Investing is riddled with uncertainties. High conviction investing is the process of shining light on those uncertainties until they are clear enough that you can see them, understand them and manage them. This is not an easy process. As you shine light on certain areas, it can illuminate the many more areas that you cannot see clearly. Thus it is important to know how to make decisions without all the information available. This brings me to three broad aspects of making investment decisions popularised by Peter Lynch.
- The Science: basic decision making framework
The Legwork: process of gathering and analysing information
The Art: psychology of making decisions
This note focuses on The science using Xero as the example as much of the feedback from my previous post on Xero was with regard to my valuation approach. I will cover the other two aspects in seperate posts.
what are we buying?
Like most of my friends, I played a lot of computer games as a kid. Soon after graduating from university, I started to wonder if playing computer games was the best use of my time. I had just started to save a bit of money and thought I might enjoy investing.
Sitting down to look at my first stock, my first question was: ‘What am I buying here?’ When we part with $85 to purchase a single share of Xero, we receive the right to the stream of dividends Xero pays, as well as the right to vote at shareholder meetings. We are, in essence, part owners of a business.
As I read investment books, I came to realise this approach was championed by Benjamin Graham in his book The Intelligent Investor, and is sometimes referred to as Value Investing – though that term has come to mean different things to different people. What is interesting about this perspective is that it does not rely on predicting future share prices. What is important to us, is the present value of the stream of dividends the company generates through its operating activities into perpetuity. In other words, we are investing, rather than trading.
how do we value what we are receiving?
My next question was: ‘How to value the stream of dividends?’ Well, if we peel one layer back, dividends are paid from the free cash a company generates; that is, the cash left over after all other financial obligations have been met. To calculate the value of a share, we can apply a mathematical equation that has been in use for over three centuries, Discounted Cash Flows or DCF.
The most interesting element of this valuation methodology is that our return is independent of Xero’s market price.* The return is embedded in the equation as the ‘Rate of Return’. So long as our forecasts come to fruition, we are mathematically guaranteed our return, independent of changes in the share price. We don’t need to predict share prices.
The only variable we need to forecast is the cash stream. And so in this framework, risk is the probability of the company not generating the forecast cash. This differs from the trading approach where risk is viewed as absolute or relative variability in the share price.
The basic variables of a DCF are:
- Rate of Return
where we input any two variables and solve for the third. So there are essentially three ways to apply this equation:
Our preferred approach is Method Three. You can read about the other two in the Appendix at the end of this note.
method three: implied cash flows
Under this approach, the Valuation equals the current share price and Rate of Return equals our 10% target. The Cashflows are back solved (or implied) to make the equation balance. We invest in businesses where we have the greatest confidence in these implied cashflows coming to fruition.
To compare assets, we need to either:
hold risk constant and invest in the highest expected return; or
hold return constant and invest in the lowest expected risk
Methods one and two implicitly hold risk constant, while Method Three holds return constant. Practically, I find Method Three easier to execute as it removes the need to forecast cash flows.
Under this approach, risk is ultimately quantified through the stock weights. The portfolio is proportionately made up of those businesses which have the greatest probability of achieving a 10% pa return. In November 2019, for example, we had 12% allocated to Alibaba, 8% to Xero and 4% to Resmed, reflecting our assessment of the relative likelihood of these businesses generating a 10% return, at the prevailing market prices.
Just to be clear, this isn’t a ‘set and forget’ strategy. When the share price changes, so do the implied cashflows and associated probabilities. So if Xero’s price rose to say $100, then the implied cashflows rise, the probability of achieving them fall, and so our weighting reduces. Other changes might be from a shift in the probabilities resulting from changes in Xero’s industry, incremental research, or changes in the risk of alternate investment opportunities.
The bottom line is this is a dynamic investment process, always oriented to minimising the risk of failing to achieve our objective.
assessing the probability of xero’s implied cashflows
The primary drivers of Xero’s cashflows are its economics, and the people overseeing, managing and operating in the business. The economics relate to the growth drivers and the moat protecting its profitability, while the people comprise the Board, Management and staff. These combine to determine the gradient and strength of the future cash flow stream.
This is what Xero’s implied cash flow profile looks like using an $85 market price and a 5.5% terminal growth rate. In other words, if we buy a share today at $85, and these cash flows come to fruition, then mathematically our return will be 10% pa, independent of share price movements.
Looking at the historical cash flow, the implied numbers seem like a tall order. To assess this profile, it is helpful to break down the numbers into more predictable variables such as sales, EBITDA, capitalised development costs and so on. Some of these components can be further broken down; sales, for example, can be divided into the number of subscribers multiplied by the average revenue per subscriber for each region.
While peeling back each layer improves accuracy, it also increases the danger of getting lost in the weeds. I identify the smallest number of inputs that account for the largest impact, then focus my attention on those.
The model template we use has around 200 rows. In Xero’s case we’ve added another 100 or so rows for additional detail. Here is an extract of the Xero model and visuals of some of the key variables implied by the $85 share price.
The Legwork of Investing
The real work now begins, where we step into the world and explore the drivers of implied assumptions. This process involves asking questions which lead to the gathering of information, the analysis of that information and ultimately judgement as to how things are likely to unfold. Looking at Xero’s economic moat, for example, we might ask: Why was MYOB not able to defend against Xero even though it identified the threat many years ago?
The vast majority of our time and resources is dedicated to Legwork, it is the source of our investment conviction. I’ll provide more detail on this aspect of the investment decision in the next note.
the art of investing
An essential element of an investment decision is the judgement of the decision maker. This is partly a function of our wiring, partly experiences, and partly mind state. The emotion of fear, for example, can lead us to mis-perceive things as they are and mis-assess risks. As a student of Zen, I have come across teachings and practices that help cultivate my mind, and make better investment decisions.
I’ll share more about this aspect of the investment decision in a later note.
efficient allocation of attention
Over time, I have come to realise the most valuable resource I have is my attention, not just as an investment manager, but in life as a whole. Adopting the prism of investing, rather than trading, removes the need to predict what others are willing to pay for a stock. A byproduct of this is that it frees up my attention from predicting the mood of the market, allowing me to fully focus on each business’ capacity to generate free cash.
Using the implied cash flow approach is also helpful, as it removes the need to predict and quantify the most likely scenario. It allows more of my attention to be allocated to assessing downside risks. It also lets me compare opportunities without wondering if the probabilities underpinning say, the Xero and Alibaba valuations, are the same.
a word on traditional valuation metrics
Traders trying to predict Xero’s share price over, say, one to two years, typically use simple price-based valuation metrics. Xero, however, doesn’t stack up well using these metrics for a number of reasons.
First, Xero’s earnings are currently depressed, as a large portion of growth investment runs through the expense line. Therefore, the faster Xero grows, the lower its earnings. Historically, for most companies, the majority of growth costs would run through the balance sheet and get depreciated over time. Think factories for manufacturers, inventory and store fitout for retailers, plant and equipment for miners, land and buildings for Real Estate Investment Trusts and so on. The depressed earnings make the Price-to-Earning ratio, the most widely used traditional valuation metric, difficult to use.
Second, the earnings stream has a number of characteristics that are attractive to risk-conscious, long term investors including: recurring sales, low customer churn, long duration growth, and a strong balance sheet. Traditional valuation metrics typically don’t handle these factors well.
Finally, the company doesn’t pay out a dividend and has minimal hard assets, rendering metrics such as Dividend Yield and Price to Book of little use.
Before finishing off, I do want to once again underline that our investment decisions are couched in a prism of part purchasing real businesses. The return we are aiming to achieve is the free cash generated by those businesses, relative to the price we paid, and not by fluctuations in the share price. There is always the risk the market mood will change, and Xero will fall out of favour, resulting in a decline in the share price. So long as the company generates the cashflows implied at our time of purchase, we will achieve our objective.
I hope this note has helped you understand the basic decision making framework for our investment in Xero. In the next two notes I’ll cover the art and legwork of investing this investment.
Appendix: application of dcf
Method One: Intrinsic Value
Here we calculate the Valuation (or Intrinsic Value) by forecasting the future Cashflows, discounted back using our 10% target Rate of Return. The difference between the Valuation and the share price is our upside (or downside) – the ‘margin of safety’. We invest in businesses with the highest upside.
In Xero’s case, our valuation per share might be say $100; given a share price of $85, the upside is 18% (($100-$85)/$85). We would invest in Xero if this 18% compares favourably with our alternate investment opportunities.
Method two: Intrinsic Value
An alternate way of quantifying upside derived in Method One, is to increase the Rate of Return until the Valuation is equal to the share price. This resulting Rate of Return is commonly referred to as the Internal Rate of Return, or IRR. As with Method One, we invest in businesses offering the highest IRR.
In the case of Xero, we would need to increase the Rate of Return by ~1% to lower the $100 intrinsic value to the $85 share price. So, if the expected cashflows come to fruition, we would generate ~1% pa more than our 10% pa target return.
I prefer Method Two to Method One, as the 18% upside can easily be misinterpreted as a trading return - an expectation of the share price rising 18%. The 11% IRR more clearly conveys the return we are expecting from the business when making this investment.
*There is an implicit assumption that the cash retained by the company is reinvested at the required rate of return.