How we think about value
Like most value investors, we believe that every security has a fundamentally determined long-term value that can differ materially from its current market price. We seek investments that are trading below their fundamentally determined present values with the hope that the price of a security will converge with that security’s fundamental value over time. While this concept seems simple, it is not. Value is in the eye of the beholder.
We think of equity investments as claims on an equity issuer’s business equity. As businesses generate earnings the result is always a potential increase to business equity. Other things being equal, the greater the earnings potential the greater the potential future equity claim and therefore the present value of the investment. The key is trying to understand as much as possible about potential earnings and cash flows.
While predicting future business conditions is really difficult, we feel that understanding a company’s current business really well can help. We examine as much historical financial information as possible. We seek to gain a good understanding of a company’s target markets, competitive position, competitive environment and how all of these things might change in the next few years. We then forecast earnings, cash flows and a company’s potential financial position based on what we think are reasonable assumptions about the future.
Armed with our financial forecasts we then postulate the potential future value of the equity investment. To do this we examine how the equity market has “valued” the security (and similar securities) relative to business fundamentals in the past. Since there are no good “rules of thumb” for appropriate market valuation, we consider as many fundamental and market valuation factors as we can. We endeavor to come up with the most reasonable potential valuation metrics given what we think will happen with the business in the next couple of years. The combination of these valuation metrics and our financial forecasts yields a fundamental future value for the security.
We think of risk as the collection of things that could go wrong with our investment thesis. Any of our assumptions about the business could be wrong. The market may not value the equity like we think it should. We consider these factors on a case by case basis when we think about potential returns on investments. If the perceived riskiness of an investment makes us uncomfortable, we avoid the investment.
While the long term value of any security can be seen as the present value of future cash flows, we think that applying discounted cash flow (“DCF”) analysis to equities is difficult in day to day applications. DCF valuations tend to be heavily dependent on terminal valuations, which are in turn based on “permanent” long term growth assumptions and financial performance well into the future. Therefore, we derive our estimates of fundamental value based on rolling 12 and 18 to 24 month financial projections (updated quarterly). We believe that the one to three year time frame is the most realistic time frame over which one can confidently project financial results.
Our valuation process involves detailed long term financial analysis that helps us set a context for the future. Our analytical process generally involves seven component parts:
- Business and industry analysis
- Business/industry type (stable/cyclical/growth)
- Competitive environment
- Competitive position and strategy
- Revenue analysis
- Overall growth trends
- Organic growth trends
- Industry relative growth trends
- Margin analysis
- Gross margin (if applicable)
- Net interest margin (if applicable)
- Operating margin
- EBITDA margin
- Pretax margin
- Net margin
- Liquidity analysis
- Working capital analysis and trends
- Trade cycle analysis
- Solvency analysis
- Debt ratios and trends
- Perceived ability to meet debt requirements
- Operating efficiency
- Asset turnover and trends
- Fixed asset turnover and trends
- Per share values and multiple analysis
- Share count trends
- Trends in EPS, BVPS, TBVPS and CFPS
- Trends in P/E, P/BV, P/TBV
We are always interested in how a particular business and/or industry performs through business cycles. It is important to understand how changes in the macro economy affect revenues, operating margins, earnings and cash flow over time. If a company has a tendency to slip into cyclical losses during recessionary periods then we may avoid that company in favor of a more stable issuer – especially if we are not particularly confident in the issuer’s business or the issuer’s industry at the present time.
Once we have examined a company’s historical fundamentals we are better able to project future earnings and cash flows. Trends in revenue growth and margins provide a good basis for our model assumptions. We also always carefully consider management guidance and sell side estimates when making our projections. We are particularly interested in the reasonableness of guidance and sell side estimates; we always assess whether sell side estimates and/or management guidance seems too optimistic or too pessimistic in light of recent trends. This analysis can have a significant impact on our opinion and we will adjust our estimates and valuations based on our evaluation of model assumption reasonableness.
When we are comfortable with our financial projections we then proceed to the valuation stage. We generally apply what we think are reasonable and appropriate target multiples to forecasted EPS, CFPS and BVPS in order to arrive at our 12 and 18 to 24 month target prices. If we believe that an equity offers sufficient upside potential relative to an acceptable level of risk we consider the position for purchase.
Screening and Our Preferred Company Characteristics
Our research process involves regular screening the equity universe for potentially mispriced securities. Stock prices move every day – sometimes by large amounts – and this can create meaningful disparity between a share’s price and its underlying fundamentally determined valuation. Screening is therefore a constant activity performed by our investment team.
When screening, we generally prefer:
- Ample financial liquidity
- Adequate to excellent long-term solvency
- A track record of profitability and high likelihood of future profitability
- Lower than sector average trading multiples
- Good financial guidance
- Positive wall street opinion and ample upside to target prices
- Sufficient trading volume
We try to avoid:
- Stocks that have a tendency to blow up on earnings
- Management teams that do not provide financial guidance
- Insufficient earnings track record
- Weak balance sheets
- Relatively high trading multiples
Ongoing Research Process