At a recent lunch with another fund manager, I found myself engaged in a discussion about the state of the current market, 'From your perspective, are you seeing many good opportunities?' I asked.
‘I’m seeing good companies, but prices are toppy,’ he said, wincing before continuing. ‘More than I’d like to pay. But we’ve recently deployed more anyway.’ He shrugged his shoulders, ‘Momentum in the market is strong - the fed is decreasing rates. Despite the high prices, we wouldn’t want to miss this momentum.’
I nodded as we both acknowledged this unique investment environment of decreasing rates and high stock valuations. Yet stock prices have continued to climb steadily.
Walking back to my office I reflected, and asked myself: ‘Is now a good time to be a momentum investor, or is it time to go against the herd?’
Look at a market cycle to assess how much is left in the tank
Momentum investors have much to gain if the wave of popularity is caught early. However, be the last one to the party and you will be left with all the cleaning up. The real question is: how much more of the wave is left to catch? The solution to this contradiction can be found by understanding the long-term context.
The ratio of a company’s stock price-to-intrinsic value tells us how much the market is willing to pay for the company. It’s a useful measurement of sentiment at one point in time. There’s a clear link between sentiment (the stock price) versus fundamental value (intrinsic value).
But it doesn’t give us the full picture. To understand this contradiction, we need to see how sentiment for the stock has changed over a significant period of time - over entire market cycles. Extend the ratio of stock price-to-intrinsic value over a 15-year horizon and you’ll now gain a multi-dimensional view of just how manic-depressive Mr Market is.
As an example, here is the change in sentiment for the founder-led aerospace electronics company HEICO Corporation.
During the GFC, Mr Market was very pessimistic. He was only willing to pay 1.8x the intrinsic value of HEICO. But alas Mr Market is as fickle as they come. More recently, he has been very bullish. He’s willing to pay 4.8x intrinsic value. A large proportion of the returns have been driven solely by the company’s increasing popularity with investors.
Now we have a better view of the context. Understanding the stock price and intrinsic value over a long time period equips us to answer the following question...
The worst time to join a party
There’s an interesting observation about parties. When do they end?
Answer? They end when the alcohol runs out. Rarely do they end immediately though; good times roll on for a while longer before the sudden realisation hits the sobering crowd.
So when is the worst time to join a party?
As you’re pondering the answer, here is another view of HEICO to illustrate the point.
Although the intrinsic value of HEICO’s business has consistently increased over time, the increase in its price has far outpaced the fundamental growth of the company. HEICO is a solid and growing company, but its impressive performance has been driven primarily by sentiment and price, rather than actual business value. The price-to-intrinsic value ratio shows this.
Risk is heightened when a company’s stock price outpaces its intrinsic value for significant periods of time. As crazy as Mr Market is, one thing is certain - his enthusiasm and pessimism never last forever. The gravitational pull of a company’s fundamental value is unrelenting.
The best time to join a party is when there’s plenty of alcohol and not too many people. But tread carefully when the crowd is pumping and booze is running low. Whilst the fun may continue for a while longer yet, the risk of an abrupt ending is heightened.
A ‘reasonable’ price
Pure momentum investing focuses predominantly on the historical price movement and pays little attention to actual fundamental value. But if you want to understand if a trend is justified, the fundamentals are critical.
Armed with this insight, we can make a judgement call on what a ‘reasonable’ price would be and whether we should join the party. Some sectors run hot. Today, technology is a classic example. But a strong trend shouldn’t be a deterrent. Prices may seem exorbitant, but in the context of the company’s historical sentiment, sometimes the high price is worth paying. What may seem expensive on an absolute basis may be reasonable in the context of history. For example, the price-to-intrinsic value of Facebook was high on an absolute basis in late 2018, but was reasonable when compared to its history. It has proven to be a good entry point so far.
But there’s more for enterprising investors - the picture is still not yet complete.
A deeper level of analysis
You may have noticed my focus on individual company analysis rather than broad-based economic generalisations. We are buying slices of companies after all. Whilst we can understand the sentiment in our target company, it is also important to have context across other comparable companies. The same price-to-intrinsic value historical ratio across a few companies will give us a sense of sentiment across the sector. We’ll be able to see if there are any other reasonably priced companies.
So far the focus has been on gaining historical context. Sometimes the momentum is justified if there are tangible growth prospects. In other words, intrinsic value is expected to grow significantly with price. In those situations, the trend may be your friend. For those that heard me speak at the AIA National Conference, I outlined my framework to assess the potential growth of a company.
Speculators focus on stock price movements only. Investors focus on the underlying true worth of a company.
As Warren Buffett says “Price is what you pay, value is what you get”.
The fundamentals of a company’s value is reflected in its Intrinsic value. Importantly, in determining a company’s intrinsic value, I’ve stripped out accounting distortions that may hide a company’s true worth.
So... Is the trend your friend?
If the fundamentals of a company are sound and the price is reasonable in the context of its history and other competitors, then the trend may indeed be an ally. Ride the wave and enjoy the party.
Price and intrinsic value may deviate for many years but price will eventually move towards intrinsic value over the long-term. Seeing the full picture is key to capturing sensible opportunities. In every party, everyone sobers eventually.
I'd be interested in an comments on how you calculate your intrinsic valuation and whether the data actually shows that over time, prices do tend to revert towards your intrinsic valuation (as opposed your intrinsic value simply following the market price in a lagging fashion). Your conclusion notes that "Price and intrinsic value may deviate for many years but price will eventually move towards intrinsic value over the long-term". But the example of Heico that you use shows a share price remaining well above intrinsic value and trending further away from intrinsic value over a period of 15 years. At what point do you consider that the market price may be more correct than the intrinsic value? You may suggest that only now is the level of overvaluation at such an extreme level that only now should we avoid Heico and wait for a price closer to intrinsic value. But I'd question what is different now to 2013 when Heico was last reaching an unprecedented level of overvaluation?
The intrinsic values above are very conservative. Accounting anomalies have been reversed and the value of future growth has been kept separate. In contrast, stock prices include the blue sky assumption of future growth. How much is a reasonable multiple to pay for future growth? That depends on the factors discussed above, including any other alternative companies one could invest in. Relative measures are more useful than absolute when assessing the context of the opportunity; intrinsic values are still estimations. Extremely high prices (and stock price-to-intrinsic values) may still prove reasonable if the factors above are supportive. There are many parties one could join, so understanding the sobriety of the crowd and how much alcohol actually remains is key to deciding whether you should join this particular one. Note the article is not intended as a buy/sell recommendation for HEICO.
All this analysis assumes your valuation of NYSE:HEI is correct and looking back through the 15 years, you have consistently undervalued the business. So isnt the insight here, is that your valuation(s) are incorrect and in need of some additional work? Cant be conservative for 15 years and then just claim its all due to momentum currently...
Actually over the past five years the price of HEICO has not outpaced the growth in value of the company at all. The chart shows the price tripling from $28 to $84 and the value also tripling from $6 to $18. Classic example of how misleading arithmetic scaled charts can be when high rates of growth are concerned. I'm not arguing with the overall premise, just noting that HEICO is a poor example.
Thanks for responding Lawrence, but I don't think you've really addressed the core of my query. Is there any actual objective evidence that your intrinsic value calculation helps? Do statistics actually show that stocks trading further above intrinsic value have a tendency to underperform? Your comments seem to suggest only that the intrinsic value method is systematically flawed (too conservative as though this is a safer approach to things) and we must then make a subjective and anecdotal judgement on 'the sobriety' of the crowd. If the intrinsic value is very conservative and not necessarily reflective of where a stock price should trade, investment decisions ultimately require us to judge whether the party is still pumping or whether the mood is dying down. Rather than a general judgement of what kinda feels reasonable, wouldn't momentum be among the best indicators for that?
James, is understanding the fundamental worth of a business critical to an investment decision? Yes. The higher the price, the greater the market's growth expectations. As for the 'blue sky' component of the valuation, in my view, analysis always wins out. Price and momentum indicators are useful only in conjunction with an understanding of valuation. At Lumenary we apply an objective framework for analysing that component - but that's a topic for another article. Understanding the intrinsic value and the 'blue sky' component will help investors view prices as exactly that, prices. We have shared our framework at a few industry conferences - feel free to join us next time if you'd like to understand more. Russell, regarding intrinsic values, I disagree for the reasons I've outlined above. Stock prices and sentiments vary widely across the world. Reasonable prices are always available - one just needs to look globally for them. In addition, as a matter of overall approach, I would question whether one should re-calibrate their valuations to reflect stock price movements for one particular stock. Graeme, the first chart shows precisely the how stock price-to-intrinsic value relationship has changed over time. The growth of both variables has not been identical, even if you take the last 5 years as you've proposed.