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 principal 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 a 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.
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.
Colleague Gareth Brown 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.
Starting Forager Funds in 2009, Steve has grown the business to over $370m of funds under management. Offering an Australia and Global equity Fund, Steve focuses on long-term value investing of unloved and undervalued companies.
Interesting article, thank you. I have to agree it is very easy to misunderstand our success (or failures) by share price movement, when in fact to prove if our thesis was correct and is repeatable we need to monitor if our cash flow projections/assumptions stand the test of time. I try to encourage new investors to record all the reasons/assumptions they make when they enter an investment so it can be reviewed 3, 5 or even 10 years in the future. I will recommend your article to others. Alan ( CTHGPRO )
Thanks for the comment Alan. Spot on. We write down a road map at the time of investment and review it every results. Sometimes we look fascicle but it is a worthwhile exercise.
Great story Steve
Intelligent and succinct as always Steve, although the crux of the article seemed to relate to dividend yield instead of earnings yield; if this is the case then could you not switch from loving to hating the same company simply on the basis of their payout ratio and/or dividend/buyback policy?What weight do you attribute to retained earnings?
Thanks Charles. That all depends on what I think they are going to do with the money they keep. If a company cuts its dividend and I think they are likely to fritter away the additional retained earnings then yes, it would decrease my valuation. But if I am confident they can reinvest at higher than my required rate of return, then my future cashflow stream (and valuation would be higher). Berkshire is a good example of a company that has never paid a dividend but has compounded the money internally at a very high rate. As I said to a reader on the blog though, it's important not to get too scientific about these things. If the stock is cheap enough it should be obvious. If you are adjusting discount rates or reinvestment rates to get an answer that works, then it probably isn't cheap enough. The general point was to focus on the business, not the share price. Cash returns are a great example of proof points, because you have the money in your pocket, but a company that had dramatically increased its sustainable earnings power would be just a good an example of a investment playing out to plan.
Thanks for the article Steve, but I feel your point is far too simplistic. The challenge with your approach is actually being able accurately forecast what you're going to get, when and how much confidence you have. Our ability to actually forecast these items is often highly questionable and we'll typically be overconfident in what we come up with. You're probably familiar with the work of Philip Tetlock on Forecasting. One of his key characteristics of Superforecasters was their willingness to adjust forecasts and factor in new information when it becomes available. So if we consider this in our forecast valuations, we must recognise that our forecasts will always be subject to change. So I'm not sure that judging the success of an investment should be based on a previous (and out-dated as soon as new information comes to hand) estimate. While there will certainly be an element of volatility in share prices that we should learn to filter out, material changes in share prices will typically occur when there is a material change in the consensus forecast of future earnings (and / or discount rate). Surely this should be a signal to review our forecasts and likely make the necessary adjustments.