Model Dictates

The results of my modeling generally dictate my attitude toward investing in a company. This makes sense because presumably your best guesses about the future of that company go into your models.

The problem is that in general when I model a growth stock, I generally model a contracting multiple and when I model a value stock I generally model a stable to expanding multiple.

It doesn't take a rocket scientist to work out that usual outcome there wrt recommendations.

The Systemic Mistakes Of Bias and How It Infuses A Process (Disposition Bias)

As a value oriented analyst I find that 'disposition bias' infusing my whole process.

Whether it is using a higher discount rate than appropriate, or discounting growth and margins more than is likely.

I have found myself over the years moving from a 12% discount rate (or expected rate of return) to a 10% discount rate to recently using an 8% discount rate.

I have found myself moving from a normalized PE of 18x down to 15x and contemplating moving it up to 18x. I use the normalized PE to base relative PE's off for each stock. 

As a value investor with the implicit cautious nature of that disposition, I tend to use growth rates and margins less than what is embedded by the current consensus.

I am sure the reverse goes for a growth oriented analyst. They are likely to use lower discount rates and higher growth rates and margins than what the current consensus has embedded into the price.

What does this all mean? It means (1) You need to know the bias of your analyst, and (2) You've got to compare your assumptions with the consensus.

Note: In a world where the current WACC or discount rate is probably somewhere around 5%, growth is king. If you use a normalized discount rate of 8%-10%, then current stock prices are not going to look so bueno. But if the game is played using a 5% discount rate, rightly or wrongly, shouldn't you get with the system and play the game the way it is currently being played? Ans. No. Because when the discount rate normalizes, then stock prices will be re-rated to a normalized discount rate.

Variant Perception and Edge: Value vs Growth

There are only two possible options for variant perception for both value and growth investors.

Both investor types are forecasting either higher growth rates or higher margins or a combination of those two factors compared to the market consensus and what is baked into the stock price today.

It is as simple as that. One other possible variant perception relates to the realm of undervalued/hidden/latent assets which occurs more on the value side of the divide (although effectively that is the implied assumption also on the growth side).

So for a growth investor when they come across a growth company trading at 30x forward earnings, implying 30%pa 5 yr growth and 20% operating margins, to have a variant perception they are either forecasting growth greater than 30% and/or operating margins greater than 20%. Implicitly they are also forecasting the future multiple to be 30x or greater. Lots of moving parts in that equation and lots of hope (the future) embedded in todays price. As long term holders the odds are usually not in their favor. Although if they hit the jackpot and get a genuine emerging leader that turns into a market leader then all their misses are likely to be made up by that one single hit.

For a value investor, looking at a company trading at 10x forward earnings with consensus growth of 0%pa for 5 years and operating margins of 5%, the variant perception hurdle does not appear all that great. The risk in this space is a company going the way of the dinosaur.

Plenty of Room for the Major Indexes to Go Higher

In homage to Herman's Hermits, "2nd verse, same as the first..." (this was the same case I made in March 2014)

With large cap tech trading at middling multiples (15x) there is still room for the major large cap indices to go higher.

If large cap tech were to play catch-up (moving from 15x to 18x) it would also likely underpin the rest of the market (maybe even add a little to their valuations) and could see the general market indexes rise another 15%-30%.

Last year at this time we saw the high beta momentum plays get hung drawn and quartered even as large cap tech underpinned the "broader" strength in the market. I say "broader" because breadth actually deteriorated significantly (small-mid caps were hammered) but this was not so evident from the large cap major indices.

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. 

Keep It Simple - The Crux of Value Investing

I don't think you have to do fancy algorithms or deep quant or anything else to uncover deep value. You only have to be patient and be willing to pick-up a good company when the market has discarded it to the side of the road.

I call this value investing. In order to do it you have to have some gumption as to what you think the company is worth. The reason and the cause of the 'fall from grace' are important because you have to discern that it is a temporary setback.

The aforementioned is a company specific self-inflicted own goal or some sort.

The other major time when 'value' investing can work healthily is when the market itself has got itself in a panic and is casting everything out with the bathwater.

Contrarianism is ingrained deep within the process. 

Both instances call for a gauge of intrinsic value, conviction, courage and patience. Those are the most important elements to being and becoming a better investor.

Got To Know What You're Good At

One way to know what you are good at is to identify those things you are bad at.

I'm bad at recognizing the dislocative disruption of new players and new trends. I see the trends but I don't extrapolate their likely diffusing effects very well. At the same time, I tend to give to much credit/strength to the incumbent(s), eg. Nokia.

Another area I am not particularly good at is identifying who the next big thing is going to be, ie. emerging leader. Part of the reason is that the market has already given the name a huge multiple and I can't bring myself to join in the party (late). Of course, if something is the next big thing, then its addressable market is a multiple larger than it is at the front end and it warrants the high multiple (that in hindsight now looks like a great price).

I'm a sucker for discounted relative value plays. Currently, CALL, ESI, ACI and OUTR are on my radar. But there is usually some good reason why they traded at an apparently steeped discount to their peers. If it is too good to be true, then it is probably too good to be true. I can't tell you the number of times I've been attracted to a name (sometimes bought it) only to find out there were shenanigans going on that I didn't know about (but the smart money did).

I am good at buying companies when the market has thrown the baby out with the bath water. This is an incredibly dangerous strategy, but it is in keeping with my own investing personality (DNA).

I don't have great vision for choosing the next great growth stock, but I have the courage to buy when/after the market has thrown something on the trash heap.

Contrary investing - the trapdoor and the panic

Two good strategies. Both require tremendous patience and discipline. One is a micro approach, the other a macro angle.

The first is the trapdoor spider strategy. You keep your powder dry waiting patiently for the market to throw you a prize. The prize is a great company that is overowned and has stumbled. Problems and concerns have arisen, but there is no fundamental rearranging of the deck chairs. Just a misstep. These things happen. Could be a 1 to 2 year workout. Don't buy too soon. The stock will bottom before the worst of the information comes out. When you see it holding fast or rallying on bad news. That is a good sign. But it can take some time for the stock to find its legs again.

The second is a general market panic. Could be a country. Could be an industry. Could be the whole market. Everything is marked down. Fear is rife. Buy the country or industry champion. These are too big to fail, too deeply entwined in the fabric. Again, another 1 to 2 year workout.

Quant Achilles Heel

Some quants systems no doubt focus on either one vector or one factor. Some are no doubt multi-factor. While the truly ambitious are no doubt seeking a unified theory of the markets, ie. try and incorporate all known anomalies.

Such a system would incorporate small cap bias, momentum bias, quality bias, value bias, broad diversification, red flags.

It is the red flags area where short sellers focus. Myriad changes reflected in a firm's accounts may point to warning signs. You can model those and you can model management quality (based on history), but identifying frauds or accounting shenanigans is an incredibly subjective endeavor when the data points you are working with are inconclusive (and they are always inconclusive).

I guess that is why "fundamental based", qualititative oriented investors are now getting caught with their hands in the cookie jar, ie. insider trading. Finding and getting an edge is extremely difficult.

On a side note. I am amazed when I look at so-called small and micro caps where the marketing material of managers in the space talk about inefficiencies due to lack of coverage, that the stocks are generally fairly valued. Now fairly valued is in the eye of the beholder, but there are few glaring mis-valuations from what I can see across the whole spectrum.

Now back to the quants achilles heel. The rigidity of their systems (whether is a static set of criteria or pattern recognition algorithms) or the backward looking nature of the learning systems mean that quants will always miss the nuance of something and/or miss the change in environment because they lack cognitive awareness. And they will never catch the subjective dimensions of not trusting management that comes from a visceral gut feeling.

The Valuation Dilemma

The dilemma of a value oriented investor. When opportunities dry up (because markets have appreciated substantially and everything is a lot more expensive), it is still incredibly hard to sell…because (1) we are in the business of owning assets long term, (2) we don't know whether the market will continue to go up or go down, and (3) we know that timing the market is a pretty tough thing to get right consistently. So we stick with what we've got and are a prisoner to market movements.

What Drives Equities

Over the long term equities are driven by two things. One, fundamental and the other sentimental.

The Fundamental
The fundamental driver of equities values is earnings. Earnings are a function of revenues (demand), margins (efficiency) and tax regimes. Earnings may vary over time, but trend positive.

The Sentimental
The sentimental driver of equities values (which is to some extent and at different times more important than earnings) is the multiple. What the market is prepared to pay for earnings at any particular point in time. It is a function of confidence and risk. The multiple the market is prepared to pay for present (and implied future earnings) varies from a high of 35x to a low of 8x.

Since bottoming in 2009 the market has been propelled by substantial earnings recovery and earnings growth ($30 EPS to $115 EPS), and by multiple expansion (11x to 16x). With earnings plateauing, future market performance is likely a function of multiple performance. If the multiple goes from the present 16x to 20x then the market can rise to 2300 (30% above the present level). Projecting earnings is relatively easy (or if not easy, more stable). Projecting multiples is a lot more difficult.

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.