Value Philosophy, Pt. 2
The Boring Port's philosophy introduced
ALEXANDRIA, VA (Oct. 7, 1998) -- Today, we continue explaining our value philosophy. While we will have more to say on our worldview in the coming months and years, we wanted to at least introduce ourselves with an outline of how we think about things.
Regarding some of the terms we use in our discussions, we've detailed them in numerous Fool on the Hill columns, which are retrievable in our databases on the Web or on AOL. To make it easier to refer to some of the terms we use on a frequent basis, though, we'll set up an index in the Boring Portfolio area.
In regard to the current portfolio, we're aware of how it's moving performance-wise, but we're not planning to do anything about it this week or next week. Until we have the chance to look over these companies thoroughly, we won't be pushing any buttons. That will hurt us in the short-term, sure, but we're committed to a low-turnover portfolio style. One of the best ways to eat up returns is in portfolio turnover. The bid/ask spread, commissions, and dumb decisions that are made without the full benefit of quality reflection all hurt performance. If we sell things now without thinking about it, then we're just creating a precedent of moving without thinking fully about a transaction. That's not where we want to be intellectually.
Without further distraction, I'll turn this over to Alex for the second part of our value philosophy.
Value Philosophy, Part 2
Now that we have broached the subject of "value," or at least mentioned the word, a definition is in order. Here's a simple one; "A fair return or equivalent in goods, services, or money for something exchanged." The concept of value then, sets up the proposition that some kind of return is expected, and that this return should hopefully justify what was initially tendered -- that is, a fair return. Contrast this with a definition of investing: "To commit (money) in order to earn a financial return." Not much of a difference, huh? That's why we tend to laugh when people talk about value investors versus growth investors, and purple investors versus green investors. What is 'investing' if not the act of seeking value, at least sufficient to justify the amount paid?
William Miller of Legg Mason Value Trust has stated, "There is no theoretical difference between value and growth; the value of any investment is the present value of the future free cash flows of the business," and we agree. "The terms are mainly used by consultants to allow them to carve the world of money managers up for clients. They represent characteristics of stocks, not of businesses." Warren Buffett, in his typically candid fashion, highlighted these same issues in his 1987 Report to shareholders:
"Most analysts feel they must choose between two approaches, customarily thought to be in opposition: 'value' and 'growth.' Indeed, many investment professionals see any mixing of the two terms as a form of intellectual cross-dressing. We view that as fuzzy thinking (in which it must be confessed I myself engaged some years ago). In our opinion, the two approaches are joined at the hip: Growth is always a component in the calculation of value, constituting a variable whose importance can range from negligible to enormous and whose impact can be negative as well as positive."
Many investors do agree with us that business does matter. In fact, roughly 85% of those actively involved in the analysis of stocks employ some kind of "fundamental" business analysis in order to place a value on a stock. This, of course, is why the market is so efficient. People that dispute this proffer only silly anecdotes to the contrary, like Transcontinental Realty going up when positive news about Telecommunications Inc. gets disseminated. Let's face it, trillions of dollars are allocated on a daily basis, and lots of sharp people have devoted their lives to the pursuit. Any portfolio that outperforms for any statistically significant period of time does so because it contains securities that have been mispriced by the market. That is, the expectations imbedded in the share price miss the true economic potential of the firm.
It's important to realize that there are two sides to the investment coin. On the "value" side of the coin, the market is inefficient in the short run -- it tosses aside value at the expense of the most current view and the most current information. On the flip side, the information processing side, the market is extremely efficient in the short run -- it makes the necessary modification to a company's stock price to reflect the most up-to-the-minute view on the firm. Since valuation is a dynamic, ongoing process, price must be carefully monitored.
It's a mathematical truism that price determines return, and devout investors like us have long "Watch Lists" which we scan as market conditions change, hoping to take a position in a company at a price which offers a sufficient margin of safety -- that is, a substantial discount to what we have determined is the company's intrinsic value. Now, before we get into a comprehensive discussion of intrinsic value, let's take a closer look at market efficiency and the kind of metrics that investors employ to assess business performance. For many the be-all, end-all of investing is rooted in the end product of the accounting function, and that is earnings.
Accrual accounting is one of the most amazing systems ever devised, in its ability to assess the overall condition of a business -- taking into account all the myriad elements that add value and presenting a coherent, common-sized view of the enterprise. However, the last time we checked, there was no shortage of computing power. Taking simple accounting based metrics, like price to earnings, price to book, and price to sales, and performing database screens for these characteristics in an attempt to find undervalued situations is not a very fruitful exercise. It's not that these metrics don't say anything about the business, it's that they give a very unqualified view of the business. Combing through data will provide quantification but not the qualification that we need. We need to know the quality of earnings and the future prospects for those companies.
Since we believe that the value of any investment is the present value of the future free cash flows, then some method of assessing how much cash is being generated by the business must come to the fore. However, we're not just concerned about the ability to generate cash (just like we're not concerned about simply finding earnings growth) -- for a firm could be generating tons of cash and still be running itself into the ground. No, we need to get a handle on the economics of the return, and this endeavor strikes at the heart of the previously articulated debate about value and growth. All capital has an opportunity cost and should be allocated to its highest long-term use, which we'll get into on Friday.
For continued discussion in the meantime, please visit the Boring message board.
Stock Change Bid ANDW - 15/16 11.31 CGO - 1/2 24.81 BGP -1 13/16 22.81 CSL + 1/16 35.75 CSCO -2 5/16 43.88 FCH -1 5/16 19.31 PNR - 5/16 30.69 TBY - 5/16 5.50
Day Month Year History BORING -3.91% -12.67% -25.28% -5.97% S&P: -1.41% -4.56% 0.03% 56.15% NASDAQ: -3.19% -13.65% -6.86% 40.51% Rec'd # Security In At Now Change 2/28/96 400 Borders Gr 11.26 22.81 102.67% 6/26/96 225 Cisco Syst 23.96 43.88 83.15% 8/13/96 200 Carlisle C 26.32 35.75 35.80% 3/5/97 150 Atlas Air 23.06 24.81 7.61% 4/14/98 100 Pentair 43.74 30.69 -29.85% 5/20/98 400 TCBY Enter 10.05 5.50 -45.25% 11/6/97 200 FelCor Sui 37.59 19.31 -48.62% 1/21/98 200 Andrew Cor 26.09 11.31 -56.64% Rec'd # Security In At Value Change 2/28/96 400 Borders Gr 4502.49 9125.00 $4622.51 6/26/96 225 Cisco Syst 5389.99 9871.88 $4481.89 8/13/96 200 Carlisle C 5264.99 7150.00 $1885.01 3/5/97 150 Atlas Air 3458.74 3721.88 $263.14 4/14/98 100 Pentair 4374.25 3068.75 -$1305.50 5/20/98 400 TCBY Enter 4018.00 2200.00 -$1818.00 1/21/98 200 Andrew Cor 5218.00 2262.50 -$2955.50 11/6/97 200 FelCor Sui 7518.00 3862.50 -$3655.50 CASH $5750.59 TOTAL $47013.09