Valuation is an exercise in assessing future value creation and translating this into present value using a suitable discount rate. Analysts are, however, not able to reliably forecast a company’s profit beyond 4 or 5 years. To explain a company’s prospects over a longer period, one needs to first study the entry barriers to its industry driven by an economic moat. No economic moat can last for an indefinite period without attracting competition. Therefore, the skill lies in assessing how fast the economic moat will fade and assigning a reasonable value to this over a long period of time. Our experience is that intrinsic value, as a method, is superior to other methods that focus on asset value and cyclically adjusted PE’s as it has a higher tendency to explain the full value of a company. Asset Value focuses largely on hard assets and neglects the value creation from these assets. Cyclically Adjusted PE is highly reliant on timing the bottoms and tops of a cycle.
We arrive at these insights through a four-pillar process involving the steps below. Initially, we study the track record of management at allocating capital. Of particular importance, is the agency effect from incentives such as share options and bonuses. For instance, we do not want to see management applying zero-cost collar options to their shareholding as this reduces their alignment with other shareholder interests. We then perform in-depth research to classify, measure, and understand the fade period of the economic moat. This may include management meetings, expert interviews and survey data to reach a high probability conclusion.
The next step is to build a DCF model taking into account our moat rating (classification and strength) as well as any near term business events. A key aspect of the model is to calculate a company’s ROIC relative to its WACC and model the time horizon over which this spread will fade away due to competitive forces such as competition and creative destruction. The model allows us to determine the most probable fair value for the company out of a possible range of outcomes, based on our assumptions. Our buy and sell discipline is determined by the the level of uncertainty with which we are able to arrive at a probable fair value when we value a company. We do not invest in companies that make economic profits with a high or extreme uncertainty as it renders their valuation equally uncertain.
In our analytical interrogation of our philosophy, we find that high quality companies outperform the market approximately 70% of the time. While the strategy is very capable of taking an investor through the full economic cycle (most strategies take investors only up to the peak of the cycle), there is a portion of the cycle where it is likely to underperform. This is when GDP growth peaks (or is expected to peak) – at this point, stock prices of lower quality companies grow faster than their high quality peers because their profits are more leveraged to economic performance. And, of course, it goes without saying that the longer the economy stays virulent above median GDP, the longer we would underperform. For the remainder of the cycle, our key risks are: 1) overpaying for quality and 2) selling high quality companies too early. We try to enforce both buy and sell margins of safety to limit the occurrence of these errors.
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