The Two Analytical Essentials

The Motley Fool will soon unveil Motley Fool Alpha, a new investment service that seeks to bridge the gap between traditional stock newsletters and the real world of hedge fund investing. John Del Vecchio and I will be heading up this venture, drawing upon our years of market-beating experience in the hedge fund world. Alpha will opportunistically invest both long and short, with the goal of compounding our capital at 15%-plus over time while defending against significant drawdowns.

Today is the third of our four-part series on the investing principles that will guide Motley Fool Alpha. In part one, we introduced the Motley Fool Alpha investing philosophy. Part two explained how we optimize risk versus reward by utilizing an "active value" strategy. Here in part three, I'll be discussing what I consider to be the pillars of security analysis: valuation and risk. Yes, these are sometimes nap-inducing topics, but here I'll be keeping the discussion to a conceptual level -- focusing specifically on how we think about valuation and risk.

Appraise value skillfully
Portfolio decisions in Alpha will be heavily influenced by our view of each position's intrinsic value -- i.e., the value that takes into account a conservative estimate of a company's long-term value creation, then discounted back to present value at a reasonable rate. The key is to make a skillful appraisal of intrinsic value based on the circumstances unique to that particular business.

I chose the word "appraisal" because it captures the idea of an individualized assessment using tools and metrics appropriate for that particular asset. If you were appraising a diamond, your tool would be the "four C's." If you were appraising a house, the primary metric would be price per square foot for comparable homes in that particular market. A skillful appraisal demands we choose the right tool for the job, and then use that tool skillfully.

A common mistake is to assume that a single tool will work equally well with all stocks. Many market practitioners lean too heavily on a single favored metric, be it P/E or EV/EBITDA, and then they get side-swiped by scenarios where that metric doesn't apply. For instance, a business in permanent secular decline may only justify a P/E of 5 to 7 times. This is the proverbial "value trap" – a stock that looks cheap, but in fact isn't.

It's important we not get caught up in the style-box notion of value – i.e., defining "value stocks" as those with the lowest multiple to earnings or book value. Such a narrow statistical view of value has many pitfalls. Would you want to buy a buggy whip company in 1920 just because it traded at a low multiple to earnings or book? (No!) Would you want to discard Wal-Mart as an investment candidate in the 1980s because it traded at a P/E of 30? (No!) Were homebuilders cheap in 2006 at a P/E of 10? (Resoundingly, no!) You get the idea.

Our aim will be to appraise each stock's value in a manner that fits the unique circumstances of that particular business. For many manufacturing and service businesses, we'll look to free cash flow. For companies in the natural resource sector, we'll make an assessment of net asset value. For certain financial businesses, we'll refer to book value. For companies with real estate held for many decades, we'll consider the possibility of hidden value. For businesses where a money-losing division is offsetting the profits of a strong division, we'll consider how earnings power might be improved if the company were to merely shut down its bad business.

Lastly, as we make our appraisal of value, we'll seek to define it within a conservative range. Even if we're using a skillful approach and the appropriate tools, there's still the inherent uncertainty of the future. Thus, we must be conservative in our assumptions and always watchful for signs that our assumptions may be in error. Our valuation work will never be perfect, but the good news is that it doesn't have to be. If we can construct a portfolio where our longs trade at a wide discount to intrinsic value, and our shorts trade at a wide premium to intrinsic value, then we'll let the law of averages work in our favor.

Take risk seriously
Achieving our portfolio goal of 15%-plus annualized returns is in large part dependent upon avoiding big losses. And that demands we be acutely sensitive to risk – defined as any variable that could result in a permanent loss of capital. As we analyze companies, we must be wary of any discernable factor that could torpedo our position.

On the long side, risks to be watchful for include: competitive encroachment, aggressive accounting, customer concentration, the threat of adverse political developments, and business obsolescence due to disruptive technologies. In addition, we'll hold a strong bias against companies with any meaningful amount of debt, particularly callable bank debt or debt facing a near-term maturity. It's uncanny how often what seems to be an "appropriate" amount of debt can later become a horrible burden, with nasty implications for the stock price. Another more subtle but no less important risk factor to be cautious of is peaking fundamentals, either in terms of revenue growth or margins. When a company's fundamentals hit peak, so too does its stock price in many cases.

On the short side, there are two unique risk scenarios to beware. First are open-ended situations – i.e., when a company has a revolutionary product or is in the early stage of addressing what could be a large market opportunity. This is the setup for a high-flying stock price that can – and probably will – defy all normal valuation gravity. An open-ended situation is the worst kind of short because it's an inherently bad probability bet: the most you can make is 100% (if it goes to zero), but you could lose multiple hundreds of percent if you stubbornly dig in your heels. The second category of shorts to avoid are those with a high short interest -- i.e., a large percentage of the float already held short. Just like an overly crowded bar, a crowded short can be a raucous and unpleasant scene. High short interest names are vulnerable to the dreaded short squeeze, where shorts all scramble to cover at the same time causing the price to spike. There are greener pastures for shorting, so no need to waste our mental capital on these more difficult shorts.

A separate category of risk, which applies equally to longs and shorts, is the possibility of having blind spots -- threats we don't even see coming. This most often happens when we venture into a company or industry that's less familiar to us -- i.e., circle of competence risk. Buffett has rightfully said, "Risk is not knowing what you're doing." In most cases, we're best served to stay inside our circle of competence. That said, I think we should occasionally seek to expand our circle of competence, and that inevitably means pushing into riskier terrain. The key is being intellectually honest when we're exposed to the risk of the unknown. We can compensate in these scenarios through smaller position sizing, or even the usage of a stop-loss.

Finally, before leaving the topic of risk, let's also establish that we'll make no use of silly mental accounting such as "playing with the house's money" or any other method of rationalizing a foolish risk. Every market day our cost basis is established at the previous day's close, and the entirety of our position represents precious capital not to be wasted. Along the same lines, when we make portfolio decisions, we'll not allow historical cost basis to enter the equation. The only question that ever matters is this: at the present price, is the position still worth holding at the current size? Our aim in all risk considerations will be to follow the intellectual path of Charlie Munger, who when challenged to sum up his success in a single word said it was his ability to be rational.

What's next
In our fourth and final installment of the Alpha investing series, I'll give you my three guiding principles of portfolio management.

If you would like to learn more about Motley Fool Alpha as soon as details are available, click here.

Matthew Richey is excited to be back at The Motley Fool, teaming up with John Del Vecchio on Motley Fool Alpha. He doesn't own shares of any company mentioned. Wal-Mart is a Motley Fool Inside Value choice. The Fool owns shares of Wal-Mart. True to its name, The Motley Fool is made up of a motley assortment of writers and analysts, each with a unique perspective; sometimes we agree, sometimes we disagree, but we all believe in the power of learning from each other through our Foolish community. The Fool has a disclosure policy.


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