Value Investing and Relativity
Posted: August 28, 2017
“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 1000 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-light 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 that it indeed requires a big tent indeed to cover them all.
For instance, my business partner John Dorfman is a traditional value investor looking for stocks with low price/earnings, price/book and price/sales ratios and a strong balance sheet. I don’t 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 don’t believe that there are set criteria such as P/E or PEG ratios that automatically make one investment better than another. They simply note that the ultimate objective is to buy a dollar for fifty cents.
An interesting case is that of Bill Miller at Legg Mason. From the early-90s through the Great Recession, Miller had a spectacular run beating the S&P500 for 15 years in a row. Many of the more classically trained money managers argued that Miller really wasn’t a value investor at all because he owned growth stocks such as Amazon. Miller was somewhat annoyed at this assertion, arguing that any stock can be a value stock provided that 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 was as a great a shock to him as they were to his investors. He wasn’t 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 that I think can be helpful in situations like the markets in mid-2017.
- Is the company overvalued as defined by analysis of its future free cash flows?
- Is the company far in excess of normal valuation standards?
- 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 PE of 50+ 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 (EGOV a holding in some Dorfman Value Investments portfolios) a cost of capital of 9% gives a value of around $24/share. An estimated cost of capital of 12% gets me a value of roughly $15/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
My partner John Dorfman utilizes three ratios (among other criteria) in estimating the value of a holding – price to earnings (P/E) ratio, price to sales (P/S) and price to book (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 that 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 US 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 how fleeting the values of these might be over time.
In my investing methodology, I have a tendency to lean towards companies with little or no debt, high cash balances and generous free cash flow. My compatriot John Dorfman 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 don’t need to be an Einstein to be a great investor. Maybe not. But a good understanding of Lorentz can’t hurt.
As always I look forward to your thoughts and comments.