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No. of Recommendations: 33
Tom Gardner wrote today's Rule Breaker column: http://www.fool.com/portfolios/rulemaker/2000/rulemaker000602.htm

Past performance may not predict anything, but it does correlate with future success. On average, in a free-market system, isn't it true that the longer the run of triumph, the more cash a great company will store up for investments in superior future results?

I don't think you can say that past performance correlates with future success. While it's true that a long run of triumph sometimes allows accumulation of a substantial amount of cash that can be used for investments, there is no evidence whatsoever that those investments perform superiorly. Past performance does not correlate with future performance, except for horizons shorter than a year.

In that spirit, think about Rule-Making filmmaker Steven Spielberg. Past success doesn't guarantee that his next five movies will be blockbusters. But reputation, his level of experience, the loyalty of his creative teams, and his access to capital make it an odds on favorite.

I think this example is somewhat flawed. Clearly Spielberg's reputation makes him a favorite in terms of future being a blockbuster, i.e. selling many tickets for big revenue. Odds are for that. However, his abilities and reputation do not guarantee that his future movies will be business successes. While his future movies likely will rank high in terms of revenue, they will also be among the most expensive movies produced. Certainly, because Spielberg has been so successful in the past his honorarium is humongous. Therefore, by hiring Spielberg to produce your next movie you are paying a high price for high expected revenue, but there is no telling whether the odds of your movie becoming a business success are best with or without Spielberg.

And that's what we're looking to own in this portfolio. We're buying Secretariat as he storms down the stretch at the Derby. We're investing in the final three seasons of Seinfeld.

Again, you are paying very high prices. Furthermore, you only mentioned your successes here. You also end up paying high prices for Mike Tyson's before his last match and the final three seasons of Melrose Place. If you could split your portfolio ex post into the best performing and the worst performing stocks then clearly the best performing stocks will have performed well. That doesn't validate your strategy though.

And in corporate America, that odds-on-favoriteness, borne out of stellar past performance and strong present standing, leads naturally to the discounting forward of future values. The price goes up because the probabilities of success have gone way up.

Yes, at the point in time you buy them the companies are already very expensive. Therefore, even if their odds of future business success are good, we can't say that our odds of good returns have increased.

As investors in Rule Makers, we embrace that circumstance. We'd rather pay more for greatness -- watching it compound for years and years -- than get a fair price for mere competence, or score mediocrity on the cheap, neither of which is a great vehicle for compounding.

You seem to base your arguments on the assumption that you can pick great companies that outperform in the future. Assuming that I can pick future winners that's certainly what I would do rather than picking mediocre companies that underperform.

There are a wide variety of risks tied to stock-market investors, but virtually no existing taxonomic work to differentiate one from the other. For example, business schools and mutual fund companies have been suggesting for years that beta -- the volatility of a stock price -- is a measure of risk. It is, but only for traders. It isn't for investors. While America Online (NYSE: AOL) rose 150 times in value over the last ten years, did it matter how ziggy the price zigs were or zaggy the zags were along the way? But to an investor, the price movements were not risky. Risk was tied to the company's level of performance and its valuation, not its temporary price movements.

These statements seem to rely on a misunderstanding about the concept of risk. Surely price movements were risky to an investor as they reflect new information being embedded into prices about how successful the company would become and the likelihood of bankruptcy. Risk is really an ex ante proposition, i.e. given everything we know today what risks will the company face in the future. That AOL ends up exceeding all expectations ex post has nothing to do with ex ante risk. Many companies that were as risky as AOL ten years ago no longer exist, i.e. they have realized the worst possible outcomes ex post.

Now, the appealing feature about risk is that it's somewhat stable over time. For example, a historically high risk company like AOL by nature of its business also faces high risk in the future. The broadband transition is one example. Therefore, a risk measure like beta (if you like that one) estimated on historical data will likely be useful in evaluating risk for AOL going forward. Interestingly, volatility is way more persistent than return. Therefore, buying the best past performers will likely not lead to future outperformance while buying historically risky company will likely lead to future risk.

the case of Rule Maker investing, I'd like to distinguish between valuation risk and performance risk. The former is the risk of paying too much for a company. The latter is the risk of not getting what you paid for.

This again relies on the supposed link between past performance and future. As argued above, while a company that has done well in the past likely will do well in the future, it's already expensive enough to render expected future stock performance average. In other words, any performance risk that I can think of should already be build into the valuation step. There's no separation.

I herby encourage the valuation superstar out there who can use all the available data (there's tons of it) to show me the valuation methodology that:

in 1980, proves Wal-Mart (NYSE: WMT) will be worth $260 billion today
in 1990, proves Microsoft will be worth $350 billion today
in 1994, proves Cisco will be worth $450 billion today


I'm not your valuation superstar but I do know that valuation is an ex ante concept. That is, given everything we think will happen in the future, and the expected risks, what's the stock worth today. Ex post, of course, we can hope that on average the past valuation was correct. However, actual ex post realized market caps will display way more variation than ex ante predicted. In that distribution, a few companies will turn out to do extremely poorly and no longer exist, while a few will have performed extremely well. You are asking us to go back and ex ante value the three companies with perhaps the best realized ex post performance. This really has nothing to do with valuation. The only reasonable question you can ask is whether we can go back in time and correctly value all stocks on average relative to what we have realized today. Even then, you have to be very careful in accounting for any unanticipated new information that have reached the market in the meantime.

If our Rule Maker companies are required to justify their valuations based on Wall Street earnings estimates, well, we're in trouble. But if our companies -- more than slips of tradable paper -- are to be evaluated as businesses, we should use cash flows and the Flow Ratio. When we do, I think right away it becomes clear that we'll need considerably less earnings growth than Bill does to justify today's valuations.

I don't believe in historical earnings, cash flows, or the flow ratio as valuation tools. I also don't recall any serious empirical evidence that cash flows predict future stock returns better than earnings. Moreover, I have never seen any evidence on the effectiveness of the flow ratio. Do you any credible evidence that for example the flow ratio has predictive power for future returns? Anticipating that you don't have the evidence, how can you justify the strong statements you make in today's rule maker column?

Datasnooper.
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No. of Recommendations: 5
Mr/Mrs. Snooper,

Thanks for your note. I don't have the time to go into as much detail as you -- but I thank you for your thoroughgoing, thoughtful response. I don't agree with all of your assumptions -- but ahh, you don't agree with all of mine. And these are the things that make markets. I thank you for being positive, constructive, and Foolish in your reply.

Here are some brief thoughts:

1. I would never suggest that past performance provides a one-for-one correlation with future success. I won't propose how tight a correlation it is...but I do believe it's not so loose as much of the investing community presumes.

2. Your points about Tyson and Melrose Place actually, for me, support performance risk more than valuation risk. I believe our Rule Maker tools will help identify the best businesses out there. Time will tell. But I think they'd favor Spielberg over Spelling. :)

3. In your note, you use phrases like "high prices" and "very expensive". I heard the same language used about Microsoft in 1989 (when I first *sold* shares, ouch). And in 1990. In '91-'92-'93-'94-'95-'96-'97-'98 and '99. I look forward to a price valuation tool that will show that, in fact, it was as dramatically undervalued as it appears to have been all the way through. Until then, I have no way of telling whether prices are very high and very expensive or not.


When I read your post, at times, I actually believed you were making the point for really being rigorous in determining what is or is not a superior business. To clarify my position, what I am NOT suggesting is that we have the be-all, end-all way to find the best companies (heck, we don't own General Electric). What I am suggesting is that focusing on that is far more important than thinking price, price, price.

Thanks for your note and your Foolish spirit.

Tom
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No. of Recommendations: 38
"If you can buy the best companies, over time the pricing takes care of itself." - Charlie Munger, Berkshire Hathaway (OID)

That doesn't mean you can't underperform for a number of decades by overpaying for something. I think Munger has given that caveat to the thought you're citing here. Over long periods of time, yes, a company's return on capital will convene with its return to shareholders...it's pure mathematics. But let's just look at the fact that much of Cisco's capital isn't even reflected on the balance sheet (because Cisco refuses to have it reflected through its selection of accounting methods that does not reflect the equity value they trade for acquired intellectual property and other assets). We don't really know what its return on capital is. Yahoo! does the same thing, although they've done fewer huge acquisitions, so it's easier to construct. How do you make a judgment about the long-term return on capital for a company, and thus your long term returns to investors, when you can't even tell what today's return to investors is?

I hereby encourage the valuation superstar out there who can use all the available data (there's tons of it) to show me the valuation methodology that:

- in 1980, proves Wal-Mart (NYSE: WMT) will be worth $260 billion today
- in 1990, proves Microsoft will be worth $350 billion today
- in 1994, proves Cisco will be worth $450 billion today.


What do you mean? Matt Richey knows how to do a discounted cash flows. Mechanically, it's quite simple. It's having the judgment ability to look forward and use the right inputs to say "Yes, I believe Wal-Mart can increase its fixed assets at 25% per year for 20 years, it can do 'X' working capital turns, it can achieve 'X' profit margins, and it can achieve 'X' return on capital." If you can answer those questions, then you'd feel confident in assessing the intrinsic value of Wal-Mart in 1970, Microsoft in 1990, or Cisco in 1994. "Valuation" as you have identified it, Tom, has very little to do with the current P/E or the current price/sales or price/book ratios. That stuff is quite basic and not highly predictive. On the other hand, if know some things about accounting and can make some basic forecasts about business, stating your assumptions explicitly rather than assuming a company makes a great investment at any price because it has made a great investment at a number of prices in the past, then you can start to use valuation as a tool to assess risk and reward.

The valuation tool has been invented. Buffett and many other very good value investors, some of whom you know personally, use it all the time. They talk about it all the time. It's called a cash flow assumption and its practical manifestation is a discounted cash flow calculation . In it, you explicitly state your premises rather than trusting that the premises embedded in the market price of an equity can be ignored since return on capital and return to investors converge at a point 30 years in the future.

By the way, there's no reason you can't pay 700 times earnings for a company or 30 times sales or whatever multiple to a static accounting factor and still buy something at a great discount to intrinsic value. The value investor would counter that this is entirely possible. But the value investor would also say that you have reduced your margin of safety in doing so. The intelligent value investor doesn't deny there are 30, 50, and 500 baggers out there. They are just a little less formulaic and a little more skeptical than the trusting approach of the Rule Maker.

Remember, Fools, earnings and earnings-per-share (EPS) accounting doesn't reflect the balance sheet, which is critical to the analysis of any business.

I agree wholeheartedly. But the Rule Maker only pays attention to part of the balance sheet. Great attention is paid to current assets, current liabilities, and long-term debt. You don't deal with long-term assets and the equity statement. I can understand why you don't deal with long-term assets, since one of your favorite companies, Cisco, refuses to show on its balance sheet tens of billions dollars of intellectual property it now acquires on a yearly basis to keep its cash flow growing. You don't have a business at Cisco without all the long-term assets it acquires and all the shares it issues to acquire these. But you all aren't analyzing this. Every time Cisco issues shares, it's trading away part of the company you guys love and hold up as one of the great companies of our time. I would think there would be more of an ongoing analysis of the rewards of trading away ownership stakes in the current, great company for rewards that are on the if-come.

If our Rule Maker companies are required to justify their valuations based on Wall Street earnings estimates, well, we're in trouble.

This is a straw man. Most great investors (heck, most good investors) don't rely on Wall Street estimates. Wall Street analysts are good for helping you to understand a business, which is the most important thing. They're not as good, on the whole, at helping you to make a good investing decision. But that doesn't mean they're imbeciles or the system is really screwed up. It just means you have to know how to use their work, which is in many cases very good to excellent. These aren't dumb people. I think you set them up as straw men and straw women much too often.

Foolish aside: Because of the relative weakness of "earnings" as a measure of corporate success, I think we should slap a $10 fine on any writer in this space who suggests that the P/E ratio is a useful tool for investors. In fact, I propose that, due to its irrelevance, it henceforth be referred to by the authors of this column as the P-Wee Ratio.

Earnings can serve as a fine proxy for cash flow in many cases. "Never" and "always" have many places in the vocabulary of intelligent, skeptical investors, but this is a little dogmatic. I think the Rule Maker approach should be more than commended, it should be celebrated across the universe, for bringing working capital issues to the process of learning about investing. Wall Street is in at least 90% of its research totally oblivious to working capital issues, at least until they show up as an earnings issue long after they've shown up as working capital issues. But this prohibition is a little dogmatic.

Not that I don't like your sense of humor.

Okay, I've gone on long enough. I'll conclude by saying that the market may still be overvalued.

I propose that the value of "the market" be discussed only under severe duress or in case of Martian invasion. Why waste your time on it? We're all business analysts -- let's focus on what we can control and not on what we can't.

Until then, I see nothing wrong with 1) continuing to enjoy 99% of what Bill Mann writes while 2) continuing to pursue the Rule Maker's labor-light, tax-deferred, commission-free growth -- whether that's 8%, 10%, 13%, or 15% a year. I think it'll beat the market's average return.

I don't think you have to imprison yourself to achieve returns that are far better over the long-term than the upper end of your estimate here. Buffett's not some awkwardly inward guy. He's a great Dad and citizen. While Munger may have worked hard as a younger man, I think you'll see in his upcoming biography that he lead a full life and is appreciated as a wonderful person by many people. But this is the point of value investing. To maximize the upside and reduce the probability of the downside. Going to the trouble to value something correctly increases the potential upside while decreasing the potential downside. I don't see anything wrong in the world with that.

Dale
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No. of Recommendations: 7
Dale et al,

Thanks for your reasoned, intelligent, eloquent contribution. Let me throw out a single line delivered by arguably the greatest CEO of the past quarter century.

Jack Welch said (paraphrased):

"I don't believe General Electric stock can ever be overvalued, if we can continue to train the best managers in the world. We have 9 billion shares outstanding. Therefore, every time GE rises $1, we have $9 billion of equity value to deploy. If I can find a well-managed company with a solid economic model worth $5 billion, I can purchase it with GE stock and install my superior managers to accelerate its enduring success and drive its value higher than the cost."


My investment approach is profoundly influenced by this sort of thinking. It sees equity purchasing by superior companies not as dilutive but as additive, enhancing. I might actually buy Cisco at $1000 per share -- so long as I saw their services becoming more relevant, the economics of their business improving, and their management team strengthening.

In essence, I believe great investing need not consider stock valuation, so long as it is rigorously focused on the economic merits of a business and the qualities of superior management. I believe this because

1) of the increased use of equity in acquisition (for me, an indication that a great company [again, only the greatest of companies] and management team *really* thinks what it's buying is valuable...as opposed to Disney lapping up Cap/Cities with $11 billion of borrowings.)

2) I believe an increasingly efficient marketplace will begin to reward the greatest companies with vastly higher multiples than the Adequate, the Mediocre, and the Dismal (ADM). I think the valuation divide between greatness and the ADMs has only just begun.

And I believe virtually any thoughtful Fool can put this thinking to work, have loads of time, and succeed as an investor -- without having to pay 1.7% a year to have their money managed for them. But I am merely a Fool...my opinions are writ in the wind, writ in the flowing water of this digital collection of Foolish insights.

In other words, time will tell. But civil debate in the meantime is a pleasing thing. Thanks for it!

Tom
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No. of Recommendations: 2
Now this is the debate I've been waiting for Dale vs. Tom on quality vs. value. Thanks to Bill for getting the debate rolling, thanks to Tom for continuing it in tonights excellent column and thanks to Dale for pointing out the flaws in the previous post. While Mycroft was concerned about scaring or overwhelming the newbies I think that we should not only scrutinize the companies we own but the methods we choose to select them on a periodic basis. I still think that while it may be a rare event when one finds a real rulemaker trading below a reasonable intrinsic value based on discounted cash flows one has a screaming buy on ones hands and should snap it up.

-Mark
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No. of Recommendations: 4
Tom,
I agree fully with you on the Jack Welch thing. But what's interesting is that Welch has tons of MBAs running around doing valuation work. As you can see, Welch talks about the valuation of the company -- what's it's currently worth and what it can be made to be worth in the future. I like to play along at home (well, I like to play along at work, too) and see if I can discern the best opportunities for value creation for Dale Inc..

It sees equity purchasing by superior companies not as dilutive but as additive, enhancing.

I totally agree with you there. I just like to measure the prospects to see what I'm getting. All equity issuance is not dilutive. In fact, some companies underspend, which is perhaps a bigger sin than overspending, I think, because it assumes that the market will penalize the company in question if its earnings go down. This is a short-sighted management approach that drives me crazy. And believe me, I run into it in dealing with companies facing new investment opportunities that will bring down current, mature-company earnings. But mature companies have to spend in the short term on initiatives that generate far less revenues than expenses in order to adapt to the rapid changes in the economic environment today.

There's nothing I like worse than a company that protects its earnings -- that's a dinosaur in the making. There's nothing more than a company with a capital fortess and lots of investment possibilities that cost much less than their net present value to investors. That's nirvana. And that's what Jack Welch is talking about -- it's fine to issue equity when the prospective rate of return is higher than the cost of the capital being issued to take on the investment. It's terrible when the rate of return is lower than the capital used to acquire the investment.

as opposed to Disney lapping up Cap/Cities with $11 billion of borrowings

I don't think the debt had much to do with the success of the merger. The fact that many of Disney's businesses are poor ones (filmed entertainment can be a very tricky business, despite some of all time economic wonders like the film library) had a lot to do with it, in my opinion. The debt reduces flexibility in the short term somewhat, I agree, but I don't think it's in any way a long term impairment if the acquisition is a successful one. It really shouldn't have all that much to do with the financing method created.

I personally find it strange that Cisco has never used debt. Tell me how many companies of this size have no debt on their balance sheet. Is that a virtue or does it strike you as strange? I'm sure you know more than a few people with tons of cash in the bank and who could repay their mortgage 20 times over without blinking. Does that mean their personal flexibility is crimped or that they're financially illiterate? No, I think that cash generating entities can borrow sensibly because it's obvious the cost of debt is lower than the cost of equity. Much lower. I don't know, Tom. I strikes me as a supreme lack of confidence when companies with half a trillion dollars in equity market capitalization don't have a lick of debt on their balance sheet.

without having to pay 1.7%

Hey! Where did that particular number come from? LOL. The 1.7% is, in 90% of the cases, money poorly spent. 10% of investors would say it's money intelligently spent, assuming everyone is aware of the costs and rewards of paying for management. Unfortunately, many people are unaware of the costs of benefits, which is a shame. But thanks to some good people, that has changed dramatically over the last few years.

Dale

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No. of Recommendations: 5
quality vs. value

Hi Mark. I would say I'm a quality AND value guy. Quality hardly ever changes as quickly as value. You can make a lot of money at the bottom of a move up in quality and at the bottom of intrinsic value. But I've paid up for things and don't regret it at all. I don't always, robotically maximize returns -- I like to own great businesses even if I've paid intrinsic value as I currently calculate it. That's my personal life.

But hey, if I can get both quality and a deep discount to intrinsic value, I'm on cloud nine. That's when you back up the truck. And as I've said, you can pay 500 times or 700 times earnings or 30 times revenues. That Wall Street, accounting metrics stuff is wrong. It's just rare to be able to pay that and still make a world-beating return. But Rule Makers and Rule Breakers are by definition rare things. You have to know how to parse out the economics and analyze businesses to find these rare gems.

Dale
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The rule maker portfolio was started on 2/2/98.  The 
gains for the RM portfolio and the various indices are 
as follows:

RM Portfolio 68.96
Nasdaq 135.49
Nasdaq 100 241.11
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The rule maker portfolio was started on 2/2/98. The
gains for the RM portfolio and the various indices are
as follows:

RM Portfolio 68.96%
Nasdaq 135.49%
Nasdaq 100 241.11%

So the only index that the RM portfolio has beaten is the s&p500 index. But that too is not far behind at 52.47 %.

Its only been two years, but there is no evidence so far that the RM strategy will produce market beating returns. You have to beat QQQ, if not whats the point, especially if you are investing in tech stocks!

To a person who is just now beginning to invest, in my opinion, QQQ is the best choice. Only if you can identify a RB and hold it all the way to a RM is there a chance of beating the QQQ.

On another note, I didnt realize that Dale Wettlaufer has started posting on these boards! You might was well take over the Boring port again Dale!

vpai.


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Newbie question: Dale seems to imply that if he has the dough to buy a house for cash, he'd elect to finance it. With 30-yr. mortgages being somewhere around 8%, I'm trying to wrap my brain around the idea that equity costs more than debt. Can someone illuminate me?

Zenboy
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No. of Recommendations: 1
<So the only index that the RM portfolio has beaten is the s&p500 index. But that too is not far behind at 52.47 %.>

It should be noted that the statement above has not been accomplished by 90% of the mutual fund managers running portfolios today. With the addition of Nokia,JDSU and CSCO to the portfolio you should see some real improvement in the performance of the RM Portfolio.

Nokia 2/2/98

1098% return

JDSU 2/2/98

1888% return

CSCO 2/2/98

504% return

So the boys at Rule Makers have put some real tech muscle in the portfolio. We may even give the old Nasdaq a run for its money now!!!

Fool On "Learning Together" But most of all patience!!!

MYCROFT
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No. of Recommendations: 1
Dale's back. :-)

I didn't know it until this post, but I'm going to go back and read all 66 (or however many) of his prior posts under this ID. I recommend you all do that, too. His writings are well worth the effort.

Now, if only Robert Sheard would start posting here again...

--Anthony
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No. of Recommendations: 10
I'd add here that in most things of high quality that there is, and should be a premium associated.

I believe fully that the market does a fair job of evaluating companies over the long term. But where Tom and I come at this from a slightly different perspective, (i.e. where Tom Gardner is completely wrong ;-) ), is the degree to which rules such as "quality over valuation" should apply.

Discounting Cash Flows, as Tom said, is a poor predictor of the future. But it's not supposed to predict. It is a process that many investors use to try to gain deeper insight about a company and how it operates. If you pick ,say, 10% as an arbitrary future growth rate, DCF is at best unhelpful. If you get down and dirty, recognize what type of returns you want, and concentrate on what you believe the true growth prospects for the company are, you can make great use of DCF.

At some point -- and make no mistake, that point is not "knowable" -- the amount of future cash flow has a better than even chance of underperforming current assumptions. In this way stocks are the ultimate in pari mutuels. When you are buying a stock that you believe will appreciate, someone else is selling that same stock to you, since for them there is a better place for that money.

I'll pay full price for a top-notch company and feel no remorse whatsoever. But I won't pay MORE than what I believe the intrinsic value would be. Using DCF keeps me honest that way, and is my main reminder that valuation, and attempts to determine fair value, are in fact important.

Fool on! and thanks for a great discussion.
Bill Mann

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No. of Recommendations: 3
<<I don't believe in historical earnings, cash flows, or the flow ratio as valuation tools. I also don't recall any serious empirical evidence that cash flows predict future stock returns better than earnings.>>

Repo Man,

There have been empirical studies about this. Check out virtually any of the articles at www.capatcolumbia.com, many of which contain the analysis and list in the footnotes the sources.

Best,

Bill Barker
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I wrote: I don't believe in historical earnings, cash flows, or the flow ratio as valuation tools. I also don't recall any serious empirical evidence that cash flows predict future stock returns better than earnings.

TMFMax replied: There have been empirical studies about this. Check out virtually any of the articles at www.capatcolumbia.com, many of which contain the analysis and list in the footnotes the sources.

I have been to that site before, but fail to find any relevant empirical evidence. I know the literature on return predictability quite well and way beyond the material presented on that site. Could you be a little more precise?

Datasnooper.
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No. of Recommendations: 4
Tom Gardner:

Thanks for your replies, both to my message and another in the same thread.

1. I would never suggest that past performance provides a one-for-one correlation with future success. I won't propose how tight a correlation it is...but I do believe it's not so loose as much of the investing community presumes.

From the evidence I have seen that correlation is very difficult to distinguish from zero.

2. Your points about Tyson and Melrose Place actually, for me, support performance risk more than valuation risk. I believe our Rule Maker tools will help identify the best businesses out there. Time will tell. But I think they'd favor Spielberg over Spelling. :)

Now it's more clear to me what you mean by performance risk. However, any valuation attempts to quantify the risk that things might turn out differently than predicted by risk adjusting the discount factor. If you can further separate the future good surprises from the bad a priori you are effectively saying that you are a good stock picker. That is, part of the risk that I would use in my valuation is not risk for you (you call it performance risk) because you can successfully identify future good surprises, something the general market by definition can't. If you actually have stock picking skills then more power to you. My problem is that I can't understand why the tools you use would help.

3. In your note, you use phrases like "high prices" and "very expensive". I heard the same language used about Microsoft in 1989 (when I first *sold* shares, ouch). And in 1990. In '91-'92-'93-'94-'95-'96-'97-'98 and '99. I look forward to a price valuation tool that will show that, in fact, it was as dramatically undervalued as it appears to have been all the way through. Until then, I have no way of telling whether prices are very high and very expensive or not.

Actually, I believe more in market efficiency than you so I have no problem imagining that MSFT was neither undervalued nor overvalued in the years you mention. My use of the term "very expensive" was just a dollar comparison of Spielberg's honorarium compared to his colleagues. Needless to say, although his honorarium looks very expensive in dollar terms it might not be when you consider his abilities, or it might. This is exactly why I think you need the valuation step, see also below. You might like Spielberg and his reputation, but he might still be too expensive for your movie project.

When I read your post, at times, I actually believed you were making the point for really being rigorous in determining what is or is not a superior business. To clarify my position, what I am NOT suggesting is that we have the be-all, end-all way to find the best companies (heck, we don't own General Electric). What I am suggesting is that focusing on that is far more important than thinking price, price, price.

I'm saying that if you can successfully pick stocks then by definition markets are likely not efficient and it follows that all stocks are not priced fairly. Then it doesn't really matter how you pick stocks, you'll always need to do a proper valuation because the stocks you pick might be too expensive even though you like them. I think your argument is logically inconsistent.

My investment approach is profoundly influenced by this sort of thinking. It sees equity purchasing by superior companies not as dilutive but as additive, enhancing.
1) of the increased use of equity in acquisition (for me, an indication that a great company [again, only the greatest of companies] and management team *really* thinks what it's buying is valuable...as opposed to Disney lapping up Cap/Cities with $11 billion of borrowings.)


This I don't understand. In equilibrium when everything is priced fairly capital structure doesn't matter, i.e. it shouldn't matter whether you are purchasing using equity or debt. Equity financing is more expensive than debt financing interest-wise, but equity is also less risky to the firm making them indifferent between using debt or equity. Outside of equilibrium when everything is not priced fairly, the situation I believe you have in mind, firms will prefer debt financing. The reason is that they are buying undervalued firms, or firms that can be used to exploit economies of scale, and by using equity they would be sharing those gains with others. In contrast, by using debt those gains belong to the current shareholders only. Therefore, in contrast to what you are saying I would argue that debt financing in a positive indicator while equity financing is not. In fact, equity financing is typically only used when debt financing is impossible. For example, Amazon.com recently had to issue convertible bonds that for all practical purposes are equivalent to equity because of its low credit rating (low quality junk). Next time Amazon may be forced into a pure equity issue.

Datasnooper.
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<<I have been to that site before, but fail to find any relevant empirical evidence. I know the literature on return predictability quite well and way beyond the material presented on that site. Could you be a little more precise? >>

DS,

If you've read all the articles there and can't find any relevant empirical evidence, then nope, I can't help.

Bill
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Am I the only one stunned by this statement of Tom Gardner's?

In essence, I believe great investing need not consider stock valuation, so long as it is rigorously focused on the economic merits of a business and the qualities of superior management. (emphasis mine)

Not consider valuation at all? You must be joking. No matter how much "merit" the business has, no matter the "qualities of superior management", surely there must be some price at which you would not be a buyer.

Isn't there?

Am I the only one who finds the quoted statement bizarre in the extreme?

UsuallyReasonable


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Great discussion.

I heard the same language used about Microsoft in 1989 (when I first *sold* shares, ouch). And in 1990. In '91-'92-'93-'94-'95-'96-'97-'98 and '99. I look forward to a price valuation tool that will show that, in fact, it was as dramatically undervalued as it appears to have been all the way through. Until then, I have no way of telling whether prices are very high and very expensive or not.

This point of view is not uncommon from TMF, the reasons for which I just can't fathom. Discounted Cash Flow is not, itself, a forecasting method. It is the quantification of forecasts, which are made in the assumptions contributed to the model. So it's inapposite to say that no DCF model could never have accurately forecasted Microsoft's value ascent. Of course one could. Input the exact growth and discount assumption that actually came to pass, and you will see the present value of today's market capitalization back in 1990. What DCF does is refine the level of precision, regardless of the level of optimisim or pessimism inherent in its inputs.

Of course, precision can often be imposed so as to interfere with accuracy, as in the old "it's better to be approximately right than precisely wrong" line. While that's a legitimate point, it's anything but a condemnation of DCF, or valuation in general. Quantification doesn't demand any particular level of precision. Tools like sensititivity analysis, or the more intuitive ranges you allow your variables to encompass allow valuation outputs with ridiculous latitudes. In a lot of cases that's the best you can do. At that point, you have the opportunity to decide if the range you've established as compared to the current market price gives you enough confidence to satisfy your investment decision threshold. You could demand a fairly narrow range, or accept a broad one.

But I can't see how fear of precision would lead anyone to ignore valuation altogether. That approach axiomatically discards the ultimate arbiter of investment returns: outlow versus inflow. Personally, I would much prefer to attempt to trancribe nebulous notions like "great management," "superior cash conversion cycles," and "sustainable business moats" into the numbers that will eventually bespeak your success. If I was so wholly unsure about assigning any range of inputs than I might be a little hesitant to put my investment capital to work with the expecation of satisfactory returns.

I believe, as others have pointed out, that the Munger quote is attributed to bolster a conclusion that neither he nor Buffett would support. Instead, I think their (to the extent you can combine the two) ideas on the priority of business quality over purchase price is more a general statement along the continuum. In particular, they seem to reconcile the threat of using DCF to the point of counterproductive micro-precision by favoring opportunities where they can use back of the envelope (for them, at least)valuations to compare intrinsic value with market prices. Likewise, applying a margin of safety to this strategy allows them to inherently narrow their range of acceptable outputs (circles of competence, in a way) without resorting to quantitative redux. But make no mistake; Buffett and Munger would never eschew valuation or price in making an investment decision.

The other point I'd like to make about this argument - that traditional valuation is worthless in modeling the futures of extraordinary businesses - is that it presumes an uncertain ex ante determinism in companies with ex post facto success. While the future success of Cisco, EMC, Dell, AOL and Microsoft may seem to have been eminently predictable in retrospect, the most successful companies always will. Even if DCF were a forecasting model - which it isn't - there is little reason to believe that the existence of outliers is curable. While there is nothing wrong with looking for superior indicators to pick out future Rule Makers, Rule Breakers, Gorillas, or whatever, there is also good reason to think that an efficient market will necessarily hold information about the companies that can not be reliably used to predict their future performance - at least with the current state of human knowledge about the world.

I've gone on far too long already, but I have one quick comment on Jack Welch's line about the impossibility of GE being overvalued. Let's say, hypothetically, that as currently set up, the present value of GE's future cash flows was around $1 trillion. Let's say now that the market values the company as $2 trillion. Welch then goes out and buys $1 trillion worth of great companies (really worth $1.1 trillion), and makes them even better, earning an excess over the WACC used in the acquisitions (post six sigma worth of $1.2 trillion). GE shareholders who paid $2 trillion for GE, went from owning X/Total of GE's $1 trillion worth of future cash flows to earning (X/total)/1.5 of $2.2 trillion in future cash flows, which, though superior to the pre-acquisition position, is still not desirable. Price matter.

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<<<<In essence, I believe great investing need not consider stock valuation, so long as it is rigorously focused on the economic merits of a business and the qualities of superior management>>>>

Tom,
Surely you made this statement to excite controversy. Or perhaps I am misunderstanding it.

But since you seem to be willing to pay any price, let me give the economic merits of my home. It could easily collect rent of $1,000 a month. All the expenses would be about $600 a month. The management is superior...unless you want to insult my wife.

I estimate the rent can increase by 6% a year indefinately. Of course, the expenses would increase that much too. So profits will increase by 6% a year. If we reinvest all the earnings, that amounts to a 12.36% annual growth rate in earnings.

Would you please send me a check for $990,967 for my home. Afterall, if you would send a check for $1,000 for $0.36 of questionable earnings for CSCO (stock options, pooling of interest acquisitions) surely you can pay the same ratio for my home.

Unless of course, you think valuation does matter.





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When considering ROIC for a company such as Cisco which has acquired millions in intellectual property over the last ten years, can't an individual capitalize acquired R&D on the asset side of the balance sheet and increase owner's equity/decrease cash by the amount issued/paid for the technology? Further, if one is dealing with patents, copyrights, trademarkds, etc, these usually show up in the footnotes when FIRST acquired, and while their carrying value will not change over time to reflect their economic value, one can capitalize the intangible asset in the first year and then use a replacement-based model to value its true economic value as time progresses?


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When considering ROIC for a company such as Cisco which has acquired millions in intellectual property over the last ten years, can't an individual capitalize acquired R&D on the asset side of the balance sheet and increase owner's equity/decrease cash by the amount issued/paid for the technology? Further, if one is dealing with patents, copyrights, trademarkds, etc, these usually show up in the footnotes when FIRST acquired, and while their carrying value will not change over time to reflect their economic value, one can capitalize the intangible asset in the first year and then use a replacement-based model to value its true economic value as time progresses?

Cisco's acquired R&D is now approaching a hundred billion dollars if it hasn't passed that mark. So I think one has to consider that the cash flow characteristics of Cisco are nowhere near as good as the bare financials suggest. That being said, it's easy to see why the company is valued in the half trillion dollar range. There's a ton of capital invested in the company and it earns a decent return overall. As to the method of replacing it, well, that's where the management has to step up to the plate and face economic reality in reporting to shareholders, which they do not do now. I know, everyone loves Cisco, but their discussions of pooling and purchase accounting are laughable and horribly naive.
Dale
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With a degree in finance, I have utilized QFV, Creating Shareholder Value, Berkshire Hathaway Annual Reports, all the capatcolumbia.com articles, Buffettology, and a few other valuation pieces as my "educational material" in intrinsic valuation calculation. I really respect your level of accounting acumen and your understanding on how financial statement manipulation can play havoc in valuing a company. Do you have any suggestions of other sources of literature I could read that would help me "bone up" on accounting shenanigans and other technical aspects of reporting to help me dissect financial statements better?

Thanks for the reply,

Matt
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Matt,

No problem - it's my pleasure. The first thing I would do is delete any valuation thoughts you might have picked up from Mary Buffett's books. She doesn't seem to get that there's a leverage factor in ROE. Warren Buffett is really a high ROA guy. He doesn't exhibit a marked preference for either margins on turns in getting to that high ROA, either. What he likes is a long competitive advantage period. In any case, I think you've hit a lot of the good literature. I would include the classic Ben Graham works in your repetoire. They're a common thread in many of the sources you cite and are also very interesting documents of intellectual history. The 1934 edition of Security Analysis is a great read. I also liked The Rediscovered Benjamin Graham.

Aswath Damodaran's Investment Valuation and Copeland et. al.'s Valuation are also very good to have on hand.

The one I wouldn't read is Financial Shenanigans. It's very simplistic and basic. I personally like to re-read accounting textbooks to really grind in the basic mechanics of accounting.

I would also suggest some of the good books on behavioral finance, which helps you to identify mistakes -- your own and others. This allows you to cut down on your own and to capitalize on others'. Some good authors include Thaler, Belsky and Gilovich, and Shefrin. I would also suggest Cialdini's powerful Influence : Science and Practice.

Dale
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Thanks Dale,

I have read "Intelligent Investor" and have the last rev. of "Security Analysis", I recognize that I need to delve into the text more than I have been doing. Thanks for the suggestion about Janet Lowe's book on Graham, do you know when her bio of Munger is coming out?

Copland's "Valuation" has a new edition coming out in August that values Insurance companies and deals heavily with real options, so I'll probably wait until the rev to see what is new, however, Damodred's "Investment Valuation" is something I'll have to pick up. I agree wholeheartedly with the behavioral finance selections, I have read Cialdini's "Influence: The Power of Persuasion", Thaler's "Winner's Curse", Belsky and Gilovich's "Why Smart People Make Big Money Mistakes", and Piattelli-Palmarini's "How Mistakes of Reason Rule Our Minds", but Shefrin is a new name. Have you read any of Kahnmann or Tversky's texts? I hear they are very technical and potentially not worth the time of layman...

If you don't mind me asking, do you work directly under Bill Miller? I worked as an intern for Jim Oelschlager's Oak Associates Investment firm (mutual funds White Oak: WOGSX, Pin Oak: POGSX and Red Oak: ROGSX) and they have a lot of respect for Bill's work.

PS - Working for Legg Mason, do you feel any certain way about Robert Hagstrom's "The Warren Buffett Way" and "The Warren Buffett Portfolio?" I have read both was interested if the company utilized any of the fundametal framework he pushes in the texts...
Sorry for the length and thanks a million for you time, I know it is valuable,


Matt
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Dale,

In order to be able to contribute more of value to coversations in the future, I have two final questions re: our previous conversation...

One, what accounting textbooks would you reccommend? Iam unfamiliar with which authors are considered noteworthy...

Two, do you feel Value Line is an adequate research source when first looking into a company's financials? I haven't used it in years but heard it mentioned by individuals who I respect.

Three, Have you ever heard of "A Guide to Business Periodicals," which Mary Buffett references. Even though her book did seem like a ten step program, if a resource like that exists if would be of interest.

Thanks,

Matt
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Matt,

I haven't read the authors you mention. If it gets too technical, I start to get lost. I remember trying to read "Path Dependence in the Economy," which was supposed to explain network externalities and technology lock-ins, but it was all Greek letters and huge formulae. Whatever the author was saying was lost on me.

I would be interested to see what Copeland has to say about valuing insurance companies. For Berkshire, I have valued the insurance companies using an economic value added approach. The "X" factor that seems to get lost on commentators such as Jeff Bronchick at TheStreet.com can easily be explained by the real option value of the excess capital at Berkshire, which I estimate at $25 billion. The rest is pretty straightforward.

I work in Bill's group, on Value and Special. I left the Fool to join here when I was offered a position and am enjoying it immensely. I've been very lucky over the last four years to have worked for two such excellent and fun organizatizations as Legg Mason and the Fool.

I did a pretty lengthy interview with Robert Hagstrom last summer. It should pop up pretty quickly in the search engine here. The tenets of The Warren Buffett Portfolio are something I have tried to practice for a long time. It just makes sense to confine your portfolio to your most preferred choices. The Warren Buffett Way is an excellent introduction to Berkshire Hathaway, but the second Buffett book is the biggest addition to investment literature by Robert. I really think it's an important book because it pulls together some interesting stuff and moves way beyond the same old things that most "value" investors talk about. My second-favorite Hagstrom book is The NASCAR Way, because it explained the economics of NASCAR very well, which I always appreciate in a business book.

Dale
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Matt,

I haven't heard of the guide reference by Mary Buffett. By the way, I did mean to say that I thought her list of companies followed by Buffett was most useful.

I'm not really a fan of Value Line. I have never trusted canned data of any kind. Maybe if I used it I would recommend it. I've always gone (well, since 1995) straight to the EDGAR websites.

Granoff and Bell are a pretty good beginning accounting text, I have found.

Dale
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If you have an inclination, I'd like to discuss with you certain aspects of a conversation you were having in the Boring Port board regarding ROIC and its weakness in capturing the capital spent to acquire intangible assets. This conversation came out of a discussion regarding Charlie Munger's comment that EVA was a bunch of twaddle and the mental model didn't work at BRK.A annual meeting. I have an idea on what he meant that hasn't been expressed yet on the boards.

ROIC can be broken down many ways, with different definitions depending on whether you look in <i/Security Analysis/> or in QFV. A basic definition that we will assume here most people use is as follows:

ROIC = NOPAT/IC
= NOPAT/Cash Sales * Cash Sales/IC
where NOPAT =
Cash Revenue
-CGS adjusted for Inventory valuation (LIFO v FIFO)
-SGA
-Interest Expense on Non-Cap Leases
-Cash equivalent of options granted using fair value or BS model
-Cash Taxes (taking into account the tax benefit from issuing option grants)
= NOPAT

where IC =
All Debt (including ST, current portion of LT, capitalized lease obligations, PV of non-cap leases)
+Common Equity (including LIFO reserve, accum goodwill amortization and other equity equiv.)
= IC
... Now much of the discussion surrounded various attempts to re-engineer the IC denominator in ROIC in order to adequately account for capital expended acquiring intangible assets. However, I think Munger was critical of this thinking process, instead viewing the problem in another fashion.

ROIC is useful as an investment ratio because it considers the cash consequences of how a company invests its capital. It represents the inputs of the company, what it does with the cash that it gets at the end of the day. However, I believe that this ratio and its underlying problem can be re-framed to answer the same question "How well is the company allocating capital?" without as much of the accounting headache. To paraphrase the part of Munger's response that was left out of the quote, the name of the game is to turn every dollar of RE into more than one dollar of Market Value.

All companies cash earnings can either be retained to fund CAPEX or other potentially value additive activities such as buying back stock, or they can be paid out to the owners of the company. Instead of looking at the inputs, ie what the company does with RE specifically, one can instead look at the only directly linked casual effect that matters, Market Value. By comparing the annualized rate of growth in RE per share with the annualized rate of growth in market value per share, an investor need not worry how the company deploys their funds, merely that they do so in a value additive way. By focusing on the casual effect of capital allocation (output) reflected in the share price and not at the highly involved ROIC formula, an investor will see how a company performs with capital allocation decisions, regardless of whether these decisions are reflected on the balance sheet and statement of cash flows or not. Charlie's mental model is much simpler than those posed in EVA, it allows one to ultimately compare what is done (Retain cash earnings instead of pay them out to owners) with what happens (does the market value of the company go up by more of a margin than earnings were retained?). Investors ultimately focus on the forest and not the trees.

As a securitization analyst who will be dealing with alot of off-balance sheet financing, while I want to be able understand the accounting affects of corporate decisions, one should view investing in the right framework and I find WEB and Munger's intuitively more appealing. Behavioral economists discuss "framing" blindspots and how they can confuse the rationality of the human mind. I believe that this conversation regarding Munger's comments may have highlighted just such an occurence.
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Dale,

I want to specifically thank you for the opinions and suggestions. I agree with your sentiment regarding Hagstrom's WBP, Munger was correct in stating that it is one of the single most important advances to financial thought in the past 50 years.

Matt
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Am I the only one stunned by this statement of Tom Gardner's?

In essence, I believe great investing need not consider stock valuation, so long as it is rigorously focused on the economic merits of a business and
the qualities of superior management. (emphasis mine)

Not consider valuation at all? You must be joking. No matter how much "merit" the business has, no matter the "qualities of superior management",
surely there must be some price at which you would not be a buyer.

Isn't there?

Am I the only one who finds the quoted statement bizarre in the extreme?

UsuallyReasonable


My first reaction was like yours, but the more I think about it, the more I tend to agree with Tom. If I believed that the market was perfect and each stock was perfectly priced at all times, I would agree 100% with Tom. The price is always "right," so why sweat it?

Since over the short term it's obvious that the market can't make up its mind about valuation, price can't rationally be ignored. A better valuation might be a running average of price, I guess. But how do I use this piece of information? The market is fickle - a pox on it!

I can't figure out how to arrive at valuation, but I can do a fair job of evaluating quality and make an informed judgment about the business model, so quality should carry a lot more weight in making a buy decision. I think that was Tom's general thrust. I think.

My head hurts. Time to go fishing.

Dave Ayers, aka Domestique
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To paraphrase the part of Munger's response that was left out of the quote, the name of the game is to turn every dollar of RE into more than one dollar of Market Value.

Yup. If retained capital cannot beat its cost of capital, then the market will mark down the price of the retained capital in the same way a bond will be marked down such that yield to maturity matches prevailing interest rates. In this analogy, the prevailing interest rate would be the required return on capital. So, I think as an intellectual construct, EVA works fine, but Stern Stewart mucks it up with lots of little tweaks here and there that allow them to sell their services. If a company just realizes that equity actually has a cost, then they've got 99% of what is important in the whole EVA or economic profits mental model. I think that's the objection that Buffett and Munger have -- the agency costs that the Stern Stewart systems impose on clients when it could all be explained and monitored without all the extra BS.

Dale
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I also don't recall any serious empirical evidence that cash flows predict future stock returns better than earnings.

There was actually a published study I read that supported this very viewpoint. It's called "Do Stock Prices Fully Reflect Information in Accruals and Cash Flows about Future Earnings." It was published in the July 1996 edition of The Accounting Review. Here's the abstract:

This paper investigates whether stock prices reflect information about future earnings contained in the accrual and cash flow components of current earnings. The extent to which current earnings performance persists into the future is shown to depend on the relative magnitudes of the cash and accrual components of current earnings. However, stock prices are found to act as if investors "fixate" on earnings, failing to reflect fully information contained in the accrual and cash flow components of current earnings until that information impacts future earnings.

Here's one other line from the intro that's of interest on this subject: "The paper adds to the growing body of evidence indicating that stock prices reflect naive expectations about fundamental valuation attributes such as earnings."

I obtained a copy of the article by contacting the publication through an Internet search. The person that sent me the article was Michelle Clousing. Here's her e-mail aaamichelle@packet.net. I'm not sure if that's still valid as I received my copy of the article last August. I believe that it cost $0.25 per page. I'll warn you though that it's pretty dry reading.

Please note that I'm a bit behind on this board, so that if you respond, it may take awhile until I get back to you.

Phil
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