– Andrew Macken
As Warren Buffett once said: “Price is what you pay; value is what you get.” This simple definition underpins the logical pursuit of value investors to make investments in businesses only when prices are materially below their true value. This seems absurdly obvious and yet executing on this approach is rather difficult. Why? Because “true value” is, essentially, unobservable.
That said, there are some logical analytical steps that can be taken by diligent investors to ascertain, with some degree of accuracy, the true value of businesses – or range of values more typically – with a reasonable degree of confidence. These steps can be broken up into two broad buckets: (i) what does the future hold for the business; and (ii) how can that future be converted into a single numerical value – or range of values – today?
In assessing the first bucket, it will not be surprising to learn that predicting the future with any degree of sustainable accuracy is hard (or more specifically, impossible). But thinking about a range of possible outcomes and assigning probabilities to these outcomes is more achievable. One can think about the inherent advantages, or lack thereof, of the business in question. Are these advantages strengthening or weakening due to competition? How quickly is the industry likely to grow over the long term? Will the business in question be a long-term winner in its space? How likely is this business to create new, as yet unimagined, revenue streams? Think about how Amazon, Alibaba and Tencent continue to surprise with new lines of revenue today that seem unrelated to their core business 10 years ago.
The answers to these questions feed into an assessment of the range of possible long-term outcomes for the business and associated probabilities for each outcome. In today’s stock market, there are surely pockets of exuberance along this dimension. Said another way, it is likely that possible optimistic scenarios for certain businesses are being assigned unnecessarily high probabilities by the market. Think of certain areas of technology today such as electric vehicles, online gambling or payments, for example.
In assessing the second bucket, three factors among many stand out for their outsized impact on one’s ultimate estimation of true business value: (i) the growth rate of earnings over time; (ii) the capital intensity required to achieve said growth; and (iii) the general level of global interest rates. Similar to the factors considered in the first bucket, predicting these with great accuracy is near impossible – but there are certain observations that can assist in one’s assessment. For example, the corporate sector in the aggregate cannot grow their revenues faster than broad economic growth – after all, GDP is essentially the sum of all revenues in an economy. But businesses which are disrupting other businesses and industries can certainly grow at higher rates for a sustained period of time. Similarly, for businesses that exhibit positive feedback loops and strengthening advantages – often related to the collection and use of large amounts of data – growth can also likely be sustained for a long time. The economics of different industries are important to understand as well. Software, for example, carries with it very different economics to materials, energy and financials.
Finally, the general level of interest rates over time are important to appreciate. If they are to remain low, then valuations must be higher, all else equal. And vice versa.
On these second-bucket issues, there is every likelihood that the market is being conservative in some instances and not yet fully appreciating the true impacts of these dynamics.
Pockets of exuberance in the first bucket and under-appreciation in the second. This is one important reason why investing is hard.
Andrew Macken is the Chief Investment Officer at Montaka Global Investments.
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