On Asymmetric Opportunities
Most difficult investing decisions are not caused by fine distinctions. Two apparently similar stocks are usually just that. There is little difficulty in evaluating such situations. More importantly, the magnitude of whatever miscalculations are made is likely to be small. The true difficulties arise when the investor is presented with two or more asymmetric opportunities.
The intrinsic value of a business isn’t printed anywhere. To the extent that a business’ intrinsic value is similar to its earnings power, the evaluation process is simplified. In fact, this so greatly simplifies the process that many investors are tempted to calculate earnings power alone and simply assume the intrinsic value reflects the earnings power.
This is a mistake. While you will rarely lose a lot of money by focusing on earnings, you will miss some great opportunities if you rely solely on earnings.
The intrinsic value of a business is the discounted value of the cash that can be withdrawn from the business. It is not merely the discounted value of the future cash flows generated from operating activities. This may sound like I’m splitting hairs. But, it’s an important concept to understand.
Obviously, a cash flow neutral business with several hundred million dollars in cash (in excess of total liabilities) is worth more than the intrinsic value of zero that would be calculated based on the free cash flow generated from its operating activities. You could account for this by treating the excess cash as a reduction to the purchase price. That is essentially what you’re doing when you use a company’s enterprise value instead of its market cap.
Actually, you’re doing more than that, because you are adding debt in excess of cash to the purchase price. Should you do that? It’s hard to say. For some businesses, this is an unnecessarily harsh adjustment, because the debt needn’t be repaid anytime soon. The advantages of the free cash flow generated will be amplified by the debt, which needn’t be repaid until long after the cash flows are received.
But, by the same logic, one could argue that whatever excess cash a business holds needn’t be returned to shareholders via a dividend, stock buyback, etc. within the next few years. If that cash isn’t utilized relatively quickly, its intrinsic value will be diminished.
In my experience, you will seldom go wrong by valuing a company’s cash too highly. Judging by the spreads in EV/EBIT ratios among various stocks, the market doesn’t seem to overvalue cash too often.
So, my advice is to count the cash as if it were being paid out to you at the time you purchase the shares. Since the cash has already been taxed, whatever advantages you would have in generating returns on the cash greater than those the retained cash generates will be mitigated.
Counting excess cash as a reduction in the price per share isn’t a perfect solution, but it is a simple, workable solution. As I mentioned in a previous post, there are advantages to having a very strong financial position. Counting excess cash as a reduction in the purchase price per share will have the effect of rewarding financially strong enterprises.
However, one thing to keep in mind is that cash generated from the issuance of new shares should be viewed differently than cash generated from operations or from asset sales. While the cash is worth just as much, you may want to make a mental note of the source so you can assign a black mark to the management team.
What about non-cash assets? Is a business’ intrinsic value increased by real estate holdings, intellectual property, etc. even if these assets are not currently generating earnings? To the extent that these assets can be converted into cash they are valuable.
In the case of real estate, you will often need to make an adjustment to earnings even if the real estate doesn’t generate rents, because the operating activities will appear more profitable where they use owned assets instead of leased assets. Where the book value of the real estate is far below its market value, both the adjustment and any attempt to value the real estate will become more difficult. In some cases, it is possible to estimate the value of the real estate, because similar properties are frequently sold. But, most of the time, it’s very difficult to value the real estate.
Don’t try.
Look for a mediocre (or better) operating business with real estate holdings that happens to be selling for less than its book value. If you can buy the operating business at a reasonable price, you’ll get the real estate for free. As a result, you’ll have a little more upside and a lot less downside.
Most other types of non-operating assets will be of little use to an investor who isn’t knowledgeable in a particular area, because these will often be accompanied by large liabilities.
Marketable securities are easy to value, but they are often held by companies with liabilities that are not easy to quantify. Occasionally, you will find interesting opportunities in small companies that have important assets that could be separated from the operating business. These opportunities become increasingly attractive as liabilities decrease.
The best opportunities are those where the assets are clearly much greater than the liabilities plus the market value of the equity. But, even beyond this, you want to make sure the liabilities are not too large compared to operating activities alone, because some managements are stubborn enough to dig themselves into a very deep whole. If you can’t take a large ownership stake in the business, you’ll have to accept the fact that assets can be terribly mismanaged.
How do you compare asset heavy businesses that aren’t particularly profitable to asset light businesses that are highly profitable? In one case, you’re likely buying a business at a price below its book value; in the other case, you’re likely paying several times book.
The highly profitable business will better reward you the longer you hold it. The business with all those great assets (but poor profitability) will become a less attractive investment the longer you hold it. But, obviously, you don’t know how long you’ll have to hold it, because you don’t know how long it will take the market to realize the true value of its assets.
This is a very difficult problem. Most short-run / long-run problems are. Where does the short-run end and the long-run begin? No one can answer that. These bargains exist largely because investors feel the short-run will last forever.
How often have you heard someone say this stock hasn’t gone up in years, what’s going to make it go up now? People will ask this question even when they know the market is currently undervaluing the business. They’re afraid the short-run may last a very long time.
The only effective method I know of that will tell you how long to hold a stock, when to sell it, etc. is to look at the opportunity cost. What is the best alternative? When there are plenty of great businesses selling at reasonable prices, the book value bargains become less attractive.
Today, I don’t see many great businesses selling at reasonable prices; so, now might be a good time to buy businesses based on more than just earnings. Where the liabilities are very low, and there is at least some free cash flow generation, you are likely to find good relative returns in a market that won’t provide the kind of great returns most people still seem to expect. Now might be a good time to look at some financially strong low price-to-book value businesses, land rich businesses, and low EV/EBIT businesses.
It’s always difficult to value these asymmetric opportunities. Just don’t fall into the trap of only buying cheap businesses or only buying good businesses. Buy bargains. When the market is asking high prices for good businesses, buy the cheap ones – and vice versa.
I don’t talk about buying cheap stocks enough. You shouldn’t overlook that strategy. It has worked in the past and will continue to work in the future. But, even when buying cheap stocks, you need to be very selective.