun 1 fired first and Gun 2 fired second. For individual B 1,000 yards away, it might appear Gun 2 fired first and Gun 1 fired second. This relativity of simultaneity is demonstrated using the Lorentz transformation, which relates the coordinates used by one observer to coordinates used by another in uniform relative motion with respect to the first. (Read that one twice!) All of this (along with Henri Poincarè’s light signals) became the basis for Einstein’s theory of relativity and his famous train thought experiments. The world of physics would never be the same.

Can we agree on value?

I bring this up because the definition of value investing could qualify as having its own relativity. There are so many definitions of value investing, it requires a big tent to cover them all.

For instance, my business partner John Dorfman is a traditional value investor looking for stocks with low price-earnings (P/E), price-book (P/B) and price-sales (P/S) ratios and a strong balance sheet. I do not put much priority on the first three but agree on the last. Elements vital to me are high return on capital, return on equity, return on assets and financial strength. Yet we both have a bedrock requirement of buying shares at a significant discount to their intrinsic value. We have our own version of the Lorentz transformation, so to speak.

Marathon Asset Management expressed my view well when they wrote:

“The ‘value/growth dichotomy’ is false - at least, to a true value investor, whose aim is not to buy stocks which are ‘cheap’ on accounting measures (P/E, price to book, etc.) and to avoid those which are expensive on the same basis, but rather to look for investments trading at low prices relative to the investor’s estimate of their intrinsic value.”

The Marathon folks do not believe there are set criteria such as P/E or PEG ratios that automatically make one investment better than another. They simply note the ultimate objective is to buy a dollar for 50 cents.

An interesting case is that of Bill Miller at Legg Mason (NYSE:LM). From the early 90s through the Great Recession, Miller had a spectacular run beating the S&P 500 for 15 years in a row. Many of the more classically trained money managers argued Miller really was not a value investor at all because he owned growth stocks such as Amazon (NASDAQ:AMZN). Miller was somewhat annoyed at this assertion, arguing any stock can be a value stock provided it trades at a discounted level relative to its intrinsic value. Of course, Miller’s famous streak did end. His disastrous returns in the 2007-2009 financial crisis were as great a shock to him as they were to his investors. He was not alone. Some of the great names in the value world suffered enormous losses during the same period. One manager summed it up well:

I think it (the market’s returns) proves that even with many styles of individual value investing strategies, collectively we all got one thing wrong – we mispriced the assets. We were not purchasing stocks at a discount to intrinsic value. Rather we were purchasing incredibly risky assets that were mispriced with no margin of safety at all. It turned out that wasn’t value investing, it was a mispriced bet on assets we didn’t understand and we lost.

Why this matters

As the bull market runs into its ninth year, now is a great time to be taking a look at your holdings from multiple angles. Think of it as creating your own personal portfolio Lorentz transformation. I would suggest investors use multiple models to assess where the greatest risks are in their portfolio. What appears fairly priced to some may be expensive to others. Getting a view from multiple angles of risk will allow investors the chance to protect to the downside. There are three questions I think can be helpful in situations like the markets in mid-2017.

  1. Is the company overvalued as defined by analysis of its future free cash flows?
  2. Is the company far in excess of normal valuation standards?
  3. Do you fully understand the risk associated with assets and their impact on implied value?

Discounted free cash flow/stock price

When using a discounted cash flow model, there are two assumptions that can really skew your valuation – estimated future free cash flow and estimated cost of capital. Both are easy to get wrong. Think of the estimated growth numbers required in 2000 to justify a P/E of 50-plus for many technology stocks. Cost of capital can be a tricky number as well. Raising or decreasing it by a small amount can have a dramatic impact on your estimated valuation. As an example, in my DCF model for NIC Inc. (NASDAQ:EGOV), a holding in some Dorfman Value Investments portfolios, a cost of capital of 9% gives a value of around $24 per share. An estimated cost of capital of 12% gets me a value of roughly $15 per share or 63% less. Now is the time to test both assumptions – growth in free cash flow and the future of interest rates.

Earnings growth/price growth

As discussed earlier, my partner John utilizes three ratios (among other criteria) in estimating the value of a holding –P/E ratio, P/S ratio and P/B ratio. Fidelity’s Peter Lynch was a big fan of the price of earnings over growth (PEG) ratio. Each of these can tell you whether you are paying more (and by how much) for each unit of earnings, sales and book value – or for the growth in those units. As a snapshot in time, these numbers can be helpful, particularly when you measure the value of your investment against its historical average. If your holding is trading at 60% above its historical P/E, for example, it might be time to take a much deeper look at the market presumptions going forward.

Risk of assets

One of the most overlooked measures in 1999-2000 as well as 2007-2009 was the risk assets on corporate balance sheets were overstated. For industries such as financial services, these numbers can be surprisingly flexible. In 1960, a bank’s assets might have consisted of cash or short-term U.S. government treasuries. In today’s world, the balance sheet might be filled with mortgage-backed securities and credit default swaps. Just ask past shareholders of Bank of America (NYSE:BAC) how fleeting the values of these might be over time.

Conclusions

In my investing methodology, I have a tendency to lean toward companies with little or no debt, high cash balances and generous free cash flow. My compatriot John looks for similar balance sheet strength but very different price to value multiples. I think exploring these differences and seeing price to value from very different vantage points make us both better investors. Someone once said you do not need to be an Einstein to be a great investor. Maybe not. But a good understanding of Lorentz cannot hurt.

Disclosure: Several clients at Dorfman Value Investments own NIC Inc. in their portfolio. We have no positions in any remaining stocks mentioned in the article.

About the author:

Thomas Macpherson
I served as CIO of the Nintai Charitable Trust and consult with Dorfman Value Investments as an investment advisor. I look for companies with high ROIC, significant free cash flow, no debt and that trade at a deep discount to fair value. Much of my writing consists of thoughts on the Nintai Charitable Trust portfolio. I am the author of "Seeking Wisdom: Thoughts on Value Investing". It is a book written to get investors thinking differently about their investment approach. Unless otherwise stated, views represented in my articles are based on my former role as CIO of the trust, which I personally managed.

Visit Thomas Macpherson's Website


Rating: 4.6/5 (7 votes)

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Comments

Soid Ahmad
Soid Ahmad premium member - 2 months ago

Seeing the title, quantitative easning was the first thing that came to my mind. Good read though. Thanks.

eguruguy
Eguruguy premium member - 2 months ago

Thomas. Good article my first or your columns to enjoy since finnishing you book. Loved the book. Just receiced the paper version yesterday and am highlighting away. Perhaps you could spend a column educationg us on how to best manipulate the parameters of the DCF calculator in GF. ie Growth rate, terminal growth rate, year GR, and discount rate.

yusaw
Yusaw - 2 months ago    Report SPAM

Five star article, I like this article. Thanks.

Thomas Macpherson
Thomas Macpherson premium member - 2 months ago

Hi Soid. Thanks for your comment. I'm pretty sure you wouldn't want me to write an article about quantitative easing! Value investing is hard enough. Fed policy? That's a whole different beast. My circle of competence is pretty small and has nothing to do with economics. Thanks for your comment. Best - Tom

Hi Eguruguy. I'm glad you are enjoying the book. I'm not sure my senior year English Lit professor would have thought I was capable of such a task (I think he believed ANY task in writing was beyond me 😀) and I would have agreed. The GuruFocus community really made it possible. I will certainly think about an article on GF's DCF model. Thanks again. Best - Tom

Hi Yusaw. I'm glad you found the article useful. Feedback from readers like you really make writing a positive endeavor. Thanks again. Best - Tom

Praveen Chawla
Praveen Chawla premium member - 2 months ago

Excellent topic and article.

Its obvious the more traditional value managers model themselves after Ben Graham while the more modern value second level approach is emphasis on ROIC's, ROE, free cash flow etc. A third level of thinking add the concepts of "moats" and "owners earnings" as defined by Buffet and fourth level the concept of "compounders" and "cannibals" as defined by Munger.

Its a real revelation that a company selling at very high P/E but compounding earning and buying back stock at a ferocious rate may actually be intinsically better value than a low P/E company which is growing very slowly.

Miller's downfall in the financial crisis was clealy due to balance sheet woes. Its critical for value investors to start with the balance sheet first before moving to the income and the cash flow statements.

stocdoc
Stocdoc - 2 months ago    Report SPAM

Hello,

Read your wonderful book also. Congratulations for such eloquent and lucid portrayal of value investing. You refer to your proprietary DCF model in the bbok. If you provide a simple but useful DCF model for everyday investor to follow, all of us followers will be grateful.

Thomas Macpherson
Thomas Macpherson premium member - 2 months ago

Hi Praveen. I absolutely agree that it all starts with the balance sheet, then cash flow, and finally the income statement. I think some value investors got a little intellectually lethargic and didn't spend the required time to see connections that posed a huge risk. In 2007, much like today, new highs on a near daily basis requires wise investors to double down on their research. Thanks for your comment. Best - Tom

Hi Stocdoc. Thanks for your comment. I'm glad you enjoyed the book. One of these days I'm going to do a multi-part article on my DCF model. My new article this week actually touches on it by discussing the impact of moats on terminal value and price estimates. Thanks again. Best. - Tom

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