I wanted to write a quick post about an interview I recently did with Miguel Barbosa of Simoleon Sense. Miguel’s is a great blog that covers a number of aspects of financial behavior and psychology.
You can find part 1 here, and part 2 of the interview here. It shouldn’t surprise you that it’s in two parts: The interview was conducted through e-mail and, in my long-winded fashion, came out to seven or eight pages typed. As a comparison, my posts are usually between three and five; so, brew some coffee!
I titled this post as such in reference to a Twitter comment made by Jae Jun (@Jae_Jun) over at Old School Value in response to the interview:
@JoePonzio @SimoleonSense Actually it’s a great prequel to F Wall Street
Enjoy!
Filed under: Miscellaneous
Just read “The Drunkard’s Walk” by Leonard Mlodinow. A good intro to the history of probability and statistics. I liked most of the message, which is that randomness plays a larger part of our lives than most of us would admit or believe. But, it sounds like the author doesn’t believe that anyone can beat the market by skill or knowledge other than having inside information. He especially picks on Bill Miller, and his recently broken streak of beating the S&P500 for 14 years in a row (with some qualifications). I believe that the methods at FWall Street, or rather the philosophy, is one that can’t be argued against. The author would probably say that I’m a victim of confirmation bias, that I only see instances when buying low relative to a business’ intrinsic value works well, but I don’t see the times it doesn’t. The problem is, when it doesn’t work out, I can easily attribute the failure to a lack of judgment, miscalculation, or error in perception. Either that, or it’s just a matter of time that it will work out.
Anyway, it doesn’t matter what someone else believes, it matters what I believe. And there are two axioms that have to be believed if you believe the deep value approach espoused on this blog: 1) When you buy a stock, you are buying a piece of a business, and 2) Price follows value. The first I can easily accept, because if it doesn’t hold true, there really is no sense to the market, but I’ve always wondered about the second. Why does price follow value? I know it does, but it’s always been just a given, even Ben Graham didn’t bother to try to explain it. Theoretically, if a business closed shop abruptly, the value of the assets of the business would be liquidated, and you would receive your share of the assets (although the goodwill would then be worthless, as you couldn’t receive a portion of the goodwill, which would then bring up the question of why the business would be liquidating if the goodwill was still a significant asset). I have a more practical reason, but it doesn’t explain why price follows value so much as it explains why price cannot go too far below value. My amateur theory: the value of the business sets something of a lower bound on the price of the stock. There is no upper bound, the price can fluctuate indefinitely above or near the business’ value. But if the price of the stock were to drop too far below the business’ value, some entity would just purchase the entire business. After all, we live in the real world, and if a business is generating real cash, someone would recognize a great deal when they saw it and just scoop up the entire business if the price of the business was much less than the present value of its future cash flows. So, if you buy at significant margin of safety, you are always protected by this lower bound.
It’s Labor Day weekend, and if you can’t tell, I have more spare time than usual.
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Good interview. I always enjoy reading stories about people abandoning “mystical investing” (which is what I call using charts and hunches) for a value approach.
Allen – Ben Graham basically gives the explanation you provide in his section about NCAV investing.
He said that stocks selling so far below net assets (current assets – total liabilities) is fundamentally illogical, since you could close up shop and distribute the assets for a profit. This means that people are expecting management, on average, to kill all of the value by driving these businesses into the ground, which is not logical. Graham explains stocks trading way above value as people becoming increasingly speculative because they see stock prices going higher, and start believing that good stocks are a value at any price. It’s crazy, yes, but how else do you explain the high multiples we see during booms.
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Joe a question: I’ve been doing more reading/research on valuing businesses and running DCF models and a lot of what I’ve seen calculates DCF by taking projected future free cash flows into perpetuity, usually using 3% economic growth rate for that portion of the calculation. In your analysis, you don’t calculate cash flows into perpetuity but instead use stockholder’s equity in your valuation. Is there a reason you do it this way? Shouldn’t we be buying businesses for their future growth not what they’ve done in the past (ie what they’ve accumulated in stockholder’s equity?) In my mind, the value of a company’s equity is only of importance if you think the business will close up shop in the near future and you are purchasing a piece of that equity available to you in liquidation. If you believe the business is not a going concern, wouldn’t the DCF model taking cash flows into perpetuity be a better approximation of intrinsic value? I’d love to hear your thoughts.
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Allen: Great question. “Why does price follow value?” Buffett once asked a similar question to Ben Graham – “How do we know it will come back?” Graham supposedly shrugged his shoulders and replied, “It just does.”
I take it that won’t suffice! ☺
In reality, you answered your own question – “But if the price of the stock were to drop too far below the business’ value, some entity would just purchase the entire business. After all, we live in the real world, and if a business is generating real cash, someone would recognize a great deal when they saw it and just scoop up the entire business if the price of the business was much less than the present value of its future cash flows. So, if you buy at significant margin of safety, you are always protected by this lower bound.”
That’s the cornerstone of the value investing practice, and you’re dead on. The only problem is that it is impossible to know when the value will be realized. Six months? Ten years? That’s why, ideally, you’ll buy companies that you know, with a reasonable degree of competence and confidence, will be more valuable five or ten years from now. If you pay $50 for a stock that has an intrinsic value of $100, and it takes ten years for the markets to realize the value, you want to be in a business that can grow its intrinsic value to, say, $200 during that time.
So…why does price follow value? As you pointed out and what many of the scientists/scholars can’t wrap their head around: we live in the real world; cash is cash; and shrug…it just does.
Ryan: I didn’t have any problems. If you do have problems, it is a problem on the SEC’s side as the feeds come directly from them.
BPal: The alternative scenario (cash flows into perpetuity) assumes growth ad infinitum, and I’d hate to project and pay for a company’s growth 94 years from now only to see it close down after 40 years. It’s a sure-fire way to overpay for many businesses. I use shareholder equity (or modify it somewhat, as I did for Adobe) as a break-up terminal value of sorts. If I’m wrong and the business continues for many years into the future, I get that growth for free.
Jason: See my response to BPal above, and then consider this: why not five…or fifty? Projecting growth twenty years into the future helps weed out those marginal businesses that you may want to take a flyer on, without the problem of ad infinitum growth as I mentioned to BPal. It forces you to look for strong companies with durable moats, which should be the sole investment strategy for most people investing in stocks.
Once you’re comfortable with that part of investing, you can then ditch the spreadsheets and move on to more “marginal” businesses, like Volt Information Sciences.
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Enjoyed the interview so I didn’t realise it was around 8 pages
If the market keeps going up and value becomes hard to find, I hope that you’ll have some more time to write for us Joe.
Thanks for the link as well.
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