Our quest for predictable outcomes in our everyday lives has implications for how we invest. It is easier to invest in companies with certain or relatively predictable outcomes. Not only is it easier to sleep at night, it is also a lot easier to justify one’s investment decisions. This can create significant price distortions. The market tends to inflate the prices of assets whose outcomes are perceived as relatively predictable, while assets that are perceived to have more uncertain (or volatile) outcomes are often priced at a discount.
“In fiction: we find the predictable boring.
In real life: we find the unpredictable terrifying.”
- Mokokoma Mokhonoana
Stable earnings inflate a share price
Take for example two hypothetical companies, Company A and Company B. Company A operates in a relatively stable environment with a history of reasonably predictable earnings. Company B operates in a less predictable environment with an erratic earnings history. Assume that the future expected earnings profiles of the two companies are as shown in Graph 1. Both companies are expected to earn $126 over the next 10 years. Company A’s earnings are expected to grow steadily at 5% per annum. Company B’s earnings are extremely volatile and appear to be quite random.
Graph 1: The earnings profiles of two hypothetical companies
Source: Allan Gray
If you ignore the time value of money, assume that future earnings from both companies are identical in magnitude, and only differ in terms of timing and predictability, investors should be indifferent as to whether they hold Company A or Company B if the price of the two companies is the same. However, the price of these two companies is never equal.
Investors are happy to pay more for certainty, even if the return is lower
Company A may attract a 15 times multiple of year one’s earnings or $150. The more volatile Company B may attract a lower multiple, say 10 times, or $50. Investors are generally happy to ‘pay up’ for certainty and try to avoid holding companies where the future is very uncertain. The return to investors will therefore be much higher for Company B than for Company A. Both earn $126 over the next 10 years, but Company B only costs $50 whereas Company A costs $150.
The price that you pay makes a significant difference to your return
Even if the premium for certainty never goes away, the impact that one’s entry price has on the internal rate of return (IRR) is significant. The IRR measures the compound annual rate of return of an investment. For example, let’s assume that, in year 10, Company A still sells for 15 times earnings and Company B for 10 times earnings. Company A would be worth $240 in year 10 (15 times $16) and Company B would be worth $200 (still a discount to Company A’s valuation). Without boring readers with the maths, an investment in Company A would result in an 11% IRR over this 10-year holding period (commendable in the context of what is sustainable and achievable). Company B, however, would deliver a 30% IRR.
If you pay for the predictable, you may miss an opportunity
If you rush to pay high multiples for seemingly stable and predictable company earnings, you can miss out on significant opportunities. In the example above, you could have bought Company B and earned a 30% return per annum over 10 years, but instead you bought Company A for an 11% per annum return. One may well do much worse than the Company A example above. There is rarely such a thing as a certain outcome and investors generally pay a higher multiple of earnings for perceived certainty. The reality is often very different to the outcomes predicted by an exuberant and overly confident analyst community.
Investors in Challenger Ltd were recently reminded of the danger of extrapolating past earnings into the future
In the five years from 2012, Challenger’s investors experienced consistent strong growth with pre-tax ‘normalised’ earnings increasing 9% per annum. Potential favourable retirement income reforms and the prospect of further success in Challenger’s financial adviser aligned distribution strategy boded well for future earnings. Between June 2012 and December 2017, Challenger’s share price increased over fourfold as investors baked in continued strong earnings growth far into the future. This has proven wildly optimistic. Whilst its annuity sales have continued to grow, the mix has favoured less profitable annuities and investment assets. In addition, management’s assessment of ‘normal’ investment returns achievable, and therefore ‘normalised’ earnings, has also proven to be optimistic. Declines in interest rates and credit spreads have also started to put pressure on Challenger’s earnings. The once ‘certain’ high single digit earnings growth each year has evaporated. Challenger’s reclassification from a Company A-type company (with consistent earnings growth) to a Company B-type company (with more erratic earnings) has been painful, with its share price falling by more than 50% since December 2017.
Benefitting from mispricing opportunities is not as easy as it sounds
It requires a long-term perspective, a contrarian approach to investing and one must recognise that the future is far less predictable and certain than consensus would have one believe. These are some of the attributes that form the very fabric of our investment strategy at Allan Gray.
Contrarian investing is not for everyone, however there can be great rewards for the patient investor who embraces Allan Gray’s approach. For further information hit the contact button below.
Thanks for the article Simon. Just to offer a different perspective. While generally it is true that predictable companies tend to sell at a higher multiples hence one would expect shareholders to earn closer to market return, it is also true that investors discount predictable companies that can deliver in the long run. Case in point is Cochlear. One could have paid for 30x earnings for COH in 2003 and still earns a compounded return of 15% p.a for the next 15 years, or 20% if all dividend reinvested. In the long run, the return an investor earns shall track close to the return of capital of the business. And you're right about Challenger, it is an unpredictable business confused as predictable. Growth and earnings are easy to measure (hence extrapolate), but durability isn't.
Thanks Simon! Appreciate excellent article and thought provoking topic. RE: Ricky Yeo comments. (below #s as at 13 Aug 2019) Firstly 2009 to 2018FY average Return on Capital for Cochlear is 31% and Return on Equity is 34.50%. One cannot expect to obtain ROE type of returns from a business, unless they invest at/near Book Value. For excellent high-growth or high ROE businesses this would typically require one to be a Founder, or Seed Capital Investor who has negotiated exceptional terms. I.e. near no listed business with a long-term ROE of 20 is trading at/near book, and very very few at book with ROE > 15. Agree your point, that taking end of 2003 price-cohort, Cochlear's compounding return excl. dividends is ~ 15.50%. That buy was possible, albeit VERY VERY fortuitous selection of entry-point, and we’re choosing a business that has grown its Global Share, Net Profit Margin (12 to 18%), Addressable Market, and experienced Industry wide Health-product inflation rates ~ 3 x global inflation rates. All this, with market-themes on interest rates and P/E expansion to boot. Suggestion being, there's a lot that went right for the stock you’ve chosen, and if you pick your exact dates correct, 15.50% compounding return (excl dividends) was available. But, for this same, mega successful (super quality) business, if one instead takes the start of 2003 price-cohort and invests into COH at that time instead (i.e. 364 days earlier), Cochlear's compounding return excl. dividends is now only ~ 10.40%. (i.e. 5.10% less). Thus, even with an absolute winner in share price and fundamentals, switching the month in 2003 speaks to ~ 1/3 of the return, even over a > 15 year holding period. Thus, cohorts clearly matter. Entry prices matter, and valuation principles (even when dealing in with Tier-1 winning companies over > 15 year periods) make a very large difference.