Appearance versus substance

One of the most frustrating parts of being a professional investor is being pleased with how an investment company is doing only to see Wall Street sell it off time after time.

It’s bad enough to invest other people’s money into investment companies that do poorly, but when the one’s that are doing well get crushed, it’s hard not to heave a big sigh.

I was reminded of this ever-present need for patience watching a couple portfolio companies report earnings this week.

In both cases, I was pleasantly surprised to see things were going better than expected only to find Wall Street selling the companies down to the tune of 5% and 10% one-day losses. Why, oh why?

The answer may be frustrating, but it is simple. 1) Wall Street doesn’t focus on the same metrics as rational owners. 2) Wall Street is focused on 6-9 month results because that’s its average holding period.

Wall Street is enamored with certain metrics that business owners care much less about. In retail, it’s same store sales. In computers, it’s market share. In telecommunications, it’s new customer additions.

I don’t mean to imply that such metrics would be unimportant to rational owners, but they wouldn’t necessarily be the all-consuming focus that it is to Wall Street.

What matters most to owners? Cash flow. How much money came in and how much money did was spend to get it. That’s it.

Warren Buffett calls it owners earnings–the earnings an owner could use to build the business, buy back stock, pay off debt or pay a fat dividend.

An easy way to think about this number is to look at a company’s cash flow statement: subtract maintenance capital expenditures (capex required to keep the same level of sales and profits) from cash flow from operations.

Perhaps a couple of other adjustments may be necessary, but in general that’s it.

Both of my portfolio companies reported strong free cash flows.

A retailer reported 12 month free cash flows that are a mere 5.6x current price, or a free cash flow yield of 17.9%. It’s price was down 5% that day.

A computer company reported quarterly free cash flows that are a mere 5.7x current price (minus cash on the balance sheet), or a 17.5% free cash flow yield. It’s price was down 10%.

Owners of such companies would be salivating to have such returns in a lousy economic environment like this. But, Wall Street is not full of stock owners. It’s full of renters.

Renters don’t care what will happen over the long term (even 3-5 years, it seems). They are just in it for the quick “kill.” Does anyone wash a rented car?

With a time horizon of 6-9 months, Wall Street doesn’t care about free cash flow yields. All they want is to beat “estimates.” Estimates of what? You may have guessed: market share, incremental revenues, same-store sales, new customer adds, average revenue per user, etc.

What matters to owners? Free cash flows to price. That’s the bottom line.

I know I’m whining, but I also know that patience is well-rewarded in the end. Eventually, Wall Street does wake up to free cash flow yields. Eventually they notice how much value resides in businesses that throw off a lot of cash relative to price.

It takes a lot of patience to wait for that fish to come in. But, when it does, my whining sighs turn into war-whoops of triumph.

Nothing in this blog should be considered investment, financial, tax, or legal advice. The opinions, estimates and projections contained herein are subject to change without notice. Information throughout this blog has been obtained from sources believed to be accurate and reliable, but such accuracy cannot be guaranteed.

Being a value investor requires painful patience

I’ll spare you the academic citations, but there’s a solid body of evidence that value investing beats growth investing over the long run.

If it works so well, why isn’t everyone a value investor?

Because it hurts.

Value investing is based on a couple of key principles:
1) you can determine the value of a business
2) the price of a business on a stock exchange diverges from value
3) at some point in time, stock price converges on value

The hard part in value investing is point 3).

No one is surprised that you can determine the value of a business.

Not many are surprised (finance and economics academics excluded) that stock prices diverge from value.

The hard part is that first phrase in point 3), “at some point in time.” How long do you have to wait for “at some point in time”? As Shakespeare put it, there’s the rub.

No value investor knows when the herd mentality of the stock market will converge on underlying value. Why not? You might as well as ask why a weather expert can’t predict how many inches of rain will fall on one square inch of land in Bowie, Maryland during a 12 hour period on June 30, 2014. The system is simply too complex for an accurate prediction to be made.

And, as any value investor can tell you (ask Bill Miller), it seldom works the way you think it will.

If the company you’ve bought consistently reports growing earnings per share, surely then the market will converge. No, it doesn’t.

Sometimes price converges on value without any news whatsoever. Sometimes price converges when a company announced declining earnings for quarters on end. Most of the time, while you wait, it doesn’t converge at all.

You simply can’t know when it will happen.

I’ve seen it happen in one day, and I’ve seen it take over 7 years.

And, that’s why it works. Most people don’t have the patience to wait. They want prices to go up soon…today…RIGHT NOW!!!

Value investing works because few people have the intestinal fortitude to wait.

It’s like asking an overweight person about losing weight or a poor person how to become wealthy. They both know the answer. The overweight person will tell you it requires a good diet and exercise, but they won’t do it. The poor person will explain that you need to spend less than you make to become wealthy, and yet they won’t do it.

The reason it works is not because people don’t understand what to do, but because it hurts to do it.

That’s why I say that value investors get paid to endure pain. It’s painful to wait if you don’t know when price will reflect value. It’s painful to buy something cheap just to watch it become dramatically cheaper. It’s painful to watch fundamental performance deteriorate even though you know it will improve several years from now.

Anyone who has done their homework knows what it takes to beat the market. Value businesses, buy when price is significantly below value, sell when price reflects value. Everyone knows it, but hardly anyone does it.

Why? Because it’s painful. But, boy, does it work!

Nothing in this blog should be considered investment, financial, tax, or legal advice. The opinions, estimates and projections contained herein are subject to change without notice. Information throughout this blog has been obtained from sources believed to be accurate and reliable, but such accuracy cannot be guaranteed.