Valuation: a simple word that is the focus of finance classes at business schools across the world and the embodiment of uncertainty for a majority of investors. Some have tried to find ways around this by avoiding it completely (momentum, technical traders, etc), while others have ventured in, attempting to remain unbiased and objective in the search for “truth”.
As noted by Columbia University professor Bruce Greenwald, attempting to patch some of the loose ends in DCF, including predicting 5 and 10 year growth rates, is often an act of futility. Other methodologies attempt to mitigate these problems, but usually end up using different assumptions that are subjective as a result. Reverse DCF leaves you with the issue of trying to evaluate growth rates (as opposed to an input in DCF, growth rates become outputs based on the “implied” rates cooked into the stock price), which are still based on personal beliefs.
Almost all valuations suffer from the subjective act of inserting inputs for the “rule of thumb” values (i.e. discount rate), which is necessary evil in order to attempt replicating actual business results. As noted by money manager David Dreman, analyst estimates over the past thirty years for earnings in the next QUARTER have been wrong by an average of 41%. People who are in direct contact with management and work full-time trying to guesstimate out how much money a company will earn over the next three months struggle to even come close; how can one expect to realistically complete this estimate 10 years from now?
While these tools can be useful, they are far from the end game (thankfully, or any valuation inefficiencies would be quickly found and arbitraged by computer models alone). As noted by Charlie Munger during a speech at the University of California in 2003, this realization can be used by the diligent investor as a stepping stone rather than as a hindrance: “You’ve got a complex system and it spews out a lot of wonderful numbers that enable you to measure some factors. But there are other factors that are terribly important, [yet] there’s no precise numbering you can put to these factors. You know they’re important, but you don’t have the numbers.
Well practically everybody overweighs the stuff that can be numbered, because it yields to the statistical techniques they’re taught in academia, and doesn’t mix in the hard-to-measure stuff that may be more important. That is a mistake I’ve tried all my life to avoid, and I have no regrets for having done that.” I think this is best summed up by a sign that Albert Einstein had hanging in his office at Princeton: “Not everything that counts can be counted, and not everything that can be counted counts."
Historical numbers can tell you a lot about a company’s past, but can only be used so much as a guide to the future. Figuring out what lies ahead involves industry and company specific analysis, which can leave us with a considerable amount of uncertainty. As investors, this leaves us in an uncomfortable position, especially when our retirement savings are in question. Our natural tendency is to search for absolutes to seek comfort, and our brains will adapt and “trick us” to quiet any uncertainty. As noted by Jason Zweig in “Your Money and Your Brain”, our brains are subject to two kinds of thinking; these are divided into our reflexive system and our reflective system. The reflexive system is subconscious, and can activate an alarm in less than a tenth of a second.
This intuitive/emotional system acts as our first filter for information. This type of thought, as popularized by Malcolm Gladwell in “Blink”, was necessary for early humans; for investors, it can spell trouble. The reflective part of the brain is used to solve more complex issues, and intervenes when the reflexive brain needs help. However, when a problem is difficult, the reflective brain may simply hand back the problem to the reflexive brain. The reflexive brain will attempt to overcome dilemma this by searching for psychological proof or backwards reasoning: confirmation bias, social proof, etc; in other words, conclusions that have little/nothing to do with the long term success of the business. It will act based on pure speculation and avoid confrontation in order to remain comfortable with its conclusion.
As rational investors, how can we mitigate these two contrasting views? How can we find a solution that avoids reliance on excel spreadsheets or false hope/guessing alone? I believe that the solution lies in the gray area between black (valuations) and white (psychology). Both of these components have factors that can be useful to us as investors. Valuation is a necessary part of valuing a business. And while one methodology may not hold the answers, the use/combination of various methods can help us get closer to “truth”. The same can be said for the study of emotional/psychological constructs. This is similar to the Peter Lynch model: use your personal expertise (career, for example) and the new/changing businesses that you come across every day in your life as the cornerstone for your investment research. As individual investors, a focus on companies that analysts don’t follow and that mutual funds can’t buy (the ones springing up in your neighborhood) is a great place to look for potential investments.
In our approach to investments, we hold another competitive advantage over institutional investors. Unlike mutual funds and money managers, we are not competing against a benchmark over the coming year alone; many of us are looking to save for retirement or to build wealth over a long period of time. Based on those incentives, we can use our timeframe as a competitive advantage and avoid the trading strategies popular on Wall Street (where we are at a serious disadvantage). Beyond the clear benefits of lower trading costs and taxes, holding an investment for an extended period should help you to sit down and contemplate whether you would be happy being an owner in this business if the market closed tomorrow and didn’t open again for 2-3 years.
As noted above, periods of pessimism have and will continue to sweep through markets. I don’t think you can find many investors today who believe that Coca-Cola (KO) or PepsiCo (PEP) have changed drastically over the past 18 months ago. But if you would have bought both of these two companies in early 2009, you would be up roughly 60% and 35%, respectively, from the lows over the past year and a half. This opportunity was presented because of economic conditions that had very little chance of affecting the long term success of these two businesses. For individual investors with patience and chutzpah, a couple of concentrated investments in great companies during periods of excess pessimism can drive returns for a lifetime.
Valuation clearly has a place in the strategy of any serious investor. Understanding businesses and investing based on consumer trends/paradigm shifts is also helpful in investment research. But these pieces alone are not the solution to our problems; they are parts of our investment philosophy that, like all other components, has its usefulness and limitations. Developing a backup system before any investment decisions, like a checklist, can help to remove the affects of a world full of noise and distractions that can impart bias on our analysis. Individual investors possess certain characteristics (like these) that cannot be measured or counted; like a sustainable competitive advantage, investors should use these intangible assets to improve their results and achieve their goals over time.
Author's Disclosure: Long PEP