CHAPTER 7
Getting to Yes
A long-ago mentor, in a business other than investing, used to like to make one of his favorite points by describing how he could create the most popular restaurant in New York City. He would hire the best real estate experts to identify the ideal location and then pay whatever it took to acquire the property. He'd spare no expense in hiring world-class architects and designers to build out the space with only the highest-quality materials, fittings and furnishings. He would staff and outfit the kitchen under the direction of chefs who he had poached from the world's finest restaurants by allowing them to name their price to come onboard. Once the doors opened, he'd offer four-course prix-fixe menus, including wine, for $9.99 each, with tips and valet parking included. “Voilà, New York's hottest restaurant is born,” he'd say.
An extreme example, to be sure, but the point stuck: Business is all about what you pay for what you get. If costs to produce are too high relative to what you're paid—no matter how sublime the product or service—you will ultimately fail.
This same basic principle applies to investing. Through creative and diligent research you may uncover fascinating companies in wonderful industries. Through brilliant and incisive analysis you may see unfolding for a company positive events that mere mortals would miss. But all of that is for naught if you pay too much for a stock relative to what you get. Price obviously matters—the cheaper it is relative to what you believe a company is worth, the better.
This section is about how smart investors conclude whether the price they're paying for a stock is sufficiently cheap relative to the value they believe they will receive through their resulting partial ownership stake in the company. While there are clearly common elements in how investors ascribe value, we've been struck over time by the variety of valuation measures they utilize and how they approach and answer the question, “What's cheap enough?”
CASH (FLOW) IS KING
There are some prevalent themes in how smart investors approach valuation, the primary one being their focus on the future stream of actual cash that the company is expected to generate after taking in all revenues and paying out all expenses.
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It has always made sense to me to rely far more on cash flow than reported earnings. When I was in graduate school, my brother-in-law hired me to do some temporary work at a canning company. One project was to go through a pile of invoices and pull out anything that looked at all like a capital purchase, even for things like tires and other pretty basic recurring expenses. I finally asked why I was doing that and he said the CFO wanted to capitalize anything that remotely looked like capital spending so they could write it off over time.
The lesson in that for me was that a clever accountant can make financial statements say whatever he wants in the short term. That conclusion has only been reinforced over time, especially as the differing tax regimes and accounting conventions you see overseas can make comparisons based on reported net income even more meaningless.
—David Herro, Harris Associates
Earnings are basically a negotiated number between management and the auditors, subject to considerable manipulation. Cash flow—earnings before depreciation and amortization and after working-capital changes and either maintenance or total capital spending—is much less subject to manipulation and just a much better measure of corporate profitability.
At the same time, free cash flow is what allows companies to increase the value of the business—from making capital investments, to making acquisitions, to paying down debt, to buying back stock or paying dividends. Companies that produce free cash flow also attract potential buyers, either financial or strategic.
—John Osterweis, Osterweis Capital Management
We ask what our expected rate of return would be if we owned the whole business, which is essentially taking pretax free cash flow and dividing it by the current enterprise value. For pretax free cash flow we look at normal earnings before interest, taxes, depreciation and amortization, less maintenance capital spending. In the denominator, we adjust enterprise value by adding contingent liabilities and subtracting any kinds of hidden assets we find. If after all adjustments we can see a mid-teens rate of return, we're very interested.
—Steven Romick, First Pacific Advisors
We've always done very well when we can use sixth-grade math on the back of a postcard to show how inexpensive something is relative to its free cash. Once we start getting more sophisticated—trying to prove something rather than see if we can disprove it by killing the business—we get into trouble.
We're looking to pay 10x free cash flow or less, period. If you find those and you can't kill the business, you should be buying all day long.
—Bruce Berkowitz, Fairholme Capital
We want to see at least a 10 percent free-cash-flow yield and a 6× or less multiple of enterprise value to next year's earnings before interest, taxes, depreciation and amortization [EBITDA]. For enterprise value we use the current market value plus the estimated net debt 12 months out.
Most of the companies in our universe generally live within a range of 6× to 8× EBITDA. The idea is to identify companies having some earnings or other trouble that leave them trading at the low end of the valuation range. If our analysis is right that the difficulties are temporary, we get two boosts: from earnings recovering and from the market reacting to the earnings recovering and moving the multiple to the higher end of the range. We believe that dynamic gives all our core positions a very high probability of at least a 50 percent return within two years.
At the end of the day we're trying to buy companies as if we were buying a $10 million office building across the street. We do our homework on the tenants and the leases in place and make sure it's financed in a way that produces a 10 percent free-cash-flow yield. The idea is to increase equity by paying down debt with the free cash flow and also to benefit from the asset appreciating over time. With stocks, if you focus on companies with around 10 percent free cash flow yields and highly predictable, sustainable franchises, you protect your downside and set yourself up for nice capital appreciation.
—Alexander Roepers, Atlantic Investment Management
Our valuations are based on estimated EBITDA 12 to 18 months out. We don't look out further because we have little confidence in our ability to forecast beyond that and because we're most interested in what the business is worth today. The art in the valuation is arriving at the appropriate multiple to put on the cash flow. We look at private-market transactions and public comps, adjusting up or down from those based on things like the profitability of the business, its predictability, the prospects for growth, and the amount of leverage.
—James Shircliff, River Road Asset Management
We look at the securities analysis part of what we do in the way people look at valuing a bond. Ignoring the maturity date, what you need to know is the price, the coupon, and the reinvestment rate. It would be crazy to value a bond knowing only two of those things and we look at stocks the same way.
For price, we look at enterprise value, because you need to take into consideration all the calls on the earnings that are senior to you as an equity holder. We also try to mark the balance sheet to market by adjusting for things like underfunded pensions or real estate on the books at cost.
As a coupon, we're looking at owner earnings, which adjusts GAAP earnings to arrive at the cash flow you'd have at your disposal as an owner. There are many adjustments to make, but the most important is accounting for the difference between the inflation-adjusted amount of capital a company spends to maintain its competitive position compared to its reported depreciation levels.
The third key item is the rate at which owner earnings can be reinvested. This is the hard part, but obviously enormously important to any investment thesis. If you look out 5 to 10 years, as we typically do, that return on incremental capital is going to be far more important than the earnings yield you get in year one. That's why the business analysis is so important.
—Christopher Davis, Davis Advisors
What gets our interest is when a target company's share price goes down to the point where the free-cash-flow yield—EBITDA minus real capital spending, minus incremental working capital, divided by enterprise value—is at least 10 percent.
The reason we have do at least cursory work on 100 companies per year is that it is really hard to find the three or four that in addition to the 10 percent free-cash-flow coupon, can also generate growth in free cash flow of at least 10 percent per year. In most value situations, too much of the company's revenue is tied to mature and oftentimes declining product lines. But when we can see 6 to 8 percent organic growth combined with margin gains producing double-digit free cash flow growth, that's interesting.
If we can buy 10 percent current coupons and if the coupon grows at 10 percent, the math says we will generate an annual 20 percent unlevered return. That's the target for each position we hold and it's what we expect out of the entire portfolio.
—Jeffrey Ubben, ValueAct Capital
We're trying to own things that look like value stocks when we buy them, but which turn out to be growth stocks. So we try to build a portfolio of businesses with two primary characteristics. The first is that, even in times of stress, the underlying income-producing assets are strong enough to maintain a value floor for the investment. In other words, the company is cheap based on what we can be fairly certain of now. The second characteristic is some change going on that is unrecognized by the market and likely to be very valuable in the out years—a free call option.
We generally want to invest at a price where if our growth thesis is totally wrong, we can still expect to earn at least an 8 percent nominal cash-on-cash return. That's roughly in line with what the overall market is likely to return, so we should match that even if none of the free options pay off.
—Boykin Curry, Eagle Capital
The first thing we do is normalize what we think the company's earnings power is. A lot goes into that, but it essentially means looking at what the business has traditionally been able to generate over time and adjusting for various factors that might make it more or less attractive going forward. We then estimate the percentage of those normal earnings that the company will keep after things like capital spending and investments in working capital, resulting in a free cash flow number we can divide by the current market value to get a free cash flow yield. On top of that we'll add inflation and the annual growth in free cash flow we expect in order to arrive at our estimated rate of return, which we typically want to be at least in the teens.
By focusing on forward rates of return, it keeps us more centered on the fundamentals of the business and its cash flows. We aren't counting on or trying to figure out what someone else might pay as a P/E or cash flow multiple down the road.
—Stephen Yacktman, Yacktman Asset Management
The metric we care most about is what we call reinvestment cash flow, which is essentially earnings before interest and taxes, plus depreciation and amortization, minus maintenance capital spending. We look out three years and want to see the reinvestment yield the company earns increasing relative to its enterprise value. Then using a discounted cash flow model, we calculate a warranted value that has to be at least 50 percent greater than the current market price.
—Joe Wolf, RS Investments
We're primarily focused on free cash flow yield, which, after taxes and maintenance capital spending, we want to be at least 8 to 10 percent. For faster-growing companies we accept a bit less, but that's the general guideline. We tend to look at valuation in layers. The first layer is sort of a no-growth, as-is valuation, based on historical performance and how we believe free cash flow will respond going forward to a few key variables. The second layer looks at the free cash flow yield after incorporating operational improvements we expect that don't require top-line growth. Finally, we build in the opportunities for revenue growth we see. Our goal is to be satisfied with the yield we'd get based on the first layer, but obviously the thicker the other layers are, the better the opportunity. Good things can happen when competent people are working every day to improve a high-quality company's performance, which we usually look at as free options on the upside. It's maybe a bit boring, but our objective is to compound at a minimum of 10 percent per year. You do that over 20 years and you increase capital by almost seven times. That's rare enough that when people actually do it, you're likely to hear about it.
—Patrick McNeill, Alatus Capital
We're essentially willing to pay for the current cash earnings power. It varies, but if we're paying a price that results in at least a 7 percent maintenance free cash flow yield, we believe we're paying only for what's being generated today, getting for free the ability of the business model to grow free cash flow at a rate significantly ahead of the market. We look to make money in a couple of ways. The first is through compounding of the company's intrinsic equity value at 20 percent or more per year. Secondly, if we're right in identifying this type of business earlier than other investors, we should get paid over time from multiple expansion as well.
—Joerg Diedrich, Pennant Capital
It's not exactly reducible to a bumper sticker, but the key to our approach is free-cash-flow total return. We look at free cash flow yield plus expected growth in free cash flow, compared to the market-implied rate of return. Take Amazon: the free cash flow yield is around 5 percent, but the free cash flow growth rate is 20 to 25 percent easy. So that's a 30 percent free cash flow total return versus, at most, the 8 to 10 percent you'll get on the overall market. Our view is that it doesn't take a mathematical genius to figure out that 30 percent is going to beat 10 percent if you have any time on your side.
—Bill Miller, Legg Mason Funds
Basically we have to answer three questions: Is the stock mispriced, why is it mispriced, and what's going to make the mispricing go away? If we can't adequately answer those questions, we either haven't done enough work or it's probably not a great idea. To answer the first question, we arrive at a fundamental value for each company we analyze, which is essentially the price at which its cash flows or asset values provide an adequate, risk-adjusted, cash-on-cash return. For a moderate-growth business with moderate leverage in a normal interest rate environment, that return over time would be roughly 15 percent per year. Against that fundamental value, we typically want our shorts to be at least 30 percent overvalued and our longs to trade at a 30 percent discount or higher.
—Curtis Macnguyen, Ivory Capital
I've always believed that as an investor you have to be comfortable with a number of different valuation approaches and methodologies, and that part of the art of investing is to recognize which approach is most appropriate in different situations. The metric we tend to look at most frequently is sustainable free cash flow yield—in other words, free cash flow after the capital spending necessary to maintain a company's competitive position relative to the current market price. Across most businesses we consider that a consistent, important measure of value.
—Lee Ainslie, Maverick Capital
MULTIPLE ANGLES
While some measure of cash flow relative to the current market price is the most common valuation metric used by leading value investors, they frequently utilize a number of additional measures of value in forming their judgments. This approach has strong research support, including that of What Works on Wall Street author and money manager James O'Shaughnessy, whose multi-decade research indicates that stocks that screen well on a composite of value-based factors—including price-to-book, price-to-earnings, and price-to-cash-flow—perform much better over time than those screening well on any one individual factor.
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We try to use multiple methodologies to establish a company's intrinsic value—discounted cash flow models, private market values, and market-based multiples compared to peers and the company's own history. We think coming at it from multiple directions can give us a higher level of confidence in our ultimate estimate of value.
—Timothy Beyer, Sterling Capital Management
We won't buy if we don't see a 35 percent discount to our current estimate of intrinsic value, which we arrive at in a variety of different ways depending on the company. Ideally we're running a discounted cash flow model, cross-checked against where we believe something should trade based on other metrics like price to earnings, price to cash flow, price to net asset value or a sum of the parts. We think at least a 35 percent discount gives us enough margin of safety that we can be wrong and not get killed.
—Steve Morrow, NewSouth Capital
The metrics we use to determine value are pretty much what you'd expect. We do private-market-value analysis using discounted future cash flows and by looking at breakup values. At the same time we like stocks that are statistically cheap on a traditional price/earnings basis. We focus on companies trading at a 40 percent or greater discount to our private market value or no more than 13x our estimate of next year's earnings. We have to have one or the other to buy.
—John Rogers, Ariel Investments
We like looking at multisegment businesses where it's a bit more complicated to analyze all the parts and there's not an obvious answer to the question of what the entire company is worth. In this context, we pay a lot of attention to private-market values of each segment and trying to understand how underperforming segments should be valued.
—Peter Langerman, Mutual Series Funds
We'll estimate what we think earnings can be four to five years out, apply the current multiple to those earnings, and then see what the price would be if discounted back to today using a 20 percent annual rate. If the price today implies a discount rate of more than 20 percent per year, we're interested. We're not even looking at what we think can happen next year, because that's already fairly accurately built into the stock price. We also don't usually count on multiple expansion—although it would be great if it happened—because you really can't estimate a multiple five years out unless you have a good idea what interest rates will be then, which is not something I know anything about.
—Murray Stahl, Horizon Asset Management
THE INFORMED BUYER
Value investors from Benjamin Graham on down have stressed the importance of looking at equity ownership not as the shuffling of papers to be traded, but as a partial ownership interest in an ongoing business enterprise. A logical extension of that in arriving at what a stock is worth is the frequent focus among accomplished investors on what they believe a knowledgeable buyer would pay for the entire business.
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In ballpark terms, we like to be a buyer when the current share price is no more than 60 percent of our estimate of business value, which is the highest price a cash acquirer could pay for the entire business and still earn an adequate return on their investment. The words are all important. By focusing on a cash buyer, we're trying to separate people who are paying real money from those who might overpay with their own overvalued shares. The focus on adequate returns allows for the possibility that the buyer has some way to extract synergy from the purchase. Especially when you're looking at small- to mid-cap companies, the maximum value may come from a buyer who will integrate the business into a larger organization. We're not just looking at the maximum price of a given company in its current corporate form as a public entity.
Why 60 cents on the dollar to buy rather than 50 or 40? Over long periods of time stocks tend to perform better than other assets do, and the more stringent you are about what you'll accept the more difficult it becomes to field a portfolio. We've found over our history that at 60 cents on a dollar, we've been able at any given time to field a relatively full and well-diversified portfolio of ideas. If we buy right, the discount closes, and the value of the $1 we buy today goes to $1.20 or so over the next two or three years, we have the potential to double our money. That kind of makes sense to us.
—Bill Nygren, Harris Associates
Intrinsic value to us means the price that a knowledgeable buyer would pay for a business in its entirety in cash today. Any knowledgeable buyer will recognize and take into consideration whether current earnings are too high or too low, based on the cyclicality of the business and where it is in the cycle. Similarly, we don't want to capitalize earnings streams that are too high or too low, but focus in valuation on what the cash flow of the business is somewhere between the extremes. Because the future is uncertain, we don't exaggerate the precision of the values we come up with.
—Abhay Deshpande, First Eagle Funds
We try to figure out what a rational, informed buyer would pay for the whole business. We'd expect that kind of buyer to base the price on how much cash the business would generate over the next 15 to 20 years in excess of what's needed to run the business, so true free cash flow. We use a standard 12 percent discount rate as the hurdle rate that buyer would want to earn.
—Wally Weitz, Weitz Funds
In general we want to see a 35 to 40 percent discount from what a prudent man making an acquisition would pay for the entire business. We put it that way because sometimes, such as in 2006 and 2007, acquisitions are being done at levels we consider imprudent, so we don't use them in calculating intrinsic values. If you're fairly conservative in valuing the business and then demand a 40 percent haircut off of that, you should have a pretty healthy margin of safety.
—Robert Wyckoff, Tweedy, Browne Co.
We basically focus on what a somewhat knowledgeable buyer, expecting a reasonable return, would be willing to pay in cash for the entire business. We put a lot of emphasis on comparable transaction and market values, crosschecked against valuation measures like enterprise value to EBIT. We'll generally only invest when the EV/EBIT multiple is in the range of 8× to 15×—the low end for businesses, using Warren Buffett's terminology, that might be more questionable, while the high end is for businesses that are more comfortable.
—Jean-Marie Eveillard, First Eagle Funds
We're not P/E buyers. We're not P/E-to-growth-rate buyers. And we're not EV/EBITDA buyers because we think over time that the D and A in EBITDA are real expenses you need to account for. We look at current operating income divided by enterprise value as our “cap rate,” and we want to buy when that's 15 percent or more and sell when it goes to 7 to 8 percent. I'm trying not to buy hopes and dreams, but the here and now. The layman's way to think about it is if you could buy the whole company and—before financing and paying taxes—earn 15 cents on a dollar invested, that's a pretty good deal. If the hopes and dreams come true, all the better.
—Jay Kaplan, Royce & Associates
The underlying principle is what someone would pay in an arm's-length transaction for the entire business. We usually arrive at that by applying what we consider to be the appropriate multiple to estimated EBITDA one year out, adjusted for the balance sheet. To enter a position, we want to see a 30 to 40 percent discount to our intrinsic-value estimate. We try not to fool ourselves that just because we built a spreadsheet that all of this is very precise—we're making estimates and thinking about things that are unknown. But there are cases in which our level of confidence in the estimated earnings or in the multiple is higher. The more confident we are, the more likely we'll find a 30 percent discount sufficient. The less confident we are, the higher the discount required. In our experience a portfolio of stocks with those types of entry points will generate an attractive return over time. We will not be right on every stock, we just need to be right on average.
—Andrew Jones, North Star Partners
MODEL BEHAVIOR
In the investing world writ large, there is an extremely wide variance in the extent to which money managers automate their valuation, assessment, buying and selling decisions. At one end of the spectrum are those who rely heavily on discounted-cash-flow models and other defined valuation parameters to drive portfolio decisions executed by computer algorithms that respond to changes in market prices. At the other end of the spectrum are investors with a decidedly healthy skepticism of computer models and the certainty and precision that they imply exists. Most of the investors we've interviewed fall somewhere in the middle—rigorous in their use of models to assess valuation and make trading decisions, but also relying on experience and intuition to overrule the system when they believe it's warranted. As we've said many times, there is no one right approach, but every successful investor we've come across is quite adept at describing where automation ends and intuition begins in his or her approach.
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Models beat human forecasters because they reliably and consistently apply the same criteria time after time. Models never vary. They are never moody, never fight with their spouse, are never hung over from a night on the town, and never get bored. They don't favor vivid, interesting stories over reams of statistical data. They never take anything personally. They don't have egos. They're not out to prove anything. If they were people, they'd be the death of any party.
People on the other hand, are far more interesting. It's far more natural to react emotionally or to personalize a problem than it is to dispassionately review broad statistical occurrences—and so much more fun! It's much more natural for us to look at the limited set of our personal experiences and then generalize from this small sample to create a rule-of-thumb heuristic. We are a bundle of inconsistencies, and although this tends to make us interesting, it plays havoc with our ability to successfully invest.
—James O'Shaughnessy, O'Shaughnessy Asset Management
An ideal stock according to our model would be inexpensive on an absolute basis, relative to its peers and relative to its history. It would be supported by high-quality earnings, as measured by things such as cash flow relative to net income, capital spending relative to depreciation and earnings-estimate dispersion. It would be financially secure, as measured by things like the levels of cash and operating cash flow versus liabilities, the operating return on assets, and the ratio of shareholders' equity to total assets. Finally, it would be in the midst of an upswing in business operating momentum and investor sentiment, as indicated by, say, share-price momentum and earnings-estimate revisions.
—Paul VeZolles, WEDGE Capital
We have a sophisticated, proprietary model that we have shown to be a source of alpha by valuing companies and judging where they are in their earnings cycles. That's the science of what we do and is quite systematic and repeatable.
The art of what we do is in the interpretation of that data and deciding what to actually buy and sell. Here you need to rely on experience, judgment and continuous learning. Is that repeatable as the people change? If you pick the right people, teach them well, and give them the experience necessary to act on their own, we think so.
—Ronald Mushock, Systematic Financial Management
With our quantitative and more automated approach to buying, we're just trying to take as many of the behavioral foibles off the table as possible. Think about it in terms of the S&P 500 index, which is actually a not-so-great investing strategy because all it says is “Buy big stocks.” The reason it beats 70 to 80 percent of conventionally managed funds is not because it's a good strategy, but because it's a strategy that's religiously adhered to. It doesn't panic, have second thoughts, or become jealous of what its next-door-neighbor index owns. The key to its long-term success is an unwavering implementation of an investment strategy. We're using the same logic, but with what we believe are better strategies.
—James O'Shaughnessy, O'Shaughnessy Asset Management
To arrive at an intrinsic value we forecast cash flows out five years, and then discount the first four years back to the present and add to that the present value of the fifth year's cash flow after applying a multiple to it. The setting of that multiple, of course, is very important and is where we have the most debates in our approval process. There are quantitative and qualitative aspects to it. We'll maybe start with peer multiples or the multiples at which deals have been done, for example, but that's not the only input because every company is different. We also take into consideration things like the consistency of the business, its financial strength, and the operating prowess of the management team.
—David Herro, Harris Associates
We're trying to find 20 to 30 long investments, run by management teams that truly understand the cost of capital and capital allocation, where we believe based on a dividend-discount model that we're paying 60 to 70 cents on the dollar today and that that dollar can grow at an equity rate of return. If you can buy a 60-cent dollar and over three years that dollar appreciates 10 percent per year and the discount closes, the stock will more than double. You obviously won't do that on every position, but if you hit that on half your positions on average and don't lose any money on the other half, you'll earn 13 to 14 percent per year.
—Jon Jacobson, Highfields Capital
Our discounted-cash-flow calculation then produces two prices. Our buy price is the price at which the cash flows are being discounted to produce our required real return of 8 percent. Basically, the company is priced low enough to allow us to earn in excess of the market's expected return. Our sell price is the one that discounts future cash flows at 6 percent, meaning the valuation no longer allows us to earn an expected return greater than the market's.
—Bernard Horn, Polaris Capital
Our goal is to create a detailed financial model that estimates cash flow available to shareholders over the next five years. With that model we're able to calculate the present value of both the five-year cash flows and a terminal share value, calculated by applying an estimated terminal multiple to our year-five cash flow estimate. We discount both those values back to the present using a required rate of return, which reflects the riskiness of the cash flows due to things like industry cyclicality, competitive threats and the rate of technological change. In today's interest-rate environment, required rates of return for most companies we analyze are from 8 percent to 12 percent.
—Chris Bingaman, Diamond Hill Investments
We do the same discounted cash flow analysis everyone does, but the most important variable—and the one that most impacts the answer—is the growth rate you assume for the business. Lee Cooperman always used to say that if you got that right, you were 90 percent there. I've always considered that to be true.
—Morris Mark, Mark Asset Management
If you're buying high-quality businesses at what you think are discounted prices, you can be a little bit wrong on your intrinsic-value estimates and still make money. If you've ever done a DCF analysis, you know how variable the results can be with small adjustments in things like operating leverage or discount rates. We want to buy only when the share price is 50 to 60 percent of our calculation of intrinsic value, but our qualitative judgment of the business, management, and risk involved will play a bigger role in the positions we take than whether this stock is at 58 percent of intrinsic value and this other one is at 54 percent.
—Brian Bares, Bares Capital
We're not big fans of DCF models because of the garbage-in, garbage-out risk. I don't know if lunch will be good later on today, so how am I going to forecast a company's earnings five or ten years out?
Most of our valuation work focuses on what a company would be worth today in an arm's-length transaction. The best sources for that, of course, are comparable recent deals. We also look at how valuation multiples on a given company or the sum of its parts match up against historical and competitive comps.
—David Winters, Wintergreen Fund
We try to avoid false precision when we do our valuation work. We don't know what earnings are going to be next year and we don't believe management teams themselves can know that with any great precision either. What we can try to do is estimate the normalized economic earnings power of a business and then put a reasonable multiple on those earnings, based on the characteristics of the business—i.e. growth, need for capital, competitive position—and relative to what's happening out there in the real world of mergers and acquisitions.
—Curtis Jensen, Third Avenue Management
I'm still more back-of-the-envelope when it comes to valuation. To me it all comes down to the assumptions you're making. If they're correct, a back-of-the-envelope calculation works perfectly well. If they're not, sophisticated modeling isn't going to help.
—Robert Kleinschmidt, Tocqueville Asset Management
I was brought up in the business to be skeptical of big, long-term discounted cash flow models, so that's not an important part of how we invest.
—Steven Tananbaum, GoldenTree Asset Management
Discounted cash flow to us is sort of like the Hubble telescope—you turn it a fraction of an inch and you're in a different galaxy. There are just so many variables in this kind of an analysis—that's not for us.
—Curtis Jensen, Third Avenue Management
PLAYING THE ODDS
Consistent with value investors' emphasis on what can go wrong with any given investment, they typically in their valuation work assess a variety of possible upside and downside value scenarios and, implicitly or explicitly, assign probabilities to each before making any final judgments.
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We're very focused on how much money we can lose. What's the hard asset value? What protection does the balance sheet provide? We stress test the business using draconian assumptions and compare the worst-case scenario with what we predict will actually happen. We want $4 to $5 of upside for every $1 of downside. We've found over time that if you marry improving returns on invested capital with an asymmetric risk profile, the odds of losing money are low.
—Joe Wolf, RS Investments
I'll say it in a way that implies more precision and rigidity than we use, but we also want to see potential upside versus downside of at least 3:1. If at normalized earnings levels in two years or so we see an upside that is three times the downside we could imagine in the next year or so, we're usually comfortable going forward.
—Steven Romick, First Pacific Advisors
The prospective return must always be generous relative to the risk incurred. For riskier investments, the upside potential must be many multiples of any potential loss. We believe there is room for a few of these potential five and ten baggers in a diversified, low-risk portfolio.
—Seth Klarman, The Baupost Group
One lesson from 2008 was that we were guilty of having a failure of imagination on the downside. We develop a base, high, and low case for each business we analyze and one practical adjustment we've made is to make our low cases somewhat more draconian. That comes into play in what we're willing to pay. We're more reluctant to buy a stock that might look attractive relative to the base case if the downside from the low case is too great. That's always been true—if the range of outcomes is wide, that probably means the cash flows aren't as predictable as we'd like and we require a bigger discount—but it's even more of a focus now.
—Wally Weitz, Weitz Funds
In valuing companies, we're putting more emphasis on the relationship between the current price and the worst-case scenario and—regardless of the potential upside—are more likely to sit and wait if that downside is material. In a sideways market, cash is not trash.
—David Nierenberg, D3 Family Funds
It isn't human nature to view the future in terms of a wide range of possibilities. We naturally think in terms of what is most likely to occur and implicitly assess the probability of that scenario occurring at 100 percent. That may sound reckless, but it's what most people do and isn't a bad way to think as long as less likely, but still plausible, scenarios don't have vastly different outcomes. In the investment world, however, they often do, so making decisions solely on the most likely outcome can cause severe damage.
In addition to what might be the business-as-usual case, we also want to identify four or five scenarios that are different from the recent past and analyze the present value of likely future cash generation under each. We calculate an intrinsic value and apply a probability to each scenario. Our final estimate of value is the value under each scenario weighted by its probability of occurring. A key is to capture low-probability but high-impact scenarios, primarily to see where the vulnerabilities are.
—Bryan Jacoboski, Abingdon Capital
We come at valuation in a variety of ways, but the primary one is to assign probabilities to three or four different scenarios to arrive at an expected outcome, which we compare to the current share price in looking for a margin of safety.
—Michael Karsch, Karsch Capital
At the end of every quarter we get a report showing the holdings we had in each portfolio five years ago and how those stocks have performed over the ensuing five years. The goal is to assess the decisions we made and whether the estimates of intrinsic value upon which those decisions were based were properly done.
One thing we've learned is that we often don't give companies enough credit for the fundamental strength or weakness of their competitive positions and business models. That has resulted in selling winners too soon, and in holding losers too long because we haven't had the imagination to see how bad things could get. You can never eradicate those kinds of mistakes completely, but it has made us more sensitive to both best-case and worst-case scenarios in our valuation analysis.
—Chris Welch, Diamond Hill Investments
We look back as far as possible to inform what would be the worst-case levels of revenues and margins, and then apply what we think are trough multiples to the resulting worst-case earnings. If the worst case is more than 20 percent below the existing share price we won't buy it, no matter how much the discount is to our intrinsic value.
—Charles de Lardemelle, International Value Advisers
We don't invest in things that could be a coin flip between doubling or going to zero. We want the downside of every holding to be no more than 10 to 15 percent and the upside to be at least 50 percent. The key for us is to not be wrong about the downside.
—Jon Jacobson, Highfields Capital
We don't invest in binary win/lose situations. A deep-value manager can quite openly accept that some of his holdings may go to zero, assuming that big winners will more than offset the occasional big loser. We don't contemplate losing too terribly much on any investment.
—Brian Barish, Cambiar Investors
One mistake value investors can make is to focus too literally on the absolute difference between an estimate of intrinsic value and the stock price as the valuation cushion. If the range of potential outcomes is very wide, you may have much less of a cushion than you think. One big reason we focus on better-quality businesses with great balance sheets is that the variability in outcomes—and therefore the risk of blowing through the valuation cushion—is lower.
—Dan O'Keefe, Artisan Partners
THEORIES OF RELATIVITY
An investor's attitude towards absolute versus relative measures of valuation is often a function of how fully invested he or she expects to be. If holding a decent amount of cash is not an option, for example, a focus on relative valuation against other stocks is more likely. When cash is allowed to build, managers are more apt to wait for absolute valuation criteria to be met before acting. But even holding one's cash strategy constant, views on what constitutes actual value at any given time can vary widely.
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Here's how we think about it: Say the S&P 500 companies sell at 15× next year's earnings, 3× book value, 11× cash flow, 1.5× revenues, have an ROE of 17 to18 percent and have anticipated trend earnings growth of 8 percent. We're looking for companies with equal or superior growth characteristics that sell at discounts to the market valuation.
—Leon Cooperman, Omega Advisors
We're basically willing to pay average or below-average valuations for companies we believe will continue to have better-than-average performance. Relative to more elaborate valuation disciplines you may hear about from others, ours is relatively simple. Only a small amount of our returns are from being clever on valuation when we buy.
—Eric Ende, First Pacific Advisors
We've developed a quantitative model that's designed to reflect the attractiveness of every company in our 1,000-company database based on three factors: expected earnings growth relative to the P/E multiple (the higher the better), valuation relative the company's past history (the lower the better), and the trend in consensus Wall Street estimates (upward movement gives us more confidence).
—Philip Tasho, TAMRO Capital
We rely on companies' historic valuation ranges and/or peer group valuations on traditional measures like price-to earnings, price-to-book, and price-to-sales to identify investment targets and then project future valuation ranges. The basic discipline is to buy in the lower quartile of the valuation range and sell towards the upper end of the long-term range.
You do have to recognize if a disruptive technological or structural industry change is underway or relative value will point you to a lot of value traps. We're always asking whether there's a transitory disruption to a business or whether there's a point of discontinuity, as was the case with Eastman Kodak. There are also analytical checks to do on past valuation levels. If there have been periods of hyper-normal valuations, such as technology and telecom in the 1990s, you have to ignore those data points.
—Brian Barish, Cambiar Investors
One of the big mistakes value investors can make is to be too enamored with absolute cheapness. If you focus on statistical cheapness, you're often driven to businesses serving shrinking markets or that have developed structural disadvantages that make it more likely they're going to lose market share.
—Bill Nygren, Harris Associates
We generally avoid the most deeply discounted stocks. In a normal market, companies trading at half of intrinsic value or less often do so because there is some significant risk in the business. It may be a low-probability risk, but we'll steer clear of high-severity, low-probability risks. In our portfolio today we only have one or two holdings that—after the fact—have been shown to face more of a binary outcome.
—Timothy Hartch, Brown Brothers Harriman
When I look at mistakes I've made—like buying the best sub-prime mortgage lender in late 2006—they've primarily been when I thought I was getting a great deal on a house, only to find out later there had been a fire smoldering in the basement. The obvious lesson is that things that look cheap aren't necessarily so.
—Jed Nussdorf, Soapstone Capital
One distinction we generally try to make when betting more on industry cycles is that something should be cheap based on the current numbers, not just on what is considered normalized earnings. That makes it a more conservative investment with even more upside when the cycle eventually comes back.
—Andrew Jones, North Star Partners
We focus on absolute value, trying to resist reaching for relative-value justifications just because we have the cash. Relying on relative valuation is how you end up paying silly prices for houses, Internet stocks, and anything else in life.
—Peter Keefe, Avenir Corp.
I try to own businesses that are inexpensive in an absolute rather than relative sense. No position I own today trades at more than 15× my estimate of the next 12 months' earnings. The only companies I own at more than 12× earnings are in businesses that I think are among the best in the world.
The problem I've found in paying higher multiples is that you can have a differentiated view on the business fundamentals and be absolutely right, but the risk is higher that the multiple contracts and takes away your positive return. That doesn't have to happen, of course, but I want to credibly believe the multiple trajectory is biased upwards, even if that's not the primary reason I'm investing.
—Jed Nussdorf, Soapstone Capital
We firmly believe no investment is so wonderful that it can't be ruined by a too-high entry price, so on our discount-to-cash-flow stocks we will not pay more than the market multiple on forward earnings. We want to avoid the temptation of making relative valuation bets—say, finding a software company attractive because it's only 30× earnings when the group sells at 40×.
—Christopher Grisanti, Grisanti Brown & Partners,
What you're unlikely to see us invest in is something like The Cheesecake Factory when it's at 30× earnings. At that level everybody knows it's a great story and, when it comes down to it, the bet you're making is whether or not the business grows a little faster or for a little longer than people expect. Those are not the types of calls we look to make.
—Brian Gaines, Springhouse Capital
A fair price today is one that should allow us over time to realize on our investment the same level of compound annual growth we expect in per-share book value, earnings or cash flow—whichever is most appropriate for the company at hand. What that tries desperately to preclude is paying so much that the business can do extremely well but the stock price goes nowhere, which can happen as businesses inevitably mature and valuation multiples shrink.
What that means practically to us is that if we find a business that meets all our criteria and we pay no more than 14 to 15× trailing earnings, we're not going to be wildly off on price. For any number of market, industry, or company-specific reasons, it's been my experience that we'll episodically get opportunities to pay these kinds of prices.
—Thomas Gayner, Markel Corp.
We look out two to three years at what a company can earn in a normal economy if our expectations for change play out. We don't look at a shorter period because so many other investors are doing that that it's much more competitive. Looking out much further than that, the uncertainties go up and thus our ability to predict goes down.
We then apply a valuation multiple anchored on the average S&P 500 P/E over the last five decades of around 15.8×. We consider that a fair valuation for an average company. Taking into consideration things like the balance sheet, re- turns on capital, growth, barriers to entry and management quality, we'll go up and down from 15.8× to come up with what we believe is an appropriate multiple and apply it to our EPS estimate. For a stock to be interesting, we want to see at least 50 percent upside from today's price to that fair value.
—Ed Wachenheim, Greenhaven Associates
I'm amazed at how common the relative valuation argument is. But you shouldn't forget that all that argument may be telling you is that bonds or another asset class might suck, not that equities are great. It's like going to Cinderella's house and meeting the two ugly stepsisters and being told you should be happy to date one of them. Personally, I'd rather wait for Cinderella.
None of that stops people who want you to buy equities from talking about how much better they are today than bonds. “What else am I going to do?” is not the most compelling reason for doing something. If there's nothing to do, do nothing. It's not that difficult.
Absolute standards of valuation get you away from the idea that you have to be doing something, which goes all the way back to Ben Graham. He was looking at all elements of the capital structure in a very unconstrained fashion, but was fully prepared to hold cash when there were no opportunities. Today with the rise of specialist mandates and passive indexing, so many people want to be fully invested all the time. I'd argue that has caused our industry a lot of problems.
—James Montier, GMO
PULLING THE TRIGGER
Timing may not be everything, but it's certainly of keen importance in making the ultimate decision to buy a stock. That decision can engender any number of caught-up-in-the-moment types of emotions—exactly what reasoned, rational investors try hard to avoid—and the vast majority of the time will be deemed in hindsight as having been excessively early or late. In making the final buy call, the best investors strive mightily to maintain the same patient and careful process that got them to that point in the first place. Some find virtue in a team-based approach to pulling the trigger, others argue that too many cooks spoil the broth.
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One of my favorite investing quotes of all time is from Joe Rosenberg, Loews Corp.'s chief investment strategist for many years, who said the secret to outperformance is to “have opinions at extremes, and wait for extreme moments.” We're willing to wait for the perfect pitch rather than swing at things that look pretty good. It's not that hard to find pretty good values, it's much harder to be patient and only buy the great ones.
—Chris Mittleman, Mittleman Brothers, LLC
Once we act, we forfeit the option of waiting until new information comes along. As a result, not acting has value. The more uncertain the outcome, the greater may be the value of procrastination.
—Peter Bernstein, in Against the Gods
In a world in which most investors appear interested in figuring out how to make money every second and chase the idea du jour, there's also something validating about the value-investing message that it's okay to do nothing and wait for opportunities to present themselves or to pay off. That's lonely and contrary a lot of the time, but reminding yourself that that's what it takes is quite helpful.
—Seth Klarman, The Baupost Group
Much of our research and analysis involves identifying companies we're willing to buy and the prices at which we'll buy them. If the market isn't offering up those companies at those prices, we sit and wait. Clients sometimes get anxious about that, but we try to remind them we get paid for results, not activity.
—Steve Leonard, Pacifica Capital
You obviously have to get your analysis right to be a great investor, but success also comes down to patience. We think of ourselves a bit like a lion lying in wait. There are plenty of gazelles running around, but we can't run after them all, so we wait for one to get within 125 feet before we go. Not 150 feet or 200 feet, but no more than 125. Sometimes the market offers up those great kills and we try our best to be ready and to take advantage when they come along.
—François Parenteau, Defiance Capital
In a typical year, the average large-cap stock fluctuates about 50 percent from its low to its high. If you've done your homework and you're patient, more than enough opportunities to buy will come along.
—Donald Yacktman, Yacktman Asset Management
As Graham, Dodd, and Buffett have all said, you should always remember that you don't have to swing at every pitch. You can wait for opportunities that fit your criteria and if you don't find them, patiently wait. Deciding not to panic is still a decision.
—Seth Klarman, The Baupost Group
I've never considered it a legitimate goal to say you're going to invest at the bottom. There is no price other than zero that can't be exceeded on the downside, so you can't really know where the bottom is, other than in retrospect. That means you have to invest at other times. If you wait until the bottom has passed, when the dust has settled and uncertainty has been resolved, demand starts to outstrip supply and you end up competing with too many other buyers. So if you can't expect to buy at the bottom and it's hard to buy on the way up after the bottom, that means you have to be willing to buy on the way down. It's our job as value investors, whatever the asset class, to try to catch falling knives as skillfully as possible.
—Howard Marks, Oaktree Capital
You must buy on the way down. There is far more volume on the way down than on the way back up, and far less competition among buyers. It is almost always better to be too early than too late, but you must be prepared for price markdowns on what you buy.
—Seth Klarman, The Baupost Group
[SAC Capital's] Steve Cohen thought it was the silliest thing in the world to try to capture the first and last part of a stock's move—those were the most dangerous parts of investing. For me, I'd like to capture more of the early part of the move and leave the latter part for somebody else. In general, if you're right on the fundamentals and can capture the big, fat middle portion of a stock's move, you're going to make a lot of money.
—Robert Jaffe, Force Capital Management
I'm a value guy at heart, so would rather buy early than late. The problem with being late is that you're already paying for the turnaround itself, so you have to count much more on the turnaround resulting in sustained revenue and profit growth.
—Kevin O'Boyle, Presidio Fund
A common expression we use around here is the Chinese one, “to have known and not to have acted, is not to have known.” We try to fight against statements like “this would be a great investment if it was 10 percent cheaper.” That's a wussy conclusion because you can't be wrong: If it goes down, you can say you knew it was too expensive. If it goes up, you can say you knew it was a great investment. But if you know it's a great investment you should buy it.
—Christopher Davis, Davis Advisors
When we were buying Coca-Cola years ago, I'd lay out for other investors one part of our thesis—that enormous demand in emerging markets could eventually turn Coke into a growth stock again—but many of them just weren't interested. “Tell me again in a couple of years,” they said. If we're comfortable that value will compound over a long period of time, we think it's not productive to try to time so precisely when to get in. It's too hard and you often end up missing out.
—Boykin Curry, Eagle Capital
Sir John Templeton, who always argued for buying during periods of maximum pessimism, had one of the best methods for keeping emotion out of the process. He used to do his calculations of intrinsic value when there wasn't a lot going on in the market. He'd then place a margin of safety on those intrinsic values and place buy orders with his broker at, say, 40 percent below the current market price. I'm sure a fair amount of those orders never got filled, but if there was an enormous dislocation in the market or in an individual stock, the order would fill. Psychologically, that kind of precommitment is a very powerful tool to help us in periods of emotional turmoil. If you look at something when it's just gone down 40 percent, you're probably not going to want to touch it because it just warned on earnings or something similar.
—James Montier, Société Générale
In general, we try to constantly remind ourselves that when an industry goes south, things often get worse than you expect and stay bad longer—there's usually plenty of time to find the bottom.
—John Dorfman, Thunderstorm Capital
Our primary mistake in 2008 was buying too soon when the market started cracking in September. My takeaway: Sometimes it's best to let the other guy try to pick the bottom. In selloffs like that, there will be plenty of room to get in on the upside.
—Carlo Cannell, Cannell Capital
Many value investors will buy the cheap company when there's just a turnaround story attached to it, but we patiently wait for the fundamentals to improve first. The philosophy works because investors underreact to both positive and negative changes in fundamentals. If a company has chronically underperformed, investors dislike it, don't trust management, and won't give them the benefit of the doubt. When things improve, it takes a long time for people to believe it and incorporate the improvement fully into expectations and valuations.
If we see all the ingredients of a sustainable turnaround, we'll buy after one quarter of good earnings, allowing our clients to benefit from the slow rebuilding of confidence that will be reflected in the stock price over time.
—Kevin McCreesh, Systematic Financial Management
You have to be reasonably early and we of course love to get in at the absolute bottom, but so long as our valuation work indicates enough upside and we're confident in management's ability to execute, we'll initiate a position even after a restructuring is well underway or a problem is already on its way to being fixed.
—Jerry Senser, Institutional Capital LLC
The potential efficacy of combining value and momentum factors has always been a consistent theme of my research. Our Trending Value strategy still identifies the best values in the market, with the added twist that it then chooses from that narrow list the stocks that have increased the most in price over the past six months. In other words, we're looking at stocks that are still really cheap, but the market has started to take notice. I wasn't surprised that it worked—incorporating an element of price momentum can counteract value investors' tendency to buy too early and fall into value traps—but I'll admit that I was surprised how well it worked.
—James O'Shaughnessy, O'Shaughnessy Asset Management
Valuation predominates in our models, but we do believe value managers underweight positive [share price] momentum in their portfolios. The obvious reason is that stocks with positive momentum are often overpriced, but when they're not, we think its presence helps us avoid value traps. We'll ignore momentum if there's sufficient value-based justification, but if our awareness of the effect of momentum indicates we should buy later rather than sooner, we will.
—Paul VeZolles, WEDGE Capital
One thing we may do a bit differently from others is that once we've identified a stock as something in which we're interested, my two partners and I will all separately look at the valuation and arrive independently at what we think we ought to pay, based on the potential upside and, as importantly, the potential risk. When we reach different conclusions, that leads to a very important back-and-forth as we try to find a meeting of the minds. We absolutely believe the end decision is better as a result.
—Jonathan Shapiro, Kovitz Investment Group
We have three people in charge of the portfolio and we require unanimity on a stock in order to buy. That's not to say we have to feel equally strongly about something, but a great thing about having different intuition is that we're less apt to skim over something important because we're looking at things the same way.
—Christopher Grisanti, Grisanti, Brown & Partners
We've never thought it was a good idea to demand unanimous agreement in making a buy decisions because the best investment ideas tend to be somewhat controversial. The risk in forcing unanimous agreement in any committee structure is that you too often weed out your better ideas.
—Bill Nygren, Harris Associates
I've sat on buy-list committees where everyone had to agree, and while it sounds comfortable and prudent, it doesn't work. Every good idea with a creative or provocative angle, somebody's not going to like it. You end up with ideas that don't offend anyone, which aren't likely to be very good.
—Scott Satterwhite, Artisan Partners