Musings on Investor Psychology

After spending a few years in the investment game, I now have a firsthand appreciation for the difficultly in completely filtering out the impact that share price fluctuations and other market noise have on your decision making, which can also be inherently flawed on its own. More and more I realise that having an awareness of, and being able to control cognitive biases is just as important as understanding business. Many great investors have warned against the psychological challenges involved - Charlie Munger says: Above all, never fool yourself, and remember that you are the easiest person to fool - and I would second that. It would be very interesting to see some experts in psychology try their hands at investing. 

If you can spare 10 minutes or so, I would highly recommend you read this extensive list of cognitive biases on Wikipedia. While many are clearly applicable to investing, such as loss aversion and outcome bias, there are many other social and memory biases that it would be useful to be aware of for day-to-day life. But be careful that you don't pick up one or two extra biases in reading that list - 'bias blind spot' is 'the tendency to see oneself as less biased than other people, or to be able to identify more cognitive biases in others than in oneself.'  

As it relates to investing, misjudgements due to these biases can be very costly mistakes, which is a factor that is often overlooked. While nobody is completely immune to these cognitive biases, I believe they can be reduced by continuously scrutinising one's decisions and thought processes, and having an understanding of what the various types of biases are. On the latter front, I intend to read some books on psychology after my higher school certificate exams are over, which I expect will prove fascinating and rewarding. I think that the best thing about this blog is that it has forced me to clearly argue why I have done what I have, and since it is all there in black and white, I can look back to assess why I bought or sold something without any fear of memory bias. Both of these have helped expose psychological biases in my own thinking. 

Perhaps the stock that I have had to be the most careful with in terms of cognitive biases is Delta SBD (ASX:DSB), an underground coal mining services company I bought in late February this year. While I'll try to outline my thinking, I must first warn you that my judgement of the situation is likely to be quite biased since I still hold shares in it, so as always, I encourage you to be critical of my thinking.

I initially bought in DSB late February this year at $0.76, however it has since dropped to a low of $0.33 a couple of months ago, and is now back up to $0.53. Incidentally, the day I bought was the very peak, and ever since it has been a rather painful trip down. I knew going in that this was a fairly mediocre business (current normalised return on equity of 14%, net debt to equity of 32%, and a net profit margin of 5.5%), and anticipated a less than impressive earnings outlook, but the price looked cheap enough to offer a significant margin of safety - less than 5 times FY2013 earnings. In addition, I liked that the founders of SBD and Delta were still managing the company, and held a majority stake.

Unfortunately, I underestimated the speed and extent of the downturn in the coal sector, with news day after day reporting hundreds or thousands of job losses due to declining coal prices that made many mines uneconomical. Perhaps the widespread and sudden change in sentiment towards the sector is explained by the 'availability cascade', which is 'a self-reinforcing process in which a collective belief gains more and more plausibility through its increasing repetition in public discourse'. 

I will admit that in response to this outlook, I probably fell into the trap of confirmation bias - tending to read more articles that had positive views on China and the coal sector in an attempt to justify my initial investment. After losing 31.5% in a couple of months, I decided to double my initial investment by purchasing more shares at $0.52 since I believed that the market was being unnecessarily pessimistic and thus DSB had become cheaper. Eventually I recognised my confirmation bias mistake and started listening more to the bearish arguments (although I still have a healthy scepticism for any macroeconomic forecasts). In combination with the falling share price, it soon became hard to decide on what course of action to take - should I sell, buy more or wait for more information in the annual report? My value investing framework told me that despite the poor outlook, a share price in the 30 cent region was most likely too low so I ruled out selling at that price. However, neither did I have enough confidence to buy a third time, so in the end I opted to wait more information from the company, which had been deafeningly silent in its announcements.

Eventually, the annual report came which was largely as I expected, with a great FY2013 but with an expected drop in revenues and compression of profit margin in 2014 onwards. While there is now considerable uncertainty over the future earnings of DSB, they certain to be substantially lower, with a greater than 50% drop in earnings next year looking quite likely to me. That would take DSB from a bargain basement P/E of 3.1 currently to a still quite cheap P/E of 6-7, but there is considerable downside risk to that if China well and truly blows up sometime soon, which is a risk that makes me uncomfortable holding DSB for the long term.

To break-even on my two parcels, I would need a share price of around $0.59 (including fully franked dividends and brokerage). While it is tempting to hope to sell at a break-even price, this is another psychological pitfall known as 'anchoring' that inhibits rational decision making. As Phillip Fisher put it: More money has probably been lost by investors holding a stock they really did not want until they could "at least come out even" than from any other single reason. If to these actual losses are added the profits that might have been made through the proper reinvestment of these funds if such reinvestment had been made when the mistake was first realised, the cost of self-indulgence becomes truly tremendous. Instead of calculating whether you will come out even, what needs to be asked is - 'where is current share price in relation to its intrinsic value?' If the answer is 'lower' then it usually makes sense to hold, unless as Fisher reminds us, you have found a better opportunity that you require funds for. While I am aware that my judgement may still be clouded somewhat by owning shares in DSB, for now my valuation work suggests the answer is 'a little lower' and so I continue to hold for the time being. 

The verdict is still out on what the future of DSB, the coal sector and China is, but regardless of the outcome, I hope that I will have at least taken away some valuable lessons about investor psychology that will improve my decision making going forward.

Antares Energy

Amidst the barrage of results in reporting season, I think one announcement has gone a little unappreciated. That was the news that Antares Energy (AZZ) had moved from a Letter of Intent to a binding Purchase and Sale Agreement to sell all of their Permian oil and gas assets for $300 million USD (for this post, I'll use the current exchange rate of 1 AUD = 0.903 USD, so that's $332.1 million AUD). I couldn't believe my eyes when I saw that the market capitalisation was $131 million, and this price had fallen over 6% on that day. Well it turns out that I was right not to trust my eyes, as further inspection reduced the attractiveness of this investment, but not enough to hold me back from purchasing.

First, a little background to AZZ. Back in around 2007, the management had almost sent the US focused oil and gas company bankrupt as their 'three year Strategic Plan' failed, recording a loss of $37 million, negative equity of 5 million, and negative cash flow. Shortly thereafter, the share price fell from over $1.00 to below 4 cents, and a shakeup of management occurred. A reversal in fortunes occurred as debt was brought under control and the operational side improved, with the share price rocketing back upwards to over 80 cents at one point. In FY2010, they announced that Chesapeake Energy was going to buy out the Yellow Rose and Bluebonnet assets that Antares Energy held for $200 million USD, of which $156.2 million USD would go to Antares for their proportional ownership. Further bolstering financials, 50.5 million shares were issued at an average price of $0.62, and management soon bought back 20.5 million shares at an average price of below $0.40. This action essentially netted them a profit of $4.5 million on the shares they bought back, which is a big tick in my book. And they've continued to do this, repurchasing 43.3 million shares in total for an average price of $0.413.

With a newly found cash pile, AZZ spent around $160 million on three projects in the Permian basin of West Texas in 2011 which are shale plays, and as you may know, the United States has benefitted from a shale gas boom in recent years. Reserves have grown significantly since then and this brings us to the present, where AZZ is expected to sell these assets on or before 15th January 2014 to an unnamed company (for commercially sensitive reasons). How much of the recent success is attributable to the shale gas boom and how much of it is due to good management I'm not sure, but either way, I give credit to their foresight in buying into the Permian basin when they did. From a terrible position in 2007 to being offered $332.1 million is quite an achievement.

Now, that $332.1 million isn't entirely going to be in the hands of shareholders. To begin with, AZZ currently has debt of $41 million USD and according to their most recent quarterly report, cash of $7.5 million AUD, giving net debt of $37.9 million AUD. Upon sale, the entire debt facility will be reduced to zero, leaving the only other major liability being the convertible notes. There are 10 million convertible notes on issue which have a face value of $2.00, with each note being convertible into 3 shares - i.e. it becomes economical to convert into equity at a share price above $0.66. If none of these notes convert into shares, that's an extra $20 million of debt that will have to be paid eventually (total conversion adds 30 million shares to the existing 255 million, having a similarly negative impact through dilution of shareholder interests). Although some brokers have been trying to guess about the tax consequences of the sale, throwing around figures of $25 or $35 million or even $60 million, I spoke with the chairman and CEO James Cruickshack over the phone, who surprisingly indicated to me that he expects Antares to pay zero tax from the sale. This is because Section 1031 United States Internal Revenue code allows businesses like Antares to dodge the capital gains tax if they purchase another asset within 180 days of the sale. Even if they don't purchase something else within that timeframe, Antares has until December 31 2014 to utilise any production/exploration costs as a tax deduction, so that in either scenario, no tax will be payable. And finally, there are the transaction costs, which I'll take as an extra $15 million (Mr Cruickshank mentioned the difficulty in determining the transaction costs, but confirmed that this number was in the ballpark range).

So there are a few scenarios which could happen:

1. The deal goes ahead and AZZ finds another asset in the Permian region or elsewhere to purchase (no convertible notes change into equity). Their net cash would be 332.1-37.9-20-15 = $259.2 million, or with 255 million shares on issue, net cash of $1.02 per share, double the current share price of $0.515. Should AZZ trade at this price when the sale is completed, a doubling of your money in 4-5 months is nothing to sneeze at.

2. Same as scenario 1 but all notes are converted into equity instead. Net cash would be $20 million higher as this convertible note liability would be gone, but shares on issue would be 285 million, giving net cash of $0.98 per share. (note: if only some of the notes are converted, the net cash per share will lie between these first two scenarios).

3. The deal goes ahead, and the entirety of the proceeds from the sale are returned to shareholders as a capital return. I consider this scenario rather unlikely given that management has previously bought more oil and gas assets with their proceeds, extended the maturity date on the convertible notes to October 2023, and after all, who voluntarily puts themselves out of a job? A more likely situation is the continued buyback of shares if they are cheap. (see *)

4. The deal falls through, perhaps due to shareholders not voting in favour of the sale, although I view this cause as unlikely. Another reason may be that the secret counterparty won't be able to pay, although the Board of Antares is confident that "they have the financial capacity and desire to complete the transaction". They also remind investors that they have a "100% perfect history in closing all transactions announced to the market". If for whatever reason it does fall through, the share price may drop substantially, but I am speculating that the market won't continue to assign such a low valuation to AZZ now that someone has offered them $332 million for their assets. There is also a purchase price adjustment clause in the agreement which says that if an adjustment is to be made to the purchase price if there is a 'Defect' found (eg. non compliance with environmental regulations), it will be no more than 10% of the purchase price. This means there is a $33.2 million downside to the figures I have outlined above, or $0.13 per share.

I would be quite happy with any of the first three scenarios, but there are some extra risks involved. Most obvious is the possibility of an adverse change in the AUD/USD exchange rate. If the exchange rate were to reach parity again, the net cash to AZZ would be $216.5 million AUD under scenario 1, or $0.85 per share. On the other hand, if the Aussie dollar continues to depreciate against the US dollar, net cash in Australian dollars would increase.

The second risk entails a bit of speculation on what the market will do in the short/medium term, which is something I try to avoid. Will the market value AZZ at precisely the net cash figures I have calculated? I went back to the last time Antares sold their assets and found that it traded at almost exactly its net cash per share. However, one cannot assume that this will be the case again, with the likelihood being that a discount will be placed on the valuation of AZZ since it will probably purchase another asset rather than pay out the cash to shareholders. In any case, I don't believe for a second that the market should value AZZ at just $0.515 and I expect that this mispricing will be corrected as January 2014 arrives.

The final risk is that the new acquisition/s will be a bad one, as acquisitions so often tend to be. I think this risk is somewhat mitigated by the fact that management are playing from a position of strength, not weakness (for example due to debt), in selling their Permian assets, and therefore are able to be opportunistic with their purchase. Who knows, the reason for this sale may have been because they have already identified a better opportunity. And as I highlighted above, current management have shown they are able to add considerable value through the acquisition of the Permian assets, so perhaps the market should in fact be placing a premium on the value of their net cash. Furthermore, directors hold 14 million shares, giving them an incentive not to squander shareholder money, and impressively, no director has sold a share since 2004. Nevertheless, an overpriced acquisition is certainly possible. I won't be around to see the next oil and gas play succeed or fail as I view this sector as out of my circle of competence, but I feel that I know enough in this situation to feel fairly confident about a short/medium term investment which relies on the market recognising fair value soon.

While this may not be a typical long term value investment for me due to the shorter time horizon and valuation based on net cash rather than future earnings, I still feel comfortable with this purchase given the considerable margin of safety provided by the cash in the bank. In the end, it is quite simple: if someone offered you a bank account with $259 in it, would you refuse the opportunity to take it off their hands for $131?

* Mr Cruickshank expressed his preference to me for continuing to buying back shares over a capital return or paying dividends as the easiest and most effective way to return money to shareholders, as long as the net tangible assets of the company exceed its share price and there are sufficient sellers on the market to repurchase shares. I agree with this approach taken, and see it as a sign of good management. To illustrate, lets assume a business has a share price of $1.00, 100 million shares outstanding, and its sole asset was net cash of $200 million, giving net cash per share of $2.00 (not dissimilar to the share price/net cash disparity that exists for AZZ). If management were to buy back 20 million of those shares at $1.00, that would reduce shares outstanding to 80 million, net cash to $180 million, and therefore increase net cash per share to $2.25. This really is buying $1.00 bills (or coins in the case of Australia) for 50 cents. The converse is also true: if shares were being bought back at a share price higher than the net cash, value would be destroyed. This gives me further confidence that management won't do something exceedingly silly with the funds they will receive. You might expect these principles to be obvious to CEOs and directors, but all too often I see shares being bought back at any price, without a justification as to whether the shares are undervalued or not.

** After giving further thought to the possible downside risk, and concluding there was little to no risk of significant capital loss, I subsequently bought an additional 1943 shares in AZZ at $0.515 on the 6th of September, 2013. 

Quick Portfolio Update

It's been a little while since I've updated my portfolio here, primarily because there has been nothing noteworthy happening. That is, until today, when I allocated 10% of my portfolio to Antares Energy (AZZ) at $0.515.  It is a rather unconventional purchase for me in that I do not intend to hold it for the long term, and I am valuing this business on its prospective net cash position instead of its prospective earnings. This situation involves a little more speculation than I am accustomed to, however it seems that there is an adequate margin of safety at the current price to cover any downside, with the prospect of a decent return in a relatively short period of time (less than 6 months). Unfortunately, I'm quite busy these next couple of days so hopefully I will be able to properly outline my rationale for buying AZZ soon. Yes, I can almost hear your squeals of excitement, quieten down please.

Smiles All Around

Today I noticed the 1300SMILES annual report (ASX code: ONT) came out, which unsurprisingly was a pleasure to read. Just to give you a brief overview, 1300SMILES relieves self-employed dentists of administrative hassles and provides them with dental surgeries in return for a fee, allowing them to concentrate on actually being a dentist (ONT also has some employed dentists too). I remember stumbling across this business a couple of years ago and after reading the managing director's letter, came away impressed with the level of transparency and the efforts taken to emphasise that this truly was a long-term shareholder oriented business. Regrettably, I thought it wasn't quite cheap enough to buy at the time, and have since missed out on a nice doubling in share price.

It seems the situation today is not dissimilar with Dr. Daryl Holmes still at the wheel, and ONT trading at a fairly rich 24x FY2013 earnings. As the founder of this $152 million company, Holmes owns 62%, and it is these owner run businesses that tend to produce exceptional results over the long term. You may be wondering why this is so. Well, as the largest shareholder, Holmes has a huge incentive to act in the best interests of shareholders, in contrast to many businesses with high-flying CEOs with little equity ownership that happily take their multi-million dollar pay packages, and simply jump ship when things flounder. This year, Holmes took in just $111,663, less than another executive who received $173,916! However, as he has pointed out, most of Holmes' financial reward comes from dividends and share price appreciation - I calculate he would have received over $4 million in grossed up dividends over the past year. But often more important than money in these businesses is the desire to see them succeed - it is the blood, sweat and tears that founders pour into their company that explains their zealous determination to protect and enhance the company.

Indeed, Warren Buffett recognises this formula for success and generally prefers to buy businesses in which management who are not in it for the money but are have plenty of passion. I think Holmes' shareholder letters exemplify his passion for dentistry and Buffett fans will likely find more than a few commonalities in their business philosophy, perhaps more than any other ASX listed company, which is the highest compliment I can pay a manager. I suspect Holmes may have been taking notes. ONT would probably make a great fit for Berkshire if only it were larger.

To fully understand why I like the management so much, I would recommend you read their most recent annual report here. But I'll try to pick out some key points that literally left me smiling. If you pay attention to the wording, many insights can be garnered as to how management really views their role. In the case of ONT, Holmes begins with "Dear Shareholders," before emphasising the need to read the entire report to "help you understand how your company has managed..." (emphasis mine). Not "the" company, not "our" company, as he could rightly call it, but "your" company.

He then clearly explains important business matters such as what the Chronic Disease Dental Scheme (CDDS) was and how its end affected 1300SMILES this year, the introduction of their Dental Care Plan, brand awareness, and new acquisitions amongst other issues. But this bit stuck out to me: "I have always stressed the fact that 1300SMILES is managed to deliver the best possible results over the medium and long term. Good results in the short term are always agreeable, but I believe that most 1300SMILES shareholders take a long term view and expect management to focus always on stable and growing Earnings Per Share and dividends." And these aren't just empty words, with earnings per share increasing at 15% pa since its IPO in 2005 (also keep in mind ONT pays out the majority of its earnings as a dividend), while dividends have risen by 22% pa.

Holmes believes the future looks quite good too, anticipating it seems likely that the years ahead will offer "more favourable acquisition opportunities than the years just finished. We remain totally focused on making acquisitions which make an immediate positive contribution to our results. We won't be rushed, but we will be ready to act decisively as and when suitable opportunities present themselves." This is music to my ears as all too often managers are too eager to pay for an overpriced acquisition, and it seems so far acquisitions have been very sensible. Since 1300SMILES only has 24 dental practices primarily in Queensland, there is tons of room to expand geographically to one day operate throughout Australia. In addition to the patience highlighted above, this acquisition strategy is further de-risked as the business model has been proven to work quite well - ONT could be in the 'rollout' phase, similar to retail stocks like JB Hi-Fi and The Reject Shop that have lifted earnings dramatically by simply expanding their business geographically. 

Unlike many other boards, ONT "do not seek to influence the price of shares in the company. We strive always to deliver the best possible results and leave the share market to its own activities." This is precisely the role of management: to manage the business, not the share market. 1300SMILES' management seems to be hard at work doing this: "This situation proves once again that the harder you work, the luckier you get. 1300SMILES had been working on arrangements with Queensland Health and the HHS boards for a long time, since long before there was any hint of the end of the CDDS. We didn't go looking for a replacement deal with a government when we heard about CDDS; rather we had been pursuing this obvious need and opportunity for a very long time." Through this deal, "waiting times have been reduced from ten years to a still-shocking two years, but we're working to reduce this just as fast as the various boards authorise us to go."

And they're not getting complacent about costs either: "Long term shareholders will be aware that 1300SMILES has always maintained an intense focus on cost control. Despite that, the unusual circumstances following the demise of the CDDS created opportunities for further improvement in this area." This relentless focus on costs reminds me of what Buffett said: "The really good manager does not wake up in the morning and say, 'This is the day I'm going to cut costs,' any more than he wakes up and decides to practise breathing." 

So what does excellent stewardship result in? A return on equity of 23.6%, zero debt (cash of $8 million), a net profit margin of 17.6% and a very healthy cash flow. These great numbers have been maintained over a significant period of time, resulting in a total shareholder return of 26.5% pa over the last 5 years.  As previously touched on, the future also looks bright for 1300SMILES, which wouldn't immediately require a huge capital expenditure program either - Holmes reckons the company could increase its revenue by 50% with no significant capital expenditure since they always build in extra surgery capacity in anticipation of expansion. Without going into details, ONT has a number of other tailwinds going for it.

After reading the managing director's letter, one is able to gain a thorough understanding of how the business works, how it performed, and where it is likely headed - something I cannot say about most businesses. I must admit it is very tempting to go in and purchase shares and hold forever, but once again, I just cannot stomach the price tag. 1300SMILES will likely stay on my watchlist for a long time, as I pray to the stock market gods for its share price to fall. And to Daryl Holmes and his team, keep up the great work. Not only is this how annual reports should be written, this is how businesses should be managed. Bravo.

Valuation - The Odds and Ends

After three posts about DCF analysis, you may be under the impression that is the only way I value stocks. While I certainly like its mathematical logic, one needs to be vary careful with its inputs, it doesn't work nicely in all scenarios, and usually isn't possible to do on the spot. Time to explore some other approaches. 

It may come as a surprise to learn that less than a third of all businesses listed on the ASX made a profit last year. Valuing the other two thirds on an earnings basis is quite difficult. I generally stick to researching profitable companies, but there is certainly value to be found in some loss making businesses if you compare their market value to the equity or net tangible assets (NTA) that they have. The logic is intuitive: if a business is selling for $100 million on the share market, and it has $200 million of equity (assets minus liabilities) on its balance sheet, how can you go wrong?

Indeed, Benjamin Graham, the father of value investing, employed a similar balance sheet technique known as his 'net-nets' approach: 'The type of bargain issue that can be most readily identified is a common stock that sells for less than the company's net working capital alone, after deducting all prior obligations. This would mean that the buyer would pay nothing at all for the fixed assets - buildings, machinery, etc., or any goodwill items that might exist.' He aimed to buy stocks that were selling below two thirds of their net working capital (an even more conservative measure than NTA), reasoning that a group of stocks adhering to such a strategy would produce results that are 'quite satisfactory'. Graham's performance was certainly satisfactory, but he achieved it in an environment where information was hard to access and stocks were more often neglected. Nowadays, finding a net-net is rare and these businesses are often only priced cheaply because they are plagued with severe problems, so such a strategy is limited in its application. However, outside of Australia, some stock exchanges offer a return to the net-net days - I hear Japan is good hunting ground at the moment. 

Although I recognise that buying net-nets or stocks significantly below their NTA has proven to be a valid and successful approach, I don't like to view every business through this lens of liquidation value with the mindset that they will go broke soon so investors can get their hands on those assets (unless of course, they are actually going bankrupt and there is a mispricing). Most businesses that look very cheap compared to their current NTA are haemorrhaging cash, so you could be waiting a long time before the market revalues the stock, and in the meantime NTA is evaporating. Another danger is that the assets on the balance sheet may not be quite as tangible or valuable as they seem if the business were forced to sell, perhaps due to bankruptcy. Personally, I don't have the skills or confidence yet to determine what assets would be worth under a fire sale scenario. Instead of this rather stagnant outlook, I prefer to buy compounding businesses, and the only way to compound money is to be earning it, hence my emphasis on earnings over the balance sheet for valuation purposes. This doesn't mean I wouldn't make exceptions if I thought an NTA situation was particularly attractive, but these investments would be the minority. 

As time goes on, I've increasingly favoured the simplistic measure of the price/earnings ratio (P/E ratio) and its reciprocal, the earnings yield. I know there many value investors who object to the P/E since it assumes current earnings are forever maintained and doesn't account for a host of other important factors, but it provides a very rough indication of whether something is cheap or overpriced, and that's all I really need. I'm not interested in buying stocks that are trading 10% or 20% below a calculated intrinsic value, instead I like to wait for the fat pitch, where I believe there is a high likelihood of doubling my money or more over a 5 year period (ie at least a 15% pa return). For instance, if a business is sound and its normal earning power puts it on a P/E of 5, no DCF is necessary. Looking at this example from an earnings yield perspective, if you owned a business that could pay you a 20% return from day one, and these earnings were sustainable, it's a no brainer. There's a large margin of safety just from looking at it. At the 1996 Berkshire Hathaway Shareholder meeting, Charlie Munger noted: 'Warren talks about these discounted cash flows. I’ve never seen him do one.' 'It’s true,' replied Buffett, 'if the value of a company doesn’t just scream out at you, it’s too close.' 

So after all that effort discussing DCF analysis, was it worthless? Well, I don't think so. While accessible measures like the P/E ratio provide rough clues as to the true value of the business, DCF yields the actual answer. In practice, I can generally decide very quickly whether a particular stock is a bargain or not just by looking at its P/E, but confirm this initial conclusion by doing a DCF valuation. By understanding how intrinsic value is derived from a DCF, further pitfalls of the P/E ratio can be gleaned and addressed. For instance, although many companies trade on a low P/E, DCF tells us that unless earnings are maintained and are reinvested at a decent rate of return on equity, these businesses may not be as cheap as they appear. This is often the case, so keeping such caveats in mind enhances the usefulness of the P/E ratio rather than blindly buying stocks with the lowest P/E. Another added benefit of the P/E is that it can be used to crudely test a whole range of scenarios very quickly in your head. For example, if you think earnings per share are likely to be between $1.80 and $2.00 in a few years time and that when compared to peers or the market, a P/E multiple of 10 to 12 is reasonable, the share price range is anywhere from $18 to $24. If the most conservative outcome of $18 still produces a good return, then investors may favour purchasing the stock. 

Aside from the P/E, there are many other simple value indicators that may be helpful for investors, including the price to book ratio, enterprise value, and free cash flow multiple/yield. But this final post wouldn't be complete without a quick trashing of another popular metric used in valuation. This time it's the EBITDA multiple, which stands for 'earnings before interest, taxes, depreciation and amortisation'. I can see why managers routinely choose to focus on EBITDA to make their acquisitions and their own numbers look better, but it is beyond me why investors would also choose to ignore these very real costs. Sceptics would say a better term for this metric is 'earnings before all expenses'.

In the end, valuation is as much about art as it is science. Having an understanding of how DCF analysis works is important, but even more so is common sense and the ability to stay rational. Investors should realise that assessing risk and predicting the future is difficult but necessary to attempt themselves - although many services offer to crunch numbers and value every stock automatically, no computer program can incorporate the multitude of qualitative judgements that good investors can. As Munger once said, 'People calculate too much and think too little'. I hope some of the ideas presented have made you think a little more. 

Valuation - The Discount Rate

While I said that this post would be my last about valuation for the time being, as I was halfway through writing it I realised I would only have space to talk about the discount rate here, lest this turn into a long boring essay (I'm afraid it has). So I promise that my next post will be the last. It will also be the last for a while, as I'll have my trial HSC tests coming up. Without further ado, here it is:

As I covered earlier, DCF valuations are quite sensitive to the cash flows that an investor projects. They are also very sensitive to the discount rate, or interest rate used, so getting both right is important to coming up with an intrinsic value. Unfortunately, I don't know what the proper discount rate to use is for each and every business so I can't come up with a proper intrinsic value, but that doesn't rule out the usefulness of DCF analysis for me. Let me explain...

Depending on who you listen to, experts will either tell you that the discount rate should be 'risk free rate' (due to their low perceived risk, long-term government bonds are usually taken as a proxy), or more commonly they'll say that the discount rate needs to incorporate a 'risk premium' on top of the risk free rate (to compensate investors for the extra risk in buying assets such as shares). Determining the risk free rate is quite easy - according to Bloomberg the yield on Australian government bonds for a 15 year maturity is currently around 4.2%. But the risk premium isn't so conveniently found through a Google search. 

In the 1960s, finance academics attempted to overcome this issue (not that they had Google) of the lack of an easily calculable discount rate, and came up with the capital asset pricing model, or CAPM for short. Basically, the CAPM's risk premium is the market premium (or equity premium in the case of stocks) multiplied by the beta of the asset. In my opinion, the first number is on shaky ground, while the second is downright useless for the purposes of valuation. I've read quite a few papers that attempt to estimate the equity premium - which is the excess return of the stock market over the risk free rate - from historical results and get the impression that it isn't as simple as it would seem. Depending on what timeframe you select, whether you use an arithmetic or geometric mean, and whether you include franking credits, Australia's equity risk premium seems to be anywhere from 2% to 7% (it also differs country to country). That's too large a range to be useful in accurately valuing stocks. Some argue that a forward looking equity premium is a better way to do it, but as with most forward looking estimates, they too are subject to wide variations. And others argue that it doesn't even exist at all (see here). 

But even if you look past the dubious nature of the equity premium, it is the inclusion of beta that really ruins the CAPM. Since not all stocks entail the same level of risk, the CAPM attempts to quantify the risk of a particular stock through its beta. You can find this number for any stock quite easily on most financial websites. Beta is calculated by measuring how volatile the share price of an individual stock is when compared to the stock market as a whole. A beta below 1 indicates a relatively steady share price in comparison to the market and thus is less risky, while a beta above 1 signals more volatility and more risk. 

As I explained in my earlier post, How Many Baskets? measuring the risk of a business through its share price volatility just doesn't make sense at all. Every successful value investor knows this is obvious, take Seth Klarman who wrote in his book Margin of Safety: 'I find it preposterous that a single number reflecting past price fluctuations could be thought to completely describe the risk in a security. Beta views risk solely from the perspective of market prices, failing to take into consideration specific business fundamentals or economic developments. The price level is also ignored, as if IBM selling at 50 dollars per share would not be a lower-risk investment than the same IBM at 100 dollars per share.' And he goes to point out more flaws about beta but I hope you can see that it is not a measure of business risk at all. The whole foundation of the CAPM is deeply flawed too, relying on plainly unrealistic assumptions from the efficient market hypothesis (EMH) - for example, that every investor is always rational and risk averse, taking into account all possible information available at the same time as everyone else. Any of the countless financial bubbles and crashes in human history indicate otherwise. 

And can you believe that three of the men that devised the CAPM won the Nobel Prize in Economics for it? Furthermore, the CAPM and EMH are still taught as financial theory in business schools all over the world today. I can see why this is so - when mathematically gifted people turn to the field of economics, they naturally want to come up with elegant, precise formulas just like physics but eventually get carried away with this ambition and end up neglecting reality. As a final potshot at the CAPM, James Montier, author of Behavioural Investing, has suggested that the CAPM be renamed CRAP for 'completely redundant asset pricing'. I wholeheartedly agree. 

After that long rant about the popular CAPM explaining why it should be laid to rest, it's about time I got around to how I approach the discount rate. For DCF valuations I currently use two methods in tandem:

1. I use a single discount rate across all stocks which very roughly incorporates the risk free rate and an estimate of the equity premium. If you were to only discount cash flows at the current risk free rate of 4.2%, just about every stock would seem grossly underpriced, so I justify using a higher rate by fuzzily thinking that the additional amount needed for reasonable valuations must be the equity premium. In the present low interest rate environment, I'd be inclined to use a discount rate around 9 or 10% (yes this is very arbitrary but it doesn't really matter as I'll explain). Of course, using the same discount rate across everything doesn't adjust for the different risk of each stock, so I attempt to incorporate this risk through my projections of the business' future - I use more conservative assumptions for businesses I deem to be risky. Getting a feel for this risk is something that must be learned through practice (and I am still very much learning) but things such the business model, competitive landscape, debt/equity ratio and historical profitability provide some insights. Beyond a certain level of risk, I'm unwilling to attempt a valuation. 

Although I don't pretend this approach produces a proper intrinsic value per se, it does provide a relative measure of value across stocks. Therefore, one can rank dozens of stocks on this 'relative' intrinsic value, and simply purchase the cheapest ones. This seems to be in accordance with what Warren Buffett reportedly said at the 1998 Berkshire Hathaway meeting: 'In order to calculate intrinsic value, you take those cash flows that you expect to be generated and you discount them back to their present value – in our case, at the long-term Treasury rate. And that discount rate doesn’t pay you as high a rate as it needs to. But you can use the resulting present value figure that you get by discounting your cash flows back at the long-term Treasury rate as a common yardstick just to have a standard of measurement across all businesses.' (Please note, as far as I know Buffett hasn't been very specific about discount rates and how he adjusts for risks in writing. Oral quotes such as the one above are often conflicting - some suggest he does actually adjust discount rates but I suspect he's been misquoted in some instances. If you'd like to see more comments from him about the discount rate, including the one I conveniently chose, check them out here.)

2. My second approach is to use a constant discount rate of 15% no matter what level interest rates are and purchase stocks whose share prices are below that estimated value. Since the discount rate is essentially the required return that an investor desires from investing in something, personally I would be satisfied with a 15% annual return over the long term. While the first method provides a relative measure of value, blindly following that would see me continuing to buy the 'cheapest' stocks even in an environment when stocks in general are extremely overvalued, as can happen from time to time. Hence, this second method provides an absolute benchmark of value - if nothing offers a prospective return of 15%, then the stock market is probably overvalued and it may be time to sit out for a while. 

In practice, it wouldn't make much difference if I exclusively used the second approach as both a relative and absolute measure of value. Raising the discount rate by a few percent doesn't change the relative attractiveness of a group of stocks dramatically (higher discount rates favour stocks with cash flows closer to the present and vice versa with lower discount rates), although it will result in dramatically lower intrinsic values. Likewise, I could probably get away with only using the first method and just employing some common sense to figure out when stocks are exceptionally overpriced. 

So in conclusion, by using a constant discount rate DCF analysis enables me to determine which stocks are the cheapest, without actually coming up with a true intrinsic value (although I'd love to be able to). In any case, my inability to decisively determine what the discount rate should be doesn't preclude other investors from doing so - I'm sure someone else has a more logical process. And whatever you do, remember that the CAPM is total crap!

Valuation - The Cash Flows

Just a preamble: if you are unfamiliar with discounted cash flow analysis, I anticipate much of the following discussion will be about as clear as mud, so don't get too concerned if I don't sound very coherent here.

Whilst DCF analysis is often used to value income producing assets like shares, it does have a number of flaws or weaknesses that individuals must be aware of. Most of these stem from the accuracy required in making predictions about the future and the sensitivity of DCF analysis to relatively small adjustments. As the popular saying goes, 'It is difficult to make predictions, especially about the future'. Hence, unless you have enough confidence to make reasonable guesses about the future of a business, one should just put it in the 'too hard' basket and move on.

There are however, a couple of remedies for the inherent sensitivity of DCF valuations. By testing a range of assumptions instead of just one scenario, investors can get a feel for the best case and worse case scenarios. If even under the worse case scenario, the valuation doesn't seem too bad, then you might decide to buy. Alternatively, some like to be very conservative in all their assumptions and thus while they may miss out on opportunities for being overly cautious, they also avoid buying overvalued businesses.

I'd just like to discuss something that has bothered me about the way many professionals go about DCF valuations but is rarely pointed out. Many will tell you that you need to discount 'free cash flows' (essentially operating cash flow minus capital expenditure), I beg to differ. Firstly, if you want to get the true cash flows that a business earns, then you need to subtract the capital expenditure required to maintain the business. Capital expenditure for growth is lumped together with maintenance capital expenditure in the financial statements, making it difficult to determine maintenance capex for businesses that are growing (which is the majority of businesses), and unfortunately management rarely estimate it for investors. In most cases, that's too hard, so the total capital expenditure figure is used, or otherwise earnings are used as a proxy for free cash flow.

More importantly, even if you can get this free cash flow figure, it doesn't make mathematical sense. Let's look at an example of a hypothetical scenario. Suppose a business earns a return on equity of 10% and continues to earn 10% on any retained earnings. It starts out with $10,000 of equity and therefore earns $1000 in the first year (also assume that for this business, free cash flow = earnings). If there are 1000 shares on issue, that equates to earnings per share, or free cash flow per share of $1.00. If it pays out 50% of its earnings as a dividend, earnings will increase at a rate of 5% per annum (so will equity, dividends and intrinsic value) as you can see in the table below.

Assume also that the discount rate, or required return of the investor is 10% (I'll discuss this further in my next post). If I discount the earnings per share every year as you can see in the 'Discounted earnings' column, they eventually approach zero. To come up with an intrinsic value, one just needs to add all of these discounted earnings into infinity, in this table, I've just used the Gordon growth model explained in the previous post to keep things short (only 10 years are displayed) and easily calculate an intrinsic value for each year. In the first year, we come up with an intrinsic value per share of $21.00. Sounds fairly reasonable.

Now, what if we discounted not earnings or free cash flow, but dividends as some investors advocate? Since the dividends are half of this business' earnings, dividends per share in the first year are $0.50 in the new table below. Reapplying the discounting process to the dividends, we get an intrinsic value of just $10.50 (incidentally, this is equal to the equity per share at the end of the first year). So which one is the correct value?

To sort this conundrum out, let's say we have investor A, who buys 400 shares of this business at the end of year 0, when he calculates the value of the business as $21.00, for an initial investment of $8400. Investor B does the same, but at her calculated value of $10.50, for an initial investment of $4200. At the end of the first year, they both receive their dividend, and decide to invest that money at their required return of 10%. While they could invest it anywhere else at 10% and the end result would be the same, let's also conveniently assume that the share price always trades at its intrinsic value (which should give a return of 10% if the intrinsic value is correct) and both investors decide to purchase more shares each year with their dividends.

As is visible in the two tables above, at the end of year 10, investor A ends up with 506 shares and would be sitting on an investment of $17,313, up from his $8400. This is a return of 7.5% per year, an unwelcome surprise after expecting a return of 10%. Happily, investor B ends up with 637 shares, and an investment of $10,894, for an annualised return of precisely 10%.

Thus, it is evident that discounting free cash flows or earnings overestimates intrinsic value, whilst discounting dividends produces the mathematically logical answer. This is because unless those free cash flows are paid out to the investor as a dividend, the investor cannot treat it as theirs yet, and therefore cannot discount them yet. Those retained earnings are used to boost future dividend payments so discounting free cash flows or earnings is double counting. If you're still unconvinced, consider what happens if this business only paid out 5% of its earnings as a dividend, not 50%. The free cash flow model produces an absurdly high valuation of $219.00, while the dividend discount model remains reasonable at $10.95. No sane investor would pay $219.00 per share for a business that earned $1.00 per share in the last year.

In what seems like an endless circle of problems, discounting dividends is difficult to do for a business that doesn't pay any dividends yet. In this situation, investors may skip the business entirely, try to guess at future dividend payments, or simply discount earnings if that is too hard. But as I've pointed out, discounting earnings or free cash flows overestimates intrinsic value, so it's advisable to add an extra layer of conservatism on top if taking this approach. And what if there are no earnings either? Again, either skip the business, guess at future earnings, or approach the valuation from an equity or net tangible assets (NTA) perspective, which I'll cover more in my next post. Finally, in Australia, not all businesses pay the same level of franking credits so to account for that I would suggest incorporating franking credits into the dividend figures (a little research online will show how).

A few interesting conclusions can be drawn about the DCF model from the example above and by examining how its inputs affect intrinsic value:

1. The further in the future cash flows are, the less important they are to the valuation, even though they may be rising in nominal terms (exhibiting the time value of money concept). Therefore, the job of predicting the future is made a little easier: the most important predictions to make are the ones closest to the present. 
2. As briefly hinted at, a business that perpetually earns a return on equity that is equal to the discount rate/required return is worth exactly the value of the equity itself. This can be useful to approximate intrinsic value for certain businesses in your head. 
3. A business that can earn a return on equity above the discount rate should ideally retain earnings to reinvest them rather than giving into pressure to pay dividends. This produces the highest intrinsic value (which is above the value of its equity). On the other hand, businesses that earn a low return on equity and have no good prospects of raising this should pay out all of their earnings as a dividend to maximise intrinsic value (which is below equity). Management that ignore these principles may show ignorance in 'maximising shareholder value', as they so often espouse. 

In summary: I believe that while some other methods produce similarly rational valuations, discounting dividends is the most mathematically correct way to calculate intrinsic value, but it is very dependent on putting the right numbers in. The next, and final post about valuation (for now at least) will explore the discount rate a little more, other valuation methods, and end with my thoughts on valuation in practice.