Value Investing in a New World Order

It was Oscar Wilde who once said that "A fool is someone who knows the price of everything and the value of nothing". As always, what is most important is to watch the headlines, but do numbers as well. Without a solid grounding in the valuation (cash flows, growth and risk), we are at the whim of someone else's narrative. Or, as Winston Churchill once said: “A lie can travel halfway around the world while the truth is putting on its shoes”.

The secret to great investing is a happy marriage between plausible investment stories and numbers, with the recognition that no matter what the story or potential is for a stock, the narratives eventually have to show up as numbers (revenues and earnings). In a good valuation, every number we have in our valuation, from growth to margins to risk measures, should be backed up by a story about that number, and every story we tell about a stock, including its great management, brand name or technological edge, must be reflected in a number in our valuation.

I am from the Dominican Republic, where baseball is loved deeply, and I do think that equity markets and baseball share a great deal in common. Research analysts are our baseball scouts, asking us to trust their narratives when picking stocks. CEOs at companies are our baseball managers, flaunting their industry experience and asking us to trust their gut feeling and instincts, when it comes to capital structure decisions. But like Billy Beane in the movie Moneyball, I trust valuation numbers far more than either analyst multiples or managerial stories.

It is also worth emphasizing that markets are pricing mechanisms, not value mechanisms, or as Ben Graham would put it, they are voting machines, not weighting machines, at least in the short term. Markets regularly fall prey to ‘narrative fallacy’, and have a strong predilection to shoot and think later. In other words, in the short run, the market is not a particularly smart investor. Some investors prefer to focus on the short term - next quarter, next year or perhaps two years out, using the excuse that going beyond that is an exercise in speculation. Ironically, it is the long term that determines the value of a company, rather than the near-term results.

Equities are long-duration assets (5+ years), which makes looking at valuation through the lens of either trailing or one-year forward earnings somewhat limiting. A more comprehensive metric is the price as a % of value derived from the discounted cash flow model (DCF), which is a very powerful tool to see what the market is currently discounting. Some investors seem to view discounted cash flow valuation as a speculative exercise, and instead pin their analysis on comparing on pricing multiples.

Investors who use multiples to find under and overpriced stocks do so because they do not want to confront the uncertainty associated with forecasting future growth, margins, and cash flows in intrinsic valuation. That is an illusion, since embedded in every multiple are assumptions about growth, risk, and investment efficiency. When we pay five times earnings for a stock or one time book value, we are assuming high growth in earnings for the former and a high return on equity for the latter. Put simply, if we are abandoning or refusing to do intrinsic valuation, because we feel uncomfortable with having to make assumptions, the same uncertainty is going to pervade any pricing metric as well.

The difference between intrinsic value, where we try to forecast future growth and cash flows, and pricing, where we use a multiple, is that we are explicit about our assumptions in the future, making them both more transparent and easier to critique, and that we are implicit in our assumptions with the latter, making them easier to defend but also more dangerous. After all, there should be no disagreement that the value of a business comes from its future cash flows, and the uncertainty you feel about those cash flows, and as I see it, all that discounted cash flow valuation does is bring these into the fold. It is true that we are forecasting future cash flows and trying to adjust for risk in intrinsic valuation, and that both exercises expose you to error, but I don't see how using a pricing ratio or a short cut makes that error or uncertainty go away.

Investing is really hard when central banks are tightening, and companies are dealing with a toxic combination of surging inflation, higher interest rates, and economic stagnation that could jeopardize their growth trajectory. Ironically, it is precisely at times like these that we need to go bak to basics and try valuing the business, uncertainty notwithstanding. Uncertainty is not a shield against investment decision. If we wait until we feel "certain" about our valuation, we will never act! Valuation is a pragmatic, rather than a theoretic, exercise, where the end game is not just understanding and estimating the value of a company but acting on that valuation. As an investor we must be willing to buy undervalued assets and sell short on overvalued assets, with the caveat that we do need a higher equity risk premium (ERP) to make money, and that correction may take time. The ERP is the reward we get for investing in stocks, and we want it higher, not lower.

Right now, what is driving markets is not what is happening to individual companies but what people see in the macro environment. Last year started with the onset of many unknown unknowns - omicron outbreak, war, unprecedented inflation. After such challenging times, this year will still be uncertain, with the continuation of unknowns such as high inflation, slowing growth and geopolitical tensions. And as disoriented public sectors respond to conflicting and violent changes, investors and policy makers will likely swing from shortage to abundance, from inflation to deflation, from growth to recession, from calm to extreme volatilities, and from predictability to unpredictability. Market turbulence is inevitable. Yet being an investor is to live at the intersection of story and uncertainty. And I have learned that if I worry about what has happened already and/or constantly worry about macro events, it does more damage to my investments and the portfolio than getting it right. To the degree that worrying about things I do not control is going to hurt me as an investor. So, the only rational answer is to control what one can control and avoid wasting limited intellectual bandwidth on things that one has neither control over nor has the ability to estimate.

Investing is all about maximizing the areas we have control over and know about while minimizing the areas we have no control or know little about. I also understand that it is easy for some people to get carried away and try to predict the immediate future. What will oil do? Where will inflation stop? When will the recession begin? What will it look like? And some people do this, probabilistically, and often they are right and sometimes they are not. But even if we somehow manage to get an economic forecast correct, that is only half the battle. We still need to anticipate how that economic activity will translate into a market outcome. This requires an entirely different forecast, also involving innumerable variables, many of which pertain to psychology and thus are practically unknowable. Former U.S. Secretary of Defense Donald Rumsfeld famously said: “There are unknown unknowns, things we don’t know we don’t know, and there are also known unknowns - things we know but don’t fully understand”.

One of my favorite memos is from Howard Marks, where he recalls a lunch he had with Charlie Munger: As it ended and I got up to go, he said something about investing that I keep going back to: "It's not supposed to be easy. Anyone who finds it easy is stupid". One reason that it is hard for many people to manage money is that they are influenced by what other people do. Ben Graham would say you're not right or wrong because 1,000 people agree with you and you're not right or wrong because 1,000 people disagree with you. You're right because your facts and reasoning are right. Many years ago, Jeff Bezos was asked what he sees as the defining characteristics for people who "are right, a lot". His answer really stuck with me. "People who are right a lot change their minds often". Predicting the future is easy. Getting it right is the hard part. And 'being right' comes through continuously challenging our understandings, being curious, parking our egos, and accepting that the greatest enemy of knowledge is not ignorance, it is the illusion of knowledge.

Purely picking individual stocks to gain an edge is increasingly difficult, given the wider availability of once-valuation financial information, and the fact that after more than two decades of disruption, it is quite clear that center of gravity has shifted for both economies and markets, with the bulk of the value in markets coming from companies that are very different from those that dominated the 20th century. While much is made of the fact that some of the biggest companies of today's markets (in market capitalization terms) derive their value from intangible assets, we think the bigger difference is that these tech companies are also less capital intensive and more flexible. That flexibility, allowing them to take advantage of opportunities quickly, and scale down rapidly in the face of threats, limits downside and increases upside.

Value investors are facing one of the most challenging investing landscapes in history. The shift in economic power to more globalized companies, built on technology and immense user platforms, has made many old-time value investing nostrums useless. Now value investors have to leave their preferred habitat (mostly mature companies with physical assets bases) in the corporate life cycle to find value. But one of the biggest issues with value investing is that it viewed and continues to view uncertainty as something to be avoided as much as possible, and takes the view that they cannot value businesses, where there is too much uncertainty. That view has led investors to focus on mostly mature companies and kept them out of investing in tech companies. Unfortunately, value investors are born pessimists, and they believe that making bets on the future and/or paying for growth is a sign of weakness. This is, of course, the mirror image of the investor's lament that a tech company cannot be valued.

The debate about tech valuation is interesting on many dimensions, but one that is worth focusing on is how much growth is worth, and what we are paying for it. As Bill Gross recently wrote "stocks may decline based on disappointing earnings growth, not higher interest rates". But there are some investors who argue that growth is speculative and that it is worth very little or nothing. At the other extreme are those who argue that growth is priceless and that we should therefore be willing to pay for it. Even though both groups seem to be in agreement that valuing growth is pointless (mainly because it requires estimates that will be wrong in hindsight), I do believe that it is not growth that we should be paying a premium for but quality growth, with quality defined as the excess return generated over and above the cost of capital.

Picking stocks with excess return on invested capital and avoiding those without earnings was a simple, yet extremely effective, way of outperforming in 2022. Luckily for us, we have an equity portfolio of value-creators and price-setters, with set investment objectives and risk limits, rebalancing regularly, making tactical shifts when the risk premium changes, and exploring the entire investment universe for top quality companies with solid cash flows. Within selected countries and sectors, we only own companies that can (i) invest capital at significantly higher returns than their cost of capital (value creation), and (ii) raise prices without impacting demand (price setting). Returns on capital must be high, consistent, and unleveraged, with competitive advantages, ideally switching costs and network effects, preventing returns and margins from being competed away. Pricing power, always a positive for companies that can sustain it, may be a crucial competitive advantage in the year ahead. Inflation has surfaced across many global economies, and there are signs that it could linger in the coming months. Rising costs can erode a company's profit margins and, ultimately, investor returns. Only companies with clear, sustainable pricing power can protect their profit margins by passing those costs along to customers. According to Warren Buffett, the key to investing is not assessing how much an industry is going to affect society, or how much it will grow, but rather determining the competitive advantage of any given company and, above all, the durability of that advantage.

The trickiest part of finding a great stock to own is striking a balance amongst growth, profitability, and reinvestment, while arriving at a plausible story that holds these strings together, to derive value. It is also worth emphasizing that there are lots of possible stories, a smaller subset of plausible stories, and an even smaller set of probable stories. Yes, valuing businesses across time is very labor intensive but there is no real shortcut to compounding investing knowledge. As investors, we focus exclusively on really understanding what we are looking to buy. When we buy a stock, we do become part owner of a living organism. The business is a team of people, with certain leadership, values, energy, and personality. In this process, we try to understand what makes it tick rather than the numbers alone. The underlying business, the industry landscape, its strategy, and competitive moats. We also need to look at the strength of the company's main value-drivers (sales growth, operating margin, and capital intensity) and how they are trending. Using a reverse-cash flow model (starts with the current share price), understand what level of performance (value-drivers and FCF) the company must achieve to justify the current price. We then use our information edge and knowledge of the company's value-drivers to develop our own expectations. Are our long-term performance expectations greater or less than what the market is pricing in? Greater = a potential stock to own. As Warren Buffet famously said, “we do not have to be smarter than the rest, we just have to be more disciplined than the rest”.