Questions on Value Investing

Investment Analysis Clubs Value Hounds
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Hello,

I have some general/investment philosophy questions for those who frequent this board. But first, I want to give a little background on myself, so you can understand what I’ve been exposed to from an investing philosophy and why I’m asking these questions.

I’m in my 30s and have steady income. I started using Stock Advisor in the summer of 2020, like many did, and I simply bought each recommendation without thinking much of it. I had also been spending a lot of time listening to David Gardner’s Rule Breakers Podcast. The basic stock advisor picks were working fine until early 2021 when many of these growth stocks started to sell-off. This is when I found Saul’s board. After reading those posts for a month or so, I decided to jump into that style in May of 2021. Generally, it worked extremely well for 2021, even after another growth stock sell-off at the end of the year, I was up much more than I thought I would be.

All throughout 2021 I had seen posts about valuation, occasionally on Saul’s board, but obviously more often on the individual company boards. I’m planning to do more research on how best to understand valuation, and perhaps this board has some advice on websites or books to check out.

But I guess my main questions have to do with often you are buying stocks if you are concerned with valuation and if that really limits what type of stocks you own. For instance:

  • Have valuations been too high for you to buy stocks for several years? I’ve heard some people say valuations need to come down to like 2016 or 2018 levels. Does that imply they haven’t bought anything for the past 4 to 6 years?

  • Most of the Stock Advisor/Rule Breaker stocks are at elevated levels and seem to have been at these levels for a very long time. Does this imply that you essentially don’t buy certain types of stocks because they rarely, if ever, trade at a low enough valuation? I understand the logic in that, but it seems like that would eliminate pretty much all tech stocks.

I’m trying to get my head around this type of investing philosophy because the two main people I have learned from disregard valuation (to varying degrees), and have been VERY successful. On one hand you have Saul, who is meticulous about the financial reports and doing research on his companies, while ignoring valuation. On the other hand, you have David Gardner, who seems to mostly use a framework that focuses on the company itself. He doesn’t seem to talk much about financial reports, at least on the podcast, and I don’t hear him talk about valuations much. In fact, one of his go-to sayings is “dips wait to buy the dip”.

So anyway, thanks for reading, and I appreciate any insight you care to provide.
TK

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Most of the advisory services focus on growth stocks. Those with potential to increase earnings and increase value. They can buy stocks with no earnings or very high PEs in anticipation of future earnings.

Value investors buy stocks they think are undervalued. Usually that occurs when a given business falls out of favor and investors over react. A recent example is coal. And some thought oil was headed there too. Those who bought in at the bottoms are probably doing very well.

Warren Buffett is perhaps the best known value investor. When his Berkshire Hathaway decides to buy people take notice. He resisted tech stocks for years but now owns Apple stock.

Its hard to do both at the same time. Usually you decide one or the other. But some do some of both when the opportunity comes up.

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Hi TK,

I’m glad you came here to ask about valuation. Lord knows it’s forbidden on the Saul board. I’ve been trying to figure out why questions of valuation are so taboo over there and I can’t, for the life of me, figure it out.

The first thing to know is that the way Saul understands value investing is a straw man. He defines it as investing in low PE stocks or “value” funds. All investing is value investing. All value investing means is that you take into account a reasonable estimate of the owners earnings that are likely to flow to a shareholder over the period of their investment. Those earnings can flow in one of three ways: (1) dividend payments, (2) share buybacks (if bought back at a reasonable price), and (3) earnings growth over time. This last is the real source of value for a company, the growth of its earnings power over time. When buying a companies stock we need to make an estimate of what that earnings power is and how it is likely to change over time. In doing so, we need to be conservative.

For example, let’s start with a popular hyper growth company like Snowflake, of which Berkshire Hathaway owns a slug. Snowflake earned $1.2 bil in revs in 2021 and had a market cap of $45 bil, so it’s trading at around 40 times sales. What assumptions are baked into the shares at its current price? Let’s assume that Snowflake can grow earnings consistently at 30% per year for the next decade. If they did that, sales would grow from $1.2 billion to $16.5 billion. Not many companies can grow at consistently high rates like that, but that’s what the hyper growth board is looking for in a company. While sales are great, profits are what matter because it is profits that are returned to owners in the form of dividends, buybacks, and increased earnings power reflected in rising stock prices. What net profit margin can we expect for SNOW a decade from now? It’s hard to say, but we can look at the most successful SaaS company in the world as a best case scenario–Microsoft. MSFT has net margins of 35%, so let’s assume that SNOW achieves those margins in a decade. That would mean earnings of $5.75 bil in 2032. What should the market cap be in 2032 based on these assumptions? If we give SNOW’s future earnings of $5.75 bil a 25 PE multiple, we’re looking at a future market cap of ~$145 bil. Under these assumptions, SNOW is likely to return ~12% per year over the next decade. Not bad, but is it worth the valuation risk?

Let’s look at what could go wrong with these assumptions. First, 30% annual growth in sales is pretty rich. In fact, I think most of the posters on the SAUL board would bail on SNOW if the growth rates were this low! Look what happened to Upstart today? There is no margin of error in the growth rate assumptions of hyper growth investing, and if a company hits even the slightest bump in the road the share price craters. I’m not sure 30% is sustainable for a decade, but the current price requires it for the purchase to work out. Second, net margins. Is it reasonable to assume that SNOW will hit 35% net margins in the future? What would be a safe net margin rate to expect in a decade? I’m not sure what it will be, but I know that this estimate is definitely NOT conservative. Anything short of 35% will be a disaster for the future market cap. Finally, what multiple to earnings can we expect in a decade? If these growth assumptions work out then 25 might be too conservative, but I think it is reasonable, and I wouldn’t what to bet on the whims of Mr. Market a decade from now to determine if my purchase is safe and reasonable.

This valuation exercise tells me that SNOW is a risky venture even after the recent price collapse. Worse than that, there are much safer alternatives available. Google is likely to return 12% + over the next decade at current prices and it is making money hand over fist while growing those earnings faster than a rabbit runs in the shadow of a hawk. If I were to consider an investment in SNOW, which I wouldn’t, I’d need to see prices that eliminate most of the risk of high growth assumptions (hence the reason I would never invest in money losing hyper growth stocks). I might consider throwing a tiny amount of money (maybe 1%) at SNOW under $40. This would be a price that assumes 15% annual growth for a decade with terminal net margins of 10%. Ridiculous, you might say, but that is why value investors avoid these kinds of speculations. They need prices that would almost guarantee a profit in the worst case set of assumptions.

PP

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“Value investing” just means trying to estimate the correct price for something (the intrinsic value) and buying at a discount to that price. That’s it. That means

  1. You have to have some means to estimate a correct price, and
  2. You’re going pass on some good investments.

There are a few ways to estimate that intrinsic value.

  1. You can do a discounted cash flow analysis, trying to estimate earnings out into the future and discounting them back to present value. That moves the problem from estimating price to estimating growth rates and interest rates. It’s easy to make very precise estimates about future values this way; the accuracy of those estimates will vary wildly.
  2. You can use proxies like PE ratios. This is more useful when a business has been around for a while and trades within a bound of PEs. See the next discussion about T Rowe Price (TROW) for an example of this.
  3. You can just guess.

Honestly my best value performances where using #2 and #3:

• I bought Apple stock in 2013, at split-adjusted prices of $17.86 and $15.18. I had liked Apple and its products for a while prior to this point, but held off because I was concerned about “key man risk” with Steve Jobs’s health. After he passed, the market ran away from this name, but the business kept on keeping on. The PE ratio at the time implied Apple was never going to grow again, which seemed obviously wrong. Eventually the market realized its error. I was at one time up 11-fold on the second tranche, but it’s pulled back a bit. CAGR on this one is 30% annually, which it’s kept up for nine years now.

• I bought Target (TGT) in 2015 when the “bathroom wars” were in full swing. Target was the, um, Target, of boycotts. These were not having a material effect on earnings. If I remember correctly I was in at $72, and eventually it weighed down to $55. (I had a “back up the truck” order at $50 that never filled.) I finally sold out late last year at $250. CAGR for this was 23% annually.

• Remember in the spring of 2020 when the spot price of oil went negative? Yeah, I bought oil. I had no idea what the correct price of a barrel of oil was, but I knew what it wasn’t. I bought an oil royalty trust (VOC) that had been trading between $4 and $6 in the Before Times. I got in at $2/ share, and should have bought more at $1.50 but did not. (Again, was waiting for that BUTT price that never filled.) It has been over $8/share recently, today at $7.19. Right now my CAGR is a stunning 87% on this investment. Also, I’m getting paid $1/share/year in royalties. I had expected to sell this when the price recovered but it’s been such a dividend champion that I’ve held on. Be aware royalty trusts have weird and complicated tax implications and are not for everyone. I mention this one because I never did estimate intrinsic value per share, I just noticed that oil wasn’t really worthless and expected the market to sober up eventually.

I haven’t been buying a lot lately because that discount hasn’t been there. I have been sniffing around some names that have come down nicely. You have to be patient. Buffett says “there are no called strikes in investing” and I try to remember that. I say “I’ve never lost money on an investment I did not make” and “you make your money when you buy, not when you sell.”

Regards,

  • HCF
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And you might add a typical company should grow its earnings at about the rate of population growth (usually 2%) plus the rate of inflation. Some growth companies can do much better than that but what rate is sustainable and when will they reach market saturation.

Value depends on the time frame you have in mind.

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Welcome, TK, I’m glad you took us up on our offer to be a companion board to Saul’s (the Slau Board). I really like what goes on on that board and I think that keeping valuation discussions off of it is fine. These boards can get really messy and be unproductive reading.

But to your questions, I’ll exaplin my personal approach, which has taken a very long time to refine, though I have long incorporated most elements:

  1. Find reasons not to buy a company. There are plenty of fish in the sea, and most of them are (inarguably) suckers. It’s always a few names that move the averages. If you happen to catch a high flyer, good on ya’, but don’t plan on it or expect it.

  2. Exercise patience. They say the market looks six months ahead…psssshhhh. Nobody knows what the market is doing ever. Look at a share’s chart. Does it look like a mountain? Stay away…for now. but assuming the business is growing and improving, simply draw a line (use a ruler on your computer screen) that follows the curve before the mountain happened. Enter a pick on your CAPS page at that price; note the date and trade price when you entered the pick, why you are picking it (you won’t remember), and if it eventually initiates, look at your notes, look at the news, and then watch a little longer. But set a real life buy point if it is a company that fits in your (diversified) portfolio.

  3. Realize that valuation is a collective expression. It, fundamentally, means nothing. We don’t actually own these companies in any appreciable way. It is a game. As long as there are a lot of us playing, it’s all good. When some of us run out of money (to invest, hopefully not taking our 401k to zero), we are out of the game. Fewer players equals lower prices (remember what happened to GME? That was nothing more than “a lot of players”). Unfortunately, for those who have chased shares with high valuations, the distance that they can fall is that much more. Add leverage? you will probably get wiped out; the most regrettable outcome.

  4. Pay attention to the trends in the indexes and try to discern what they mean: the market took off after the Trump tax cuts because lower taxes meant higher profits. But how much of the additional value was truly warranted, based on earnings growth? The answer is “less.” Probably a lot less. Using the chart reading technique in example 2, the NASDQ could easily be at 8500; or worse? In times of decline the market will overshoot…so maybe 7000. The baby will always be thrown out with the bathwater. Why? Point 3; less money to invest…virtually everyone will have less money to invest. In 2008, there was no place to hide. Everything went down. If you’ve seen The Big Short, you know that some made big money, but not many, and none of us could have played that game. And some big fish who did play lost their heinies because they were too early.

  5. You are probably hearing the word “capitulation” a lot right now. That is what we in Value Hounds value most. But it is an ugly thing: capitulation happens when margin calls come in, forced selling happens, and debt destruction rips holes in real lives. Nothing like that has happened yet, though another 10% decline could precipitate it. The discussion of TROW is a good one…that’s one to watch. As AUM declines, discern the reason(s). Realize that when things get cheaper, everything gets cheaper.

  6. what have I bought recently? POWL- no debt, cyclical, going to benefit from oil patch recovery, and a 5% dividend. I bought in at $30 and watched it decline another 30%, at which point I bought more (it repeatedly declined 30%, so you may not need to jump on it right away). I continue to hold it. I also bought CALM, but that’s mostly because I have reliable information on the egg market (it’s the business I’m in). I didn’t make a ton on that trade, but it wasn’t nothing and we should never feel bad about taking a profit.

  7. what am I interested in? SNOW, ZS, ZM, UPST, NET. We’ll see. I’m exercising patience, watching where they go, feeling that there are significant downdrafts taking hold in the broader markets, and soaking up all of that great analysis on Saul’s board.

oh, and #8- the most important of all; you have a lot of time. Save and invest. Don’t always swing for the fences. You have 30 years of hitting singles, which is a lot of runs.

Best of luck, and I hope we see more of you, and a lot of your mates on this board. We all benefit.

-Randy
and by the way, RB picks and the like? There is still a “better time to buy” more often than not. Just because they say “buy now?” hmmmmm…no, thank you.

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Thank you to everyone who responded with your insights on value investing. The responses are aligned with the understanding of value investing that I had in mind.

A couple more questions:
Do you find that you are more agnostic towards what companies you are buying, as long as you find that they are meeting your “value standards”?

For example, I’m not really interested in coal/oil, I’m not interested in restaurant chains, etc. I don’t necessarily have strict criteria, but I’d like to be personally interested in what the company does or feel that they are (in my opinion) making the world better, so there are just certain companies or industries that I won’t want to spend time looking into and researching.

Similarly, are there companies that you admire (meaning you like what they do, you like their industry, you like their product, etc.) but you think you’ll probably never own due to valuation concerns?

I’m asking these questions because I’m trying to figure out what sort of investing style is a best fit for me. There’s obviously a lot of ways to be successful in the stock market and I’m (mostly) enjoying spending time learning about and reading about investing, obviously it’s been a lot less fun lately with the sell-off. So essentially, I’m trying to reconcile some of the things I’ve heard about value investing that I like, with some of the attributes of different investing styles that I like. For instance, there are things I really like about Saul’s investing style. There are also things I like about David Gardner’s investing style, where he seems to mostly buy companies that he admires, is interested in, or has some value to society in general.

Again, thanks for everyone for your responses and I appreciate anything else you can add.
TK

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Do you find that you are more agnostic towards what companies you are buying, as long as you find that they are meeting your “value standards”?

I don’t really have favorite industries, if that’s what you’re talking about. I look for solid balance sheets and a history of growing earnings. Dividends are nice but not required. I require companies do what they do well, regardless of industry.

I tend to stay away from defense contractors because, in my opinion, they mostly milk the government for money instead of providing a valuable product. It’s hard for me to divorce my opinion from the business. I also stay away from tobacco companies and any business that succeeds because it’s exploiting people. There are many other targets to choose from.

Similarly, are there companies that you admire (meaning you like what they do, you like their industry, you like their product, etc.) but you think you’ll probably never own due to valuation concerns?

Tesla (TSLA). Changed the game on electric vehicles. Trying to do hard things. Worth more than all the other car manufacturers on Earth, combined? Probably not.

Like I said earlier, if you insist on getting dollar bills for 50¢ you’re going to miss some opportunities. You don’t have to catch all the fish, and you don’t have to hit every pitch. Do well in the trades you do make, and don’t lose money.

Regards,

  • HCF
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Tesla (TSLA). Changed the game on electric vehicles. Trying to do hard things. Worth more than all the other car manufacturers on Earth, combined? Probably not.

Probably not? Mr. Market is not crazy. It probably agrees with you, Tesla is probably not “worth more than all the other car manufacturers on Earth, combined.” Why then does Mr. Market give it such a high valuation? Maybe Tesla is not just one more car manufacturer.

Food for thought. I just ran across a related video:

Europe is Building a Massive Undersea Power Network

Why an interconnected energy system makes a lot of sense.

https://www.youtube.com/watch?v=2Ry38iWLJr0

The renewable naysayers keep telling us that the Sun does not always shine and the Wind does not always blow. True. The solutions are to either store the extra electricity when not needed or to ship it from where it is generated to where it is needed. In the US Tesla leads the charge with massive battery storage, in Europe they are building interconnect grids. This is the near view.

The grander view is that the paradigm shift from fossil fuels to renewables is now unstoppable. Tesla is just one cog in the clockwork being built. I invested in this paradigm way too early (and lost a ton of money) with American Superconductor Corp. (AMSC) 10/20/2009. Back then the renewable energy technology had not yet “Crossed the Chasm.” A decade later it has done so making is a safer sector to invest in. It is hard to tell when and why the crossing happened. My hunch is that the occasion was the serendipitous use of laptop and mobile phone batteries to power cars. It does take a leap of imagination to go from one to the other. When it happened I figured it was a weird if not stupid idea. Teslas became the role model for all things renewable energy.

Seen in this light, Tesla is more than just a car manufacturer.

Denny Schlesinger
Long TSLA & ENPH

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The world’s longest subsea cable will send clean energy from Morocco to the UK [update]

https://electrek.co/2022/04/21/the-worlds-longest-subsea-cab…

Denny Schlesinger

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Tesla (TSLA). Changed the game on electric vehicles. Trying to do hard things. Worth more than all the other car manufacturers on Earth, combined? Probably not.

Probably not? Mr. Market is not crazy. It probably agrees with you, Tesla is probably not “worth more than all the other car manufacturers on Earth, combined.” Why then does Mr. Market give it such a high valuation? Maybe Tesla is not just one more car manufacturer.

How about looking at it from a different angle. What makes all the other car manufacturers valuable? Most would start to answer that by listing their enormous manufacturing infrastructure. Huge factories for final manufacturing and assembly. Smaller factories for components. Factories and more factories of suppliers. There sure is a lot of it, isn’t there? It must be valuable, mustn’t it? But how much of it won’t be needed in the future? Engines are complex and expensive to design and build; they are a significant part of that manufacturing system… and they are obsolete. No, they are not going away suddenly, but anyone who can’t see that their future is shrinking dramatically is fooling themselves. Transmissions are no different, on the way out. What was an asset until now won’t be one much longer, but it still looms large on their balance sheets.

But they know all about making cars, someone will logically point out. And it is true that they have vast experience to draw upon. However when you have been doing the same things, year after year, it can be hard to measure your experience. Suppose you do the same job for ten years. Do you have ten years experience? It sure sounds like you do. Or, maybe, you have one year of experience, ten times. I think that the other car manufacturers have a great deal of experience doing the same thing next year as they did last year. Their experience is in the way things have always been, with only incremental changes. The transition from ICE to EV is not incremental at all. Is there any of those other manufacturers who has practice at having their world turned upside down? They all will be giving it a shot, no question about that, but they won’t all survive.

If they don’t survive, what happens? Lets introduce a bit of history. In 2009 General Motors declared bankruptcy. All the share holders were wiped out. All gone, not a cent left. I wasted a bunch of time trying to find out the size of that loss, to establish the market cap a while before it all went down the drain. The best I came up with was the number of shares outstanding as of some point in 2007 (565,729,615) and the share prices in that year ($30.72 start, $24.89 end). Multiplication put the market cap in the neighborhood of $14 to $17 billion in the shareholder’s accounts. (Actually shrunk to that, their hard times started years earlier.) Wiped out a couple of years later.

When you have trouble believing that all the other car manufacturers on Earth, combined are worth less than Tesla, make sure you have a realistic estimate of what all the others will be worth.

https://www.1stock1.com/1stock1_421.htm

https://www.sec.gov/Archives/edgar/data/40730/00009501240700…

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Good day, TK:
yes, pretty agnostic. Although if you are interested in a particular industry (see:Hohum), then you will likely (happily) pay more attention to it, come to understand it better and probably make better investment decisions.

I was taught early on that investing in what we are familiar with and what we like is the best way. I can tell you that that is a fundamentally flawed idea. If there is some nexus between your day job and the markets, that’s a better place to start. As I mentioned, I have been able to confidently invest in CALM through the years because I have a window on their future earnings (egg prices for the quarter before they announce, plus general trends). But there is only one publicly traded “egg stock.” I also have insights into the dairy business, but those insights have never given me a leg up in that industry.

Humility is always the strongest suit.

-Randy

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If there is some nexus between your day job and the markets, that’s a better place to start.

Not always. Eggs are low tech commodities and I can see how prices follow volume and such. Hi tech has the bad habit of not always promoting the best. Mac vs. Windoze, x86 vs. 680x0, and many more examples. I have been misled by tech a number of times. At other times it works, a cousin invested in a data compression company because data compression made a lot of sense but is is also something quite easy to do – no moat, and worse, no standards! Funny thing, my company had just created a data compression algo based on simple math freely available in any decent tech book store (this was pre Google). Each sector has its best ways to invest. One problem I have with Saul stocks is that they are fairy complicated products and services and I’m finding it difficult to tell wheat from chaff.

At the end of the day it’s what works for you. There is a joke about the guy who never made the same mistake twice but he made all of them once! The problem with investing is are the huge number of mistakes one can make. And we tend to keep quiet about them… We just brag about our victories, human nature.

Denny Schlesinger

Talking about data, I made a killing with Zip Drive because I saw how great it was and I also saw that it was a one trick pony, as soon as it peaked I started selling. The company’s other products were busts. IOmega https://en.wikipedia.org/wiki/Iomega

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