Since I received a quantity of email encouraging me to pursue discussions of stock valuation and mechanisms for reducing stock volatility, I will present a series of posts related to these issues, starting with stock valuation. Please understand that these are my beliefs, only parts of which you may encounter in your readings. So, keep in mind that my statements may contravene conventional custom - so reader beware. Think of this post as a preface for things to come.
They say that the English investor John Bull could stand many things, but he could not stand a three percent return. We suspect Dave Lehenky can stand many things, but we know he can't stand mediocre technology succeeding because of superior business strategy. I believe I am patient with many things, but I can't stand irrational investment behavior. Whatever investment strategy you choose should be consistent, extremely well thought out, and designed to make you money at some predetermined minimum level of return. And you must be totally convinced that your strategy will meet your goal. Anything short of this is wasting your time and probably your money.
Valuing stocks lies mainly in the domain of so-called fundamental analysis, and I won't deviate from this accepted view. Probably nothing I will say will be of much interest to momentum players or asset allocators.
Fundamental analysis itself has two diametrically opposed views: value vs. growth. Ask Warren Buffett about these styles and he will say they are joined at the hip and therefore indistinguishable. While naturally everyone should agree that any long-term investor should limit stock selections to stocks that have value, nevertheless a value style of investing is totally contrary to growth investing. Warren confuses the issue because he is a growth investor with a value reputation.
Both value and growth investors look at book value, cash flow, sales, earnings, PE ratios, or anything else you can find on the balance sheet or income statement. The difference is that value investors basically are bottom fishers and rely faithfully on "regression to the mean" to uplift their beat-up companies, enabling them to improve performance and thereby provide an above-average return. Book value takes on huge importance to the value investor, both to guard against bankruptcies and to provide the resources to restructure the company, hopefully leading to improved performance. John Templeton got his start by noticing that all small companies before the war seemed undervalued. He issued an order to his broker to buy 100 shares of every small company. The broker asked for clarification, expecting John to want to exclude companies which seemed near bankruptcy. John, clarified that he wanted shares in all small companies, regardless of their apparent financial health. This was a pure value play, which succeeded for some of the companies, and failed for others, but on balance was hugely rewarding because small companies at the time were grossly undervalued on average.
John Templeton went on to apply this value technique successfully to markets around the world. The value technique depends on statistics to work, and work it does. By going contrary to the market, protected by over-hangs of value, these investors simply plant their seed and wait for pleasant surprises. Since any given situation may disappoint utterly, the approach depends on diversification to make their bets pay off overall. Studies show value investing generally beats the market averages and provides reduced volatility, validating this approach as profitable to the patient investor. The Dogs of DOW is yet another example of the above-average return enjoyed by value investors. Benjamin Graham, as the father of value investing, provided painfully detailed descriptions about proper interpretation of the balance sheet and operating statements to support the value investor.
The problem with value investing is that the almost required use of diversification, needed to prevent occasional failures from diminishing overall results signficantly, also limits the upside to something only marginally better than the market average. If you seek more substantial returns, then you must set value investing aside and consider growth investing. All really big money is made with growth investing.
Growth investing uses fundamental analysis to identify companies that are expected to out-perform their peers consistently for years, with the expectation of returning an original investment many-fold over time. Growth investing was considered speculative until the 1920s, when it first began to be articulated as a reasonable strategy. The great crash of 1929 squashed that idea. In publishing their value theory of investing after the crash, Graham and Dodge denounced growth investing once again as speculative. Growth investing emerged in the sixties boldly chasing the "nifty-fifty". After a devastating bear market in the seventies, making mince-meat of the nifty-fifty, growth investing awaited the eighties to gather steam again as a practical means of valuing high-techs and bio-techs.
Given this history, you are excused if you doubt the soundness of growth investing. However, the problem was never with growth investing per se, but with its parasitic companion, momentum investing. Momentum investing is a technical approach that simply hitches a ride on a rising growth star, first taking it to extreme, and then ditching it when it succumbs to altitude sickness. Momentum investing, on the long and the short side, escalates volatility but is not fundamentally related to growth investing. The seasoned growth investor steers a steady course through choppy momentum waters, confident both of the sea-worthiness of his vessel and his measured sense of direction.
Serious growth investors focus on non-accounting indicators like product market considerations, management capabilities, franchises and barriers to entry. They use accounting data simply to rough in a value below which they can profitably buy the stock. Also diametrically opposed to value investing, regression to the mean is the enemy of the growth investor. The growth investor believes selected stocks will not succumb anytime soon to mediocre corporate performance. This means that the growth investor cannot hope to defeat the averages by distributing investments over a large number of stocks - he will be defeated by the law of large numbers. The serious growth investor is forced to concentrate investments on a very few, well-chosen companies. Unfortunately, the lack of a mechanical approach means that it is nearly impossible to gather a sample of sufficient size to remove any doubt that concentrated growth investing works. So whereas there is ample evidence of the benefits that accrue to the patient value investor, there is only anecdotal evidence to support the virtues of concentrated growth investing, like Warren Buffett and Bill Gates. Some argue that Buffett, Fisher and other highly successful growth investors are statistical outlyers, and do not necessarily represent robust styles for building wealth.
At the other end of the experience spectrum, the multi-billionaire Hunt brothers decided to bet the house and corner the silver market to no avail, and lost everything for their trouble. The lesson is that bets indeed have to be large to make extraordinary gains, but you should have the financial wherewithal to withstand the failure of any one, or even two, of them. Outside of that simple restriction, pile it on and go for the gold. Or else forget the restriction and be lucky, very good or both -- like Gates and Ellison.
Recognition of the inevitability of concentration is a relief to the serious growth investor, because so much time and effort is required to qualify individual stocks. The serious growth investor has faith that the desirability of diversification is a poor substitute for a detailed understanding of a company's business situation, and gladly forsakes diversification for concentration in a few well-selected stocks.
The next post will walk you through a method for stock valuation, introducing intrinsic value and ways to estimate mid-term market price. Armed with the ability to view stocks like WIND in the proper light, we will then turn our attention to what management might do to help us improve our valuation of the company. Finally, we will consider actions management might take when the stock is judged to be under-appreciated by the market.
Allen |
