When 60-Cent Dollars Are Good Investments

by: Lollapalooza

There have been quite a few articles written lately that cover investment philosophies of great value investors.

Many of these articles include a discussion of investment hurdle rates, often in the 15-20% range.

There appear to be two predominant methods by which value investors identify buying opportunities. (As a side note, I use both in a multi-method valuation model.) One is by taking the current or normalized free cash flow (owner’s earnings) yield and adding a growth rate to come up with a forward yield. This makes sense, but is limited in practice to only high quality businesses that have a high degree of long-term visibility.

The second approach is buying at a discount to the present value of future free cash flows. This approach is not as clean and simple as the forward yield approach, but it can be used for lower-quality businesses with limited visibility, as well as for businesses such as branded pharmaceuticals that have a finite profit cycle.

When using the forward yield approach, a 15% hurdle rate makes sense. That’s more than twice the historical average for long-term government bonds, about 10% over long-term inflation (assuming 5% true inflation), and it neatly doubles every five years.

When using discounted cash flow models, a 40% discount to fair value makes a lot of sense. First, it can be used not only for valuing future free cash flows from operations, but also net asset values. Secondly, a DCF model allows flexibility in changing variables, such as terminal yield/multiple. This is important for many investors who may need liquidity at some point and maybe don’t have a 10+ year investment horizon.

So what’s the significance of buying $0.60 dollars? As passive minority investors, most of us are typically dependent upon the market to agree with our appraisals in order to realize value. In other words, we can’t control the time horizon in stocks as we can in bonds with contractual cash flows and maturities. However, if the appraisal is correct at $0.60, then investors should earn a fair return no matter how long it takes to reach fair value.

If it takes two years to reach $1.00, then the annualized return is a stunning 29%. At three years it is 19%, and at five years a respectable 11%. As many experienced value investors can attest, discounts are typically corrected within one to three years, depending on overall market conditions. But even if it takes seven years to reach fair value, the annualized return is close to 8%, which most investors would be happy to have had over the past decade. And finally, if it takes ten years to reach fair value, the return is still 5% per annum. Most investors would consider ten years a value trap, but 5% is still comparable to historical averages for long-term government bonds and is significantly higher than current long-term treasury rates.

The best part about buying $0.60 dollars is that the investor has a 40% margin of safety on their appraisal before being at risk of permanent impairment of capital.

Disclosure: No positions