Valuations

They matter, but not in the way most think that they do

I first started writing this at the end of my time in the United States, in the familiar surrounds of LAX. Surely one of the great monstrosities of the American experiment. It was, however, a wonderful trip. I met many Twitter friends face-to-face, ticked a few items of my bucket list, and enjoyed the varied cultures of the Mid West and both coasts. Certainly the pure scale of the imperial centre is always humbling from the perspective of a provincial. While it was a bit of a culture shock coming from a place which has more conformist societal norms, it was energising seeing the optimism and entrepreneurial flare.

Now back in the prison colony, I have been thinking about valuations. I have covered my general approach to valuation work before. Generally, I look at some combination of shareholder yield and incremental shareholder yield as it relates to earnings growth (which includes the returns of incremental leverage) tempered by certainty. I’ll pay optically expensive multiples for unusual levels of earnings growth that translates into yield for the shareholder. This is a little practiced discipline amongst most value investors. Rarer still is the willingness to hold onto names which appear fully priced.

From time to time it’s important to rehash what we actually own - and by that I mean what we own in terms of the relevant financial instrument. Buffett via Graham tells us that equities are ownership stakes in businesses. This is rather straight forward, but what does ownership mean?

It’s a claim on the assets and the cashflows of a business - and not the only claim mind you.

In a company’s capital structure, equity has the last claim on the proceeds and assets of a business. The government enjoys the most advantaged claim on a business - that is a variable interest in the business’s proceeds backed up by the ability to violently reclaim that interest (taxes). Debt holders and preferred shareholders also come before the equity, although these claims are subjected to truncated pay offs.

Many companies owe a de facto claim on their resources to certain service providers, and manufacturers of critical physical goods (capex, opex, and COGS). Employees of a company share many of the same characteristics as debt holders - they enjoy a prioritised claim on the proceeds of their employer but are limited here by their contractual agreements. Only after all of the above parties have been satisfied is the poor equity owner able to claim what remains. The owner(s) of a business takes the most risk, and thus enjoys the possibility of uncapped returns.

To invert - a great business is one with the fewest possible claims on its resources, leaving ample and predictable rewards for the equity holder. It is unencumbered by the obligations of the various forms of external financing. It is not reliant on the rent extraction of various service providers (especially the tax like characteristics of 3rd party distribution). It does not need significant capital investments, and if it does they are one time expenditures and not recurring or maintenance-like in nature. In rare cases, even the government’s claim can be deferred, if not avoided all together. Those companies that truly do have an immense reinvestment opportunity can supress near term profitability, and taxation, with the promise of much greater profitability later. Although identifying these ex-ante comes with a different set of challenges.

Inverting once more - a great business is one that has a claim on the proceeds of others. Taking this a step further, some businesses are able to finance themselves with external sources of capital - think float, negative working capital, franchised restaurant concepts, and other forms of low cost financing that is modest compared to the firm’s future earnings power.

What does this have to do with valuations?

To quote David Einhorn on the state of current markets:

a very small portion of trading volume today is based on strategies that try to identify which stocks are undervalued in order to buy them for an intermediate or a long-term investment period, with a view that the shares will outperform as they close the discount to fair value

The approach that Einhorn describes above (which has historically had stretches of success) has been described by a friend of mine as relative valuation trading. I have a hard time distinguishing it from speculation. A true deep value approach seems perfectly reasonable (i.e. valuation discrepancies that are extreme and are corrected by adequate capital allocation), however making a blanket assumption that companies that trade at 10x earnings will neatly trade at 14x earnings in some number of years from your trade date is a different proposition.

If there is one mistake I see made constantly, especially by newer investors, it is that their investment process begins with contrasting present near term valuations without contrasting business characteristics between investment alternatives. Value investing is not an exercise in valuation observation (even a child can understand that there’s a difference between 10 and 13). It is an exercise in value realisation. That investors conflate relative valuation trading with Buffett’s early approach without referencing specifics is a little amusing. For example, Buffett bought a profitable insurance business at less than 1x earnings in the 1950s. To the extent that he bought securities that traded for less than their assets was also the extent that he had the ability to liquidate those assets. Said another way, apparent modest valuations mean very little without the ability to realise the returns implied by those valuations.

To the long term investor, value realisation is and can be the only thing that matters. This is why quality - as defined somewhat idiosyncratically above - is important. Having the proceeds of a business, owned through a public listing, available to the investor is an essential first step in adequate investment outcomes. Whether or not you are able to make reliable judgements about the market’s general valuation regime, and by extension the valuation that will be applied to certain individual names, is another matter entirely.

I have lived during a time where a bird in the hand has been worth far less than two in the bush. However, this is a historical, not absolute, truth:

The above twitter thread is an analysis of the returns of MCD 0.00%↑ from the top of the Nifty Fifty bubble. Despite extremely strong sales and EPS growth after 1972, it underperformed cash for over a decade.

If I can think of no more proper defence against long, protracted periods of valuation compression than the ability to contrast the value realisation potential in one’s unique opportunity set. I have written before that PM 0.00%↑ did devilishly well during the two decades post-1972 (with plenty of volatility in between) - although I’ll think you’ll find that the proceeds realised by shareholders differed greatly from those of MCD 0.00%↑ . There will be times where near term cash is worth far more than deferred cash. Making that distinction is all part of what makes investing fascinating.

Larry.