Was thinking. They teach you to be an analyst in college. Or at least they provide you with the tools to be an analyst. Everyone comes out with the same tools. But you take on an investment perspective/philosophy when you join a firm. Investment management is unique in that there are literally many ways to skin the cat - many paths to market beating nirvana (sadly none of them guarantee success). Some basic principles are essential, but after that you can seek to beat the market in any number of different ways. One reason for this is because there is no unified theory of investing. There is no one empirically correct way to beat the market.
And so, how important is the philosophical predilection of a shop? and, What effect (or bias) does that predilection have on the analyst's analysis?
Does a value oriented analyst in a value shop overly discount everything? Does a growth oriented analyst in a growth shop overestimate everything? [do they even do any analysis!!! my little joke]
Does it make any difference if you have a value-oriented analyst in a growth shop or a growth-oriented analyst in a value shop?
I would say Yes to everything.
Showing posts with label relative value. Show all posts
Showing posts with label relative value. Show all posts
Friday, June 19, 2015
Saturday, September 6, 2014
The Conceit of Value Investing
Value investors rightly argue that if you focus on acquiring undervalued assets, ie. assets trading below intrinic value (whatever that is...certainly no objective measure...a post for another day), then the market will eventually come around to recognizing the firm is worth more than what it is currently and start bidding up the price.
The irony or conceit of value investing is that it is generally in a bullish (positive growth) economic environment that either the company's fortunes turnaround or the market has pushed the value of growth and momentum names so high that it is now looking for valuation arbs and comes down to the value end of the market to find those opportunities. A positive economic environment gives the market the confidence to take a punt on a distressed asset and time is the healer of all things (which is why value performs best at the end of a cycle - it is playing catch-up).
Value investors will also argue that value investing works in down markets because you have purchased assets at depressed prices and that provides a cushion (margin of safety) relative to the high priced (multiple) growth and momentum names that have led the market. That has not generally been my experience. In a large market pullback all names seem to fall together.
Value names tend to outperform at the beginning (inflexion point) in a market cycle and toward the middle-end of a market cycle. Growth and momentum names dominate (or lead) the market through the middle of a cycle.
The irony or conceit of value investing is that it is generally in a bullish (positive growth) economic environment that either the company's fortunes turnaround or the market has pushed the value of growth and momentum names so high that it is now looking for valuation arbs and comes down to the value end of the market to find those opportunities. A positive economic environment gives the market the confidence to take a punt on a distressed asset and time is the healer of all things (which is why value performs best at the end of a cycle - it is playing catch-up).
Value investors will also argue that value investing works in down markets because you have purchased assets at depressed prices and that provides a cushion (margin of safety) relative to the high priced (multiple) growth and momentum names that have led the market. That has not generally been my experience. In a large market pullback all names seem to fall together.
Value names tend to outperform at the beginning (inflexion point) in a market cycle and toward the middle-end of a market cycle. Growth and momentum names dominate (or lead) the market through the middle of a cycle.
Friday, July 18, 2014
What Is Value?
Value is in the eye of the beholder...value is ethereal...value is a moving feast (non-stationary)...value is real...value is relative.
What is MSFT worth? What is INTC worth? What is GOOG worth? What is AAPL worth? What is ORCL worth? What is CSCO worth?
After years of multiple compression, things are looking up for the mega-cap techs. I don't know what level their multiples bottomed at but they are slowly seeing an expansion. Most are currently trading around 10x EBITDA. This seems crazy to me when they all exhibit a little growth, have monster margins, strong market positions and competent management. Still technological disruption threatens to undercut all of them and so some level of discount should be applied. But given their premium performance characteristics I would suggest the technological disruption discount should cancel the quality premium out and they should trade at a market average multiple. Given that they are essentially the market (given their size) this could of course be a tautology. Nevertheless, it is not difficult for me to see the market warm to these names and see their EV/EBITDA multiple move out to 12x or 13x. That is another 20%-30% upside tacked on to 10% earnings growth and a 3% yield. Not a bad return.
We have seen a massive move out of the smalls into the large and I don't see that changing anytime soon. The smalls got way out ahead of the game and are now mean reverting.
What is MSFT worth? What is INTC worth? What is GOOG worth? What is AAPL worth? What is ORCL worth? What is CSCO worth?
After years of multiple compression, things are looking up for the mega-cap techs. I don't know what level their multiples bottomed at but they are slowly seeing an expansion. Most are currently trading around 10x EBITDA. This seems crazy to me when they all exhibit a little growth, have monster margins, strong market positions and competent management. Still technological disruption threatens to undercut all of them and so some level of discount should be applied. But given their premium performance characteristics I would suggest the technological disruption discount should cancel the quality premium out and they should trade at a market average multiple. Given that they are essentially the market (given their size) this could of course be a tautology. Nevertheless, it is not difficult for me to see the market warm to these names and see their EV/EBITDA multiple move out to 12x or 13x. That is another 20%-30% upside tacked on to 10% earnings growth and a 3% yield. Not a bad return.
We have seen a massive move out of the smalls into the large and I don't see that changing anytime soon. The smalls got way out ahead of the game and are now mean reverting.
Saturday, March 8, 2014
Why and how the market can keep going up as breadth disintegrates
The S&P 500 is at 1878. It is up 1.61% YTD, 23.7% 1 yr, 31% since January 2013, 62.5% since October 2011.
The Nasdaq Composite is at 4,336. It is up 3.2% YTD, 36.8% 1 yr, 42% since January 2013, 75% since October 2011.
Those are all big numbers. Especially in the context of an anemic economy and being toward the end of a regular market cycle.
Earnings growth has been substantial. The S&P is trading at 15x forward earnings. The Nasdaq is trading at 18x forward earnings. Valuation is above average but by no means extreme or even stretched. It could also be argued that with rates low and expected to be low for a long time, multiples could be substantially higher. The march higher has been broad based, lead by small and mid caps.
Beyond the aggregate data, I think there is another catalyst that I have not seen talked about that could easily see the major benchmarks substantially higher (even as the broader market and market breadth falls away).
That catalyst is the low relative valuation of the benchmarks major components. The top 10 companies in the S&P 500 comprise 18% of the benchmark weighting. The top 10 companies of the Nasdaq Composite comprise 32% of the benchmarket weighting. Those companies look to me to be substantially undervalued relative to the benchmarks smaller components. If their multiple were to rise from an undervalued average of 13x to a more normal 15x, then that could easily propel the indexes much higher (throw in earnings growth and dividend yield for added support), even as breadth trails off.
The Nasdaq Composite is at 4,336. It is up 3.2% YTD, 36.8% 1 yr, 42% since January 2013, 75% since October 2011.
Those are all big numbers. Especially in the context of an anemic economy and being toward the end of a regular market cycle.
Earnings growth has been substantial. The S&P is trading at 15x forward earnings. The Nasdaq is trading at 18x forward earnings. Valuation is above average but by no means extreme or even stretched. It could also be argued that with rates low and expected to be low for a long time, multiples could be substantially higher. The march higher has been broad based, lead by small and mid caps.
Beyond the aggregate data, I think there is another catalyst that I have not seen talked about that could easily see the major benchmarks substantially higher (even as the broader market and market breadth falls away).
That catalyst is the low relative valuation of the benchmarks major components. The top 10 companies in the S&P 500 comprise 18% of the benchmark weighting. The top 10 companies of the Nasdaq Composite comprise 32% of the benchmarket weighting. Those companies look to me to be substantially undervalued relative to the benchmarks smaller components. If their multiple were to rise from an undervalued average of 13x to a more normal 15x, then that could easily propel the indexes much higher (throw in earnings growth and dividend yield for added support), even as breadth trails off.
A "bubble" in growth
The market has experienced a massive run over the past year and a half. Much of that is due to the economic/political clouds clearing, confidence repairing, earnings coming through and ZIRP (and all its manifestations, eg. Bernanke Put, etc.) supporting a one-way trade.
But there is no doubt in my mind we are experiencing a growth bubble not too dissimilar to the internet bubble (which granted was a great deal more diffuse) in a number of places. These companies are characterized by rapid revenue growth, low to no profit, and the prospect/hope of future leveraged profitability - sound familiar. What is scary to me is that like the internet bubble it kept going and going until finally you threw in the towel and drank the kool-aid yourself. There are no signs of multiple expansion declining. No signs of a prick.
We will wake-up one day, two weeks, three weeks, four weeks past the peak and realize the game is up. For me that will mean watching the aftermath. I am hopeless at chasing. I will likely have been burned badly fighting it on the way up only to have capitulated and failed to have a position (or worse had a position but failed to have the conviction/patience to let the position ride) to capitalize on the bursting.
There will no doubt come a time when the market will once again focus on long term sustainable profitability with a degree of scepticism toward these sectors (which will likely result in overshoot on the downside). The scales will fall and the reckoning will begin.
Main areas where a bubble burst in valuation will be felt: SaaS, big data, analytics, cloud, biotech, social media.
But there is no doubt in my mind we are experiencing a growth bubble not too dissimilar to the internet bubble (which granted was a great deal more diffuse) in a number of places. These companies are characterized by rapid revenue growth, low to no profit, and the prospect/hope of future leveraged profitability - sound familiar. What is scary to me is that like the internet bubble it kept going and going until finally you threw in the towel and drank the kool-aid yourself. There are no signs of multiple expansion declining. No signs of a prick.
We will wake-up one day, two weeks, three weeks, four weeks past the peak and realize the game is up. For me that will mean watching the aftermath. I am hopeless at chasing. I will likely have been burned badly fighting it on the way up only to have capitulated and failed to have a position (or worse had a position but failed to have the conviction/patience to let the position ride) to capitalize on the bursting.
There will no doubt come a time when the market will once again focus on long term sustainable profitability with a degree of scepticism toward these sectors (which will likely result in overshoot on the downside). The scales will fall and the reckoning will begin.
Main areas where a bubble burst in valuation will be felt: SaaS, big data, analytics, cloud, biotech, social media.
Monday, October 28, 2013
Sitting Out A Rally
In our business you can't sit out a rally. Even if your philosophy and your process support such a move. The reason is because "the business of money management" will not allow to sit out a positively trending market and in the back of your mind you justify staying-in on the basis that "you can't time the market." The other thing is, each time you have attempted to go to cash, you have been steamrolled.
What this does is change you from an intrinsic value investor to a relative value investor.
What this does is change you from an intrinsic value investor to a relative value investor.
Saturday, October 26, 2013
Implications of Momentum Investing
Trend following, aka momentum investing is probably the weakest part of my investing DNA. I am a natural contrarian with a strong value tilt. I have learned the value of growth and the importance of sentiment and momentum, but they are still both hard for me to fully commit to.
Over the past 10-15 years research has vindicated and validated trend following strategies as a way to add alpha. Consequently, and in conjunction with the increasingly quantitative/algo driven basis of the market, I believe trends, predicated upon more momentum investors and trend followers, will be longer and of greater magnitude that previously. The nature of momentum is that it feeds upon itself. It is self perpetuating, self replicating. There are three major implications. First, you need to incorporate momentum into your investment strategy. Second, a momentum based market leaves opportunity for fundamental based value investors. Because the trend goes longer and for a greater duration than fundamental value would indicate, it creates an opportunity for a fundamental based value perspective. Third, turns in the market or changes in trend will trip up a lot more investors. Trend followers, quant or qual, always get burnt by the turns in the market. The length and magnitude of trends will be greater on boths sides of a trend. Significant alpha will come from picking a change in trend. Incorporating a market reversal component into an investment process (albeit incredibly difficult) will be very rewarding.
The old adage, go with the flow will be the dominant characteristic of future markets.
Over the past 10-15 years research has vindicated and validated trend following strategies as a way to add alpha. Consequently, and in conjunction with the increasingly quantitative/algo driven basis of the market, I believe trends, predicated upon more momentum investors and trend followers, will be longer and of greater magnitude that previously. The nature of momentum is that it feeds upon itself. It is self perpetuating, self replicating. There are three major implications. First, you need to incorporate momentum into your investment strategy. Second, a momentum based market leaves opportunity for fundamental based value investors. Because the trend goes longer and for a greater duration than fundamental value would indicate, it creates an opportunity for a fundamental based value perspective. Third, turns in the market or changes in trend will trip up a lot more investors. Trend followers, quant or qual, always get burnt by the turns in the market. The length and magnitude of trends will be greater on boths sides of a trend. Significant alpha will come from picking a change in trend. Incorporating a market reversal component into an investment process (albeit incredibly difficult) will be very rewarding.
The old adage, go with the flow will be the dominant characteristic of future markets.
Thursday, August 1, 2013
The Cloud Bubble
There is nothing more irksome than the smugness of some momentum guy who dismisses valuation as irrelevant.
The current hot air craze is with "cloud" companies:
Amazon
LinkedIn
Netsuite
Workday
Salesforce.com
Concur Technologies
Commvault Systems
All these companies have solid topline growth, but there are minimal cashflows relative to their market value. The market is incorporating an awful lot of future unknown growth into present valuations.
For example, Workday (WDAY): $12b cap, $11b EV, 38x P/Sales, 750x TTM cash flow, 15% short interest, TTM sales are $308m, topline growth rate is 61%. The firm hasn't gone FCF positive yet, but is at the inflection point. What size do revenues need to be to justify a $12b market cap in the competitive tech industry? I would say a reasonable multiple is 4x-5x sales. 5x sales assumes revenues of $2.4b - that equates to a 50% CAGR rate over the next 5 years. Is that possible? Yes. Is it likely? Probably not (unless they are the next incarnation of Microsoft or Dell...but their addressable markets are much smaller and their competition much greater). Assuming 30% operating margins, then $2.4b in revenues produces $720m in EBITDA. That translates to the current stock price trading at 15.27x 5 yr EV/EBITDA. That is not todays EV/EBITDA multiple. That is 5 years from now, which assumes an awful lot has gone right. And if there is one thing we know from the tech world, 5 years is an eternity to techdom.
The most likely scenario is that these names will continue to trade at high multiples reflecting their leadership positions in high growth areas, but at some point in the future a transition or transposing of sentiment will take place and the tyranny of multiple compression will weigh down future appreciation. They may continue to grow like weeds and they may become obscenely profitable, but they will be paid less and less for those returns. In the case of dotcom leaders (CSCO, EBAY, INTC, MSFT, ORCL, EMC) they grew their earnings substantially but shareholder returns were highly muted by multiple compression.
The current hot air craze is with "cloud" companies:
Amazon
Netsuite
Workday
Salesforce.com
Concur Technologies
Commvault Systems
All these companies have solid topline growth, but there are minimal cashflows relative to their market value. The market is incorporating an awful lot of future unknown growth into present valuations.
For example, Workday (WDAY): $12b cap, $11b EV, 38x P/Sales, 750x TTM cash flow, 15% short interest, TTM sales are $308m, topline growth rate is 61%. The firm hasn't gone FCF positive yet, but is at the inflection point. What size do revenues need to be to justify a $12b market cap in the competitive tech industry? I would say a reasonable multiple is 4x-5x sales. 5x sales assumes revenues of $2.4b - that equates to a 50% CAGR rate over the next 5 years. Is that possible? Yes. Is it likely? Probably not (unless they are the next incarnation of Microsoft or Dell...but their addressable markets are much smaller and their competition much greater). Assuming 30% operating margins, then $2.4b in revenues produces $720m in EBITDA. That translates to the current stock price trading at 15.27x 5 yr EV/EBITDA. That is not todays EV/EBITDA multiple. That is 5 years from now, which assumes an awful lot has gone right. And if there is one thing we know from the tech world, 5 years is an eternity to techdom.
The most likely scenario is that these names will continue to trade at high multiples reflecting their leadership positions in high growth areas, but at some point in the future a transition or transposing of sentiment will take place and the tyranny of multiple compression will weigh down future appreciation. They may continue to grow like weeds and they may become obscenely profitable, but they will be paid less and less for those returns. In the case of dotcom leaders (CSCO, EBAY, INTC, MSFT, ORCL, EMC) they grew their earnings substantially but shareholder returns were highly muted by multiple compression.
Thursday, May 16, 2013
Don't Be Fooled By The Present
A good rule of thumb when modeling firms and valuing equities is not to be fooled by the present. Normalizing growth rates, margins and discount rates attempts to estimate the value of a firm over a cycle.
Here is the problem.
In accord with financial theory, market practitioners are using the 10 yr Treasury bond (or even the 5 yr) as the risk free proxy in their DCF models. When you extrapolate linear topline growth based on the recent past (ie. the recovery out of the pit) throw in a little margin expansion (a lot actually because they are universally optimistic) and then discount the future expected cash flows at basically 1% or 2%, then a lot stocks are going to look awfully attractive. And that is where we are at right now. That is what QE does. It distorts the lens through which value is assessed.
I model with a normalized risk free rate of 5% (that assumes a real return of 3% and 2% inflation). The result is drastically different from the current consensus.
If and when the economy and markets normalize (and I think they are well on their way to doing that now) and analysts start putting higher risk free rates into their weighted average cost of capital calculations, then you are going to see large headwinds for valuations (ie. target prices). That doesn't even take into account the cost of rising interest rates on the actual cash flows of a business funding off shorter term debt.
It has been a free ride for a while, but you want to get off that train before it jumps the tracks. With the Fed on hold until at least 2014 and maybe into 2015 (depending upon economic activity and the level of unemployment), then it might still be a while before that transition takes place. Having said that, the market will in all likelihood anticipate the future rise of rates and begin factoring it into models before we see the actual change.
Here is the problem.
In accord with financial theory, market practitioners are using the 10 yr Treasury bond (or even the 5 yr) as the risk free proxy in their DCF models. When you extrapolate linear topline growth based on the recent past (ie. the recovery out of the pit) throw in a little margin expansion (a lot actually because they are universally optimistic) and then discount the future expected cash flows at basically 1% or 2%, then a lot stocks are going to look awfully attractive. And that is where we are at right now. That is what QE does. It distorts the lens through which value is assessed.
I model with a normalized risk free rate of 5% (that assumes a real return of 3% and 2% inflation). The result is drastically different from the current consensus.
If and when the economy and markets normalize (and I think they are well on their way to doing that now) and analysts start putting higher risk free rates into their weighted average cost of capital calculations, then you are going to see large headwinds for valuations (ie. target prices). That doesn't even take into account the cost of rising interest rates on the actual cash flows of a business funding off shorter term debt.
It has been a free ride for a while, but you want to get off that train before it jumps the tracks. With the Fed on hold until at least 2014 and maybe into 2015 (depending upon economic activity and the level of unemployment), then it might still be a while before that transition takes place. Having said that, the market will in all likelihood anticipate the future rise of rates and begin factoring it into models before we see the actual change.
Wednesday, April 17, 2013
A Philosophy on Investing
I look for good companies with attractive stock prices.
Some may call it growth at a reasonable price. I don't like to think of it this way. First, because it is jingoistic and fails to take account of the nuances in my approach. And second, because a good company may not necessarily have great growth prospects per se, but still have a very attractive stock price (from a long term equity ownership perspective). The beauty of a good company is that it has products, a market footprint and market opportunity that is sufficiently attractive (could be large market, could be niche positioning, could be something else) and competent enough management to continue to steer the firm along a productive path.
Now there are two other associated perspectives that are worth bearing in mind. The first is that I don't want to invest in a good company with an unattractive stock price. This would be the case where the market has bid up the price of the stock (ie. it trades at a substantial premium to a reasonable estimate of its long term intrinsic value) to the point where there is little margin for safety. The second perspective is that I am leary of investing in lousy companies with what appear to be highly attractive stock prices, ie. value traps.
There are two other areas where you can make a lot of money. The first is in buying cyclical stocks at the bottom of the cycle. The second is in identifying what were previously lousy companies that are turning into good companies and have a highly discounted stock price. Those are attractive investment opportunities also. If you fish in either of those areas, then you need a framework to understand and analyze the dynamics of both of those situations.
Major unwritten rules underlying investing are patience, structure, discipline and courage.
Some may call it growth at a reasonable price. I don't like to think of it this way. First, because it is jingoistic and fails to take account of the nuances in my approach. And second, because a good company may not necessarily have great growth prospects per se, but still have a very attractive stock price (from a long term equity ownership perspective). The beauty of a good company is that it has products, a market footprint and market opportunity that is sufficiently attractive (could be large market, could be niche positioning, could be something else) and competent enough management to continue to steer the firm along a productive path.
Now there are two other associated perspectives that are worth bearing in mind. The first is that I don't want to invest in a good company with an unattractive stock price. This would be the case where the market has bid up the price of the stock (ie. it trades at a substantial premium to a reasonable estimate of its long term intrinsic value) to the point where there is little margin for safety. The second perspective is that I am leary of investing in lousy companies with what appear to be highly attractive stock prices, ie. value traps.
There are two other areas where you can make a lot of money. The first is in buying cyclical stocks at the bottom of the cycle. The second is in identifying what were previously lousy companies that are turning into good companies and have a highly discounted stock price. Those are attractive investment opportunities also. If you fish in either of those areas, then you need a framework to understand and analyze the dynamics of both of those situations.
Major unwritten rules underlying investing are patience, structure, discipline and courage.
Thursday, January 13, 2011
The Problem With Relative Value*
Virtually every asset class looks attractive relative to bonds right now (except for cash**).
And that is the problem when you have an externality like a central bank setting interest rates. That distortion of the supply/demand nexus, sets up an imbalance. In the current case, it is the misallocation of resources within an economy toward risky assets*** (although it is highly ironic that petrified retail investors actually sought out bonds like a giffen good).
Relative value investors (and that is what most are) look at those signals and from them determine that equities, commodities, precious metals, real estate, you name it, are attractive relative to bonds. And they are. The problem is bond yields are at artificially low levels, and when they normalize (a.k.a., go up) those assets that looked attractive relative to bonds previously no longer look as attractive.
Proper analysis of risk assets should incorporate normalized growth, margins, and discount rates into their framework, otherwise they risk falling for the "relative value illusion" and a host of other fallacies (ie. cyclical illusion, history will repeat illusion, et al).
*Actually there are numerous problems associated with relative value analysis, but that is for another day.
**But even cash looks attractive if you believe bond rates are going to go up.
***Actually, the misallocation may be less to risky assets, than to risky behavior.
And that is the problem when you have an externality like a central bank setting interest rates. That distortion of the supply/demand nexus, sets up an imbalance. In the current case, it is the misallocation of resources within an economy toward risky assets*** (although it is highly ironic that petrified retail investors actually sought out bonds like a giffen good).
Relative value investors (and that is what most are) look at those signals and from them determine that equities, commodities, precious metals, real estate, you name it, are attractive relative to bonds. And they are. The problem is bond yields are at artificially low levels, and when they normalize (a.k.a., go up) those assets that looked attractive relative to bonds previously no longer look as attractive.
Proper analysis of risk assets should incorporate normalized growth, margins, and discount rates into their framework, otherwise they risk falling for the "relative value illusion" and a host of other fallacies (ie. cyclical illusion, history will repeat illusion, et al).
*Actually there are numerous problems associated with relative value analysis, but that is for another day.
**But even cash looks attractive if you believe bond rates are going to go up.
***Actually, the misallocation may be less to risky assets, than to risky behavior.
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