This is a popular question among value investors. I've heard
many value investors talk about why a stock is cheap. I'll be
honest. I don't think I can explain why a stock is cheap.
There are several areas of investing where I have no expertise. I
don't think I add any value when deciding to sell a stock. Your
guess is as good as mine on selling. I don't think I add value on
position sizing. Over time, I've decided the best approach is just
to make each position the same size. I've seen no ill effects from
this. And it lets me focus on the buying part. I also have no skill
when it comes to knowing when I will get paid. I don't know what
actual catalyst will cause a stock to reach my estimate of its
intrinsic value. I have invested in situations where I believed I
knew what the catalyst was, what the timeframe for realization was,
and what the value realized would be. I've always been wrong on
this. Usually, I have been too pessimistic on the final price
someone will pay for a stock. Unfortunately - when there was an
obvious catalyst present - I've usually been too optimistic about
how quickly that value will be realized.
So I don't do selling well, or position sizing, or recognizing
catalysts. I also don't think I bring any special skills to knowing
why a stock is cheaper than it ought to be. In other words, I don't
think I'm any better at explaining the seller's rationale for
trading his shares for my cash when I buy.
Is this a necessary skill?
It seems like it should be. It seems like - to make a winning
investment - you need to know something the market doesn't.
However, I don't believe that's true. Because I don't believe
knowledge has much to do with how people invest.
Knowing is usually an intermediate step. Investors incorporate
facts into their interpretations of a stock. I don't think you need
to know different facts than other investors. You just need to
interpret the same facts differently.
There is one value approach that almost always seems to work for
me. And, in a sense, it is based on the idea of a different
interpretation of a stock. But it's not at all based on different
I'm not an expert on why other investors choose to buy and sell
stocks. But I have noticed a tendency to focus a lot on reported
results. Next year's earnings are a big concern.
So, using a combination of 3 different facts - facts you'll often
agree with the market on - you may be able to come up with a
The 3 facts I find most helpful in interpreting a stock different
are: 1) Owner earnings, 2) Enterprise Value, and 3) What happens in
Let's start with the last one, because it's the most difficult to
explain. The market is often focused on what just happened last
year and what will happen next year. Analysts and investors are
always looking ahead. But, are they often looking more than 3 years
It's now 2013. One of the first things I ask when trying to value a
stock is what it will look like - assuming a normal environment -
in 2017. The reason for this is obvious. The market may put extreme
importance on expected results in 2013, 2014, and 2015. But unless
these results indicate a pattern that will continue right through
2017, 2019, and 2020 - they aren't likely to make or break a
long-term investment in the stock.
A lot of the value in a stock will come from cash flows after the
next 3 years. A lot will also come from cash flows in the next 3
years. But everyone is trying to predict those.
Likewise, everyone is trying to predict what margins, etc will be
in an industry environment that looks a lot like today or their
expectations for the next few years. Fewer people will be looking
at what the net interest margin of a particular bank will be in
2017, what the fuel costs of a cruise company will be, etc.
If you can figure these things out - and you can't know any of
them, you can only make educated guesses - will you know something
the market doesn't?
I don't think you will. You will focus on something the market is
not focused on. But I think your facts will often be quite similar.
I was reading an analyst report recently of a stock that I just
analyzed myself. The analyst valued the stock at $50 a share. I
valued the same stock at $68 a share. Since the stock trades in the
40s this is a meaningful difference of opinion. The analyst thinks
the stock is quite fully valued. He sees no margin of safety. I see
an almost 30% margin of safety.
Do we have different facts?
Not really. His report includes most of the same facts I considered
important. Some of our future estimates were also nearly identical.
For example, he assumes a roughly 2% annual sales increase. I
assume a roughly 3% annual sales increase.
There are some differences though. He projects sales growth and
margins till 2017. He doesn't consider either number beyond that.
I can't disagree with his 2% sales growth estimate for the next few
years. In fact, I feel pretty strongly that this stock - which I
consider a good buy - actually can never grow its profits faster
than nominal GDP. The company does almost all of its business in
Europe and the U.S. So, if you predict nominal GDP of less than 4%
a year, sales growth can't be higher than that.
Of course, that estimate is very much focused on the last few years
and the next few years. In periods where there was a bit more
inflation - in other words, almost any other time in the last
century - and nominal GDP growth, sales grew faster than this
I don't disagree at all with his estimate. I have no basis on which
to disagree with an estimate like that over a timeframe like that.
Economic growth has been pretty low since the financial crisis.
It's been hard to raise prices. The only way this company makes
money over time is by raising prices. So, I have to agree that if
nobody is raising prices on anything for the next few years - this
company is going to have a hard time creating any profit growth.
So our facts are the same. And I think our opinions - to the extent
we have opinions on the same subjects - are actually identical. I
wouldn't disagree with his short-term estimates. They are
reasonable. They might turn out to be low. But mine might turn out
to be high.
Where do we differ?
In our interpretation. The framework he used was to model out
through 2017 and then stop. The framework I used was to ask: What
does this company look like in normal times? What would nominal GDP
growth look like? What would inflation look like? How much could
they raise prices then? Could profits rise faster than sales? And
could free cash flow rise faster than profits?
His analysis ended in 2017. Mine really started in 2017. Not
because 2017 is likely to be more "normal" than 2013, but because I
am interested in "earning power" rather than reported earnings. In
a normal environment, how much can this company charge?
The next area where the two of us had different interpretations was
price. He used a perfectly reasonable P/E ratio of 15. However, he
used a P/E ratio. I think that's wrong. I think it makes no sense
to value a company like this on its P/E ratio.
I use owner earnings. I always do an owner earnings calculation.
And I don't care whether earnings can be reported or not. For
example, in this situation the company's operating earnings would
be about 15% higher if you added back amortization of intangibles.
You obviously need to add back amortization of intangibles. It's
cash flow the company gets each year. And these are intangibles
from acquisitions that don't need to be replaced.
If you're focused on reported earnings, there's a problem with this
amortization. It's going to go on and on for many years. Some of
these intangibles are being written off over a period of 20 years.
Some were pretty recently acquired. That means - even if the
company never acquires another business - it's going to be taking
large amortization charges far into the next decade.
You could look at this from an EPS perspective as a natural source
of EPS growth. As intangibles are written off, the amount of
amortization required next year declines. So, EPS automatically
rises. I think that's meaningless. Cash flow is the same before and
after the write-offs. But reported earnings aren't the same.
Because of the declining intangibles balance, EPS naturally rises
without the company doing anything.
It's a silly observation. But if you are trying to estimate EPS,
it's one of the key inputs for what EPS will be in say 2017. It
will be several percentage points higher simply due to a lower
intangibles balance that needs to be amortized.
Again, I don't think this analyst and I disagree on these points.
I'm sure he doesn't view the amortization as a real economic
charge. His estimate of free cash flow would be identical to mine.
But he uses a P/E ratio. I use an EV/Owner earnings ratio.
This brings me to the last of the 3 perspectives where you can
really differ from the market without actually knowing anything the
market doesn't. I only look at a company's price in relation to its
pre-tax owner earnings. And I only care about enterprise value.
A lot of value investors also use this approach. But some folks
disagree with me on this one. They feel that it rewards companies
that hoard cash. And it punishes companies that rationally leverage
up the balance sheet to provide more free cash flow to equity.
I would agree with that assessment in a world of unstoppable
inertia. I don't agree with it in the real world. I don't agree
with it because the capital structure you are looking at is not
necessarily what the stock will be a part of when you sell it, nor
even what it will be a part of for most of the time you own it. The
capital structure is just what it looks like today.
A company with no debt can go out and - without diluting your
equity - leverage up the balance sheet and almost double its size
overnight. Conversely, an overleveraged business can - without ever
risking insolvency - use almost all of the free cash flow you
anticipate to pay down the debt in front of your common stock. It
can also - if insolvency ever becomes a problem - end up issuing a
lot of shares.
Capital allocation is terribly important. I pay a lot of attention
to it. But I don't believe that today's capital structure tells you
as much about future capital allocation as the company's past
behavior, management's statements, etc.
I especially like to focus on companies that lower their share
count year after year. I find this to be more of a predictor of
future uses of capital - of what my returns may be in the stock -
than simply calculating the leveraged free cash flow on today's
That doesn't mean I won't buy a leveraged stock. I own
Weight Watchers (WTW
). It's very leveraged. But it's also - at about 9 times my
estimate of its pre-tax earning power - a fair price to pay on an
EV/Owner earnings basis for what I think is a wide moat business.
Notice that I don't care what the P/E ratio is (even though it's
low). And I don't care what next year's earnings will be. I care
deeply about the company's solvency through the next few years. And
I care about what owner earnings will be in a "normal" looking
I don't think I know anything the market doesn't. I do think I may
be framing the question a bit differently.
We can all agree that superior knowledge without superior
interpretation is not profitable. And superior interpretation
without superior action is equally unprofitable.
It may sound like that means the chain of doing something different
from the market has to begin with knowing something different. But
I disagree. I think you can fork off later in the process. You may
know the same facts, but interpret them differently. Sometimes,
this can lead you to a different and correct action.
to Geoff about Knowing Something Different From the
Follow Geoff at Gannon and Hoang on Investing
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