"The market, like the Lord, helps those who help themselves. But, unlike the Lord, the market does not forgive those who know not what they do. For the investor, a too-high purchase price for the stock of an excellent company can undo the effects of a subsequent decade of favorable business developments."
-- Warren Buffett, 1982 annual letter to shareholders
"We submit to you then, Fool, that valuation isn't half so important as quality and the durability of the business model. At least when you're building a Rule Maker Portfolio. In fact, we'll go so far as to say that the quality of the company is fully 100 times more important than the immediate value of its stock price."
-- The Motley Fool (Step 7 of the 11 Steps to Rule Maker Investing)
I believe in The Motley Fool's core investment philosophy of buying the stocks of quality companies (or index funds), holding for the long run, and ignoring the hype of Wall Street and the media. But if I were to level one general critique of the Fool, it would be that there is not enough emphasis on valuation. I agree -- and I'm sure Buffett would too -- that the enduring quality of a business is more important than today's price, but 100 times more important? C'mon! The experience of the past few years notwithstanding, that "pay any price for a great business" attitude is a sure route to underperformance.
For a number of years now, we have been in a remarkable bull market where valuation hasn't mattered. In fact, I believe that the more investors have focused on valuation in recent times, the worse their returns have been. But this hasn't been true over longer periods historically, and I certainly don't think it's sustainable. While the laws of economic gravity may have been temporarily suspended, I do not believe that they have been fundamentally altered.
Don't get me wrong -- I'm a big believer in the ways that the Internet (and other technologies), improved access to capital, better management techniques, etc., have positively and permanently impacted the economy. Nor am I the type of value investor who thinks that anything trading above 20x trailing earnings is overvalued. I simply believe in the universal, fundamental truth that the value of a company (and therefore a fractional ownership stake in that company, which is, of course, a share of its stock) is worth no more and no less than the future cash that can be taken out of the business, discounted back to the present.
I find it hard to believe that this type of thinking is present in the hottest (mostly emerging, technology-related) sectors of the market today. The enormous valuations imply phenomenal growth and profitability for numerous companies in each sector. That's a mathematical impossibility. Sure, a few of these companies might become the next Ciscos and Microsofts, but very few will. They can't all achieve 80% market share! I believe investors in these sectors are setting themselves up for a fall, not because they're investing in bad businesses, but because the extreme valuations create a highly unfavorable risk-reward equation. I suspect many are not investing at all, but are simply speculating in a greater fool's game.
Well, if that doesn't trigger a flood of hate mail, nothing will. But before you flame me, consider this: I own some of today's hottest stocks. But I bought them at much lower (though still high, to be sure) valuations, when I felt confident that their future cash flows would justify their valuations at the time. Now, while I am not as comfortable with their valuations and am certainly not buying more, I am determined to stick to my long-term investment strategy and hang on to these stocks as long as the underlying businesses continue to prosper.
Overview of Valuation
If the future were predictable with any degree of precision, then valuation would be easy. But the future is inherently unpredictable, so valuation is hard -- and it's ambiguous. Good thinking about valuation is less about plugging numbers into a spreadsheet than weighing many competing factors and determining probabilities. It's neither art nor science -- it's roughly equal amounts of both.
The lack of precision around valuation makes a lot of people uncomfortable. To deal with this discomfort, some people wrap themselves in the security blanket of complex discounted cash flow analyses. My view of these things is best summarized by this brief exchange at the 1996 Berkshire Hathaway annual meeting:
Charlie Munger (Berkshire Hathaway's vice chairman) said, "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."
The beauty of valuation -- and investing in general -- is that, to use Buffett's famous analogy, there are no called strikes. You can sit and wait until you're as certain as you can be that you've not only discovered a high-quality business, but also that it is significantly undervalued. Such opportunities are rare these days, so a great deal of patience is required. To discipline myself, I use what I call the "Pinch-Me-I-Must-Be-Dreaming Test." This means that before I'll invest, I have to be saying to myself, "I can't believe my incredible good fortune that the market has so misunderstood this company and mispriced its stock that I can buy it at today's low price."
Since I've been quoting Buffett with reckless abandon, I might as well conclude with another one of my favorites, from his 1978 annual letter to shareholders (keep in mind the context: Buffett wrote these words during a time of stock market and general malaise, only a year before Business Week's infamous cover story, "The Death of Equities"):
"We confess considerable optimism regarding our insurance equity investments. Of course, our enthusiasm for stocks is not unconditional. Under some circumstances, common stock investments by insurers make very little sense.
"We get excited enough to commit a big percentage of insurance company net worth to equities only when we find (1) businesses we can understand, (2) with favorable long-term prospects, (3) operated by honest and competent people, and (4) priced very attractively. We usually can identify a small number of potential investments meeting requirements (1), (2) and (3), but (4) often prevents action. For example, in 1971 our total common stock position at Berkshire's insurance subsidiaries amounted to only $10.7 million at cost, and $11.7 million at market. There were equities of identifiably excellent companies available -- but very few at interesting prices. (An irresistible footnote: in 1971, pension fund managers invested a record 122% of net funds available in equities -- at full prices they couldn't buy enough of them. In 1974, after the bottom had fallen out, they committed a then record low of 21% to stocks.)
"The past few years have been a different story for us. At the end of 1975 our insurance subsidiaries held common equities with a market value exactly equal to cost of $39.3 million. At the end of 1978 this position had been increased to equities (including a convertible preferred) with a cost of $129.1 million and a market value of $216.5 million. During the intervening three years we also had realized pretax gains from common equities of approximately $24.7 million. Therefore, our overall unrealized and realized pretax gains in equities for the three-year period came to approximately $112 million. During this same interval the Dow-Jones Industrial Average declined from 852 to 805. It was a marvelous period for the value-oriented equity buyer."
It is clear that Buffett's unparalleled investment track record over many decades is the result of buying high-quality businesses at attractive prices. If he can't find investments that have both characteristics, then he'll patiently wait on the sidelines. That's what's happening today. As in 1971, Buffett has again largely withdrawn from the market, refusing to pay what he considers to be exorbitant prices for stocks. This is a major reason why the stock of Berkshire Hathaway (NYSE: BRK.A) has been pummeled. And Buffett himself is ridiculed as being an out-of-touch old fogey (you should read some of the e-mails I get every time I write a favorable word about him). Only time will tell who is right, but I've got my money on Buffett.
Next week, I will take this discussion of valuation from the theoretical to the practical by analyzing American Power Conversion's (Nasdaq: APCC) valuation.
Whitney Tilson is Managing Partner of Tilson Capital Partners, LLC, a New York City-based money management firm. Mr. Tilson appreciates your feedback at Tilson@Tilsonfunds.com. To read his previous guest columns in the Boring Port and other writings, click here.
- Boring Portfolio, 11/8/99: Slightly More Optimistic: Comments on Buffett's Fortune Article
- Boring Portfolio, 11/15/99: The Debate Over Buffett's Fortune Article
- Boring Portfolio, 11/22/99: Buffett's Prescient Market Calls
- Fool's School: How to Value Stocks
- Fool's School: Security Analysis