I presented a webinar for Netwealth last week on value investing in small and mid cap stocks. Even after a couple of decades practising value investing, going back to basics gets me thinking about the fundamentals of what we do. And it helps, a lot.
The value of any financial security is the present value of the cashflows it is going to deliver to its owner.
That is the fundamental principle of value investing. How much am I going to get? When am I going to get it? How certain am I? Answer these three questions accurately, buy with an appropriate margin of safety and you don’t need to worry about anything else. The share price can go up down or sideways. It doesn’t even matter where the shares trade at all. The business you own is going to provide you with the return you require.
Despite knowing this, despite repeating it ad nauseam to investors and potential investors alike, I still get lured into letting share prices define our success. Sotheby’s (NYSE: BID) share price has doubled since we bought it, therefore we were right. Countrywide (LSE: CWD) is down 60% over the past few years, therefore we stuffed it up.
No, and no. The true definition of success is whether the business produces the cashflow stream we expected. It is a subtle difference, because share prices tend to be highly correlated with the underlying business performance, but it is a very important one.
The true test of value investing success
We paid $22 a share for Sotheby’s and sold it only 8 months later for $40 a share. While that sounds great, the true test is whether it delivers the anticipated cashflow stream or not. Since our purchase Sotheby’s has returned about $6 to shareholders in the form of dividends and buybacks. That’s meaningful progress but it has some proving to do yet. We won’t know for five or ten years whether our purchase price was a wonderful investment or not.
Countrywide, on the other hand, has just cut its dividend and undertaken a capital raising. Rather than paying cash out, they are asking shareholders to put more in. Further down the path than Sotheby’s, it’s pretty clear we have this one wrong. Not because the share price is down, but because the cashflows are a long way short of our expectations.
https://www.youtube.com/watch?v=FqNmhrOgMLk
The more time that passes, the more evidence you get to assess the original investment case. Which brings me to one of our old favourites, B&C Speakers (BIT: BCE). This Italian speaker manufacturer has been in the portfolio since 2013 (and featured in the June 13 Quarterly Report).
The original purchase price was €4.10 per share. In the nearly four years since, earnings per share have grown from €0.38 to €0.58 and the dividends have kept pace. In total we have received €0.99 in dividends and last night the company declared another €1, including a €0.60 special dividend. Once paid, we will have received 49% of our original purchase price in cash. The underlying dividend represents a yield of 10% on the purchase price and it should grow from here.
The share price is up 150% since that initial purchase, closing at €10.23 last night. Would we care if it was still trading at €4.10? Of course not. We own a business that is delivering wonderful returns on our initial outlay. And that is the true test of a very successful investment.
Gareth and I were the first non-Italian visitors to B&C’s head office in Florence. The CFO, Simone Pratesi, shared a pizza with us in the company’s caffeteria. “You guys have the easiest job in the world” he told us. “All you need to do is invest in a B&C and go to the beach while I make you rich”.
Sometimes it’s worth remembering that successful investing really can be that simple.
Steve Johnson I love what you do. We were too late into the market to be able to invest in your small cap fund ..but the moment funds are available we will be into your international fund. Just love your concepts and approach. Thank you
Thanks Stephen, much appreciated.
Hi Steve,
Congrats on the great work you and your team are performing. I assume when value a business, you are forecasting and discounting future cash flows. This is great in theory but I think there are many practical problems with this approach, like:
1) how far out do you forecast the cash flows knowing as you go further out it is the less likely to be realistic.
2) You could try to get around the above problem by assuming a terminal va
lue but then what terminal value factor or multiple does one apply? If one assumes the Gordon Growth Model to be accurate, what long term growth assumption do you apply.
Given the need to make a whole lot of assumptions and my lack of confidence in my own forecasting abilities, I tend to use the DCF more as a tool to figure out what the market is implying the cash flows to be in the future assuming a certain discount rate and terminal growth.
I would appreciate if you could share your thoughts on this Steve, thanks.
Hi DC, you are 100% correct. The theory is more straight forward than the reality. The future is inherently uncertain and my experience has been that DCF models imply a degree of certainty that rarely exists in the real world. We use them very sparingly, for example on stocks like Lotto24 that are relatively simple to model.
So the trick is to think about how the cash is likely to come out of a particular business and pick a valuation tool accordingly. Whether it’s assets, earnings and reinvestment, dividends, acquisitions, you might use a price to book ratio, PE ratio, yield requirement or strategic value. These rough metrics should approximate a DCF model anyway, and if you demand a large enough margin of safety, roughly right is better than approximately wrong.
I’m not pretending any of this is easy. As mentioned with Countrywide above (I could give you plenty more examples), we get it wildly wrong from fairly regularly. The point is to make sure we are focused on the right thing – business performance relative to expectations – rather than the share price.
You might also enjoy our introduction to value investing video series. Cheers.
To add to Steve’s comments, we also have a ‘too hard’ basket and use it frequently. It’s about focusing on those situations where we feel particularly comfortable at the task of valuing.
Farnam street had an article that is related and is a quick read. Basically, “good decisions don’t always have a good outcome, just as bad decisions don’t always have bad outcomes.” The worst place to be is “bad process/good outcome. This is the wolf in sheep’s clothing that allows for one-time success but almost always cripples any chance of sustained success.”
Really difficult to differentiate sometimes (paraphrasing Feynman) as the easiest person to fool is yourself…
https://www.farnamstreetblog.com/2012/10/what-happens-when-decisions-go-wrong/
Steve,
with reference to B&C last paragraph featured in the June 13 Quarterly Report, ‘But for similar illiquid investments in future, we might not always disclose the stake immediately or even in the medium term.’
with regards to Australian Fund now ASX listed, is the ability to be discreet with small cap illiquid investments now more time limited?