I haven’t written much about my investing process and thought it worth sharing a little as there aren’t a lot of value investors (writing?) on the forums.
At the most basic level, value investors try to buy assets for less than they are worth.
This might sound like “duh, who doesn’t”, but what they are not doing at a fundamental level is evaluating how some given action/change/trend/force is going to directionally affect a given business and thus its stock price movement in the near-term (the approach of traders) or owning a collection of assets whose asset class exhibits some type of behavior (the approach of indexers/most traditional asset allocation strategies). To say it differently, value investors buy cash flows, not trends or correlations.
Going a little deeper, all assets have a fundamental intrinsic value. That value is the (present) value of all future net cash flows. Obviously in all real world cases, those cash flows can only be estimated. Given that we are estimating these cash flows, the reliability of our estimates are absolute critical. We can’t accurately estimate things we don’t understand to a sufficiently high degree, and we also can’t usefully estimate things that aren’t fairly durable.
This has big implications in an investing process: of all assets out there in the world, we will only be able to adequately estimate the cash flows of a small percentage, because 1) we will not have a sufficiently deep understanding of most things and 2) many things, even if we understand the situation, lack a narrow enough range of outcomes (i.e. low durability) to offer high-confidence situations. The takeaway: we can only actually come up with a useful estimate of the value of a small subset of all total assets. To tie this back to above, this is in contrast to traders who only look at how a given change is at play (stay at home orders from a virus will lead to increased demand for video conference, go long Zoom) or indexers who are trying to participate in long-term aggregated profits of publicly traded businesses. These latter two groups don’t try or need to understand the drivers of total cash flow, so can operate in a number of other spaces. Value investors are a bit more limited in this respect.
Once we accept this, we can begin to understand the above idea of buying assets for less than they are worth. We estimate the cash flows from now into judgement day for things we can adequately do so for, and then compare the current price of the asset to the intrinsic value of those cash flows. In reality, we are generally thinking about a range of value as there are a lot of different outcomes that can occur, and we take a look at the spread. If the price is below the lower end of that intrinsic value, the situation could be interesting and worth considering purchase.
At this point, it’s worth pointing out another key belief of value investors – prices diverge from intrinsic value with some regularity, spending time below, at, and above intrinsic value. Anyone who watches (publicly-traded) asset prices with any regularity can see this, although it is somewhat at odds with strong forms of certain academic finance views. Value investors accept this idea of price/value divergence as a critical component.
The next major piece of the puzzle is the idea of margin of safety. As in much of life, it is good to allow a degree of excess coverage around certain things. If you have a job interview at 3:00, it’s better to plan to arrive at 2:15 than 2:55. If you strive to be prepared to survive the ravages of environmental and their economic issues, it’s good to have low needs and multiple avenues of satisfying those needs than to rely on a single source of income that you fully spend, and then some via debt, to support your lifestyle. For investing, if you estimate an asset is worth $80-120, it’s better to buy it at $60 than $75. In both cases you are expecting to make money on the closure of the price/value gap and the cash flows of the asset, but in one case you have both higher upside and lower downside in the event you are wrong in your estimate of value. Given the difficulty of estimating value as the world is so complicated and complex, this is essential.
The final items of importance are behavioral. Many people can intellectually grasp the idea that an asset is worth the cash flows it will produce, that it is hard to predict such things so you can only do it well enough occasionally, and for that reason in addition to the allure of arbitrage paying less than value makes sense. But dealing with the reality of being patient and disciplined and waiting for prices to fall below intrinsic value before buying, holding on as they inevitably fall lower, and then waiting more for them to climb to value is a difficult thing for many. Many people are not wired for this, and you can watch it play out with every bust, and in fact this is a key reason why asset prices cycle so much to begin with. So in addition to the intellectual understanding discussed in prior paragraphs, value investors need a certain emotional ability to deal with lots of waiting and watching price declines.
To recap all of that, value investors find situations they can estimate with a reasonable degree of confidence, model out a range of cash flows of involved assets, determine the intrinsic value of those cash flows, buy those assets when the price available is meaningfully below intrinsic value, and then wait for prices to climb up to the value.
There is a lot deeper to go on all of the above – how to evaluate industry evolution, compare the industry participants, model pricing and cost trends, estimate cash flows, determine appropriate discount rates, determining an appropriate margin of safety, dealing with price/value movements with respect to portfolio management, and multiple more. But this is how I think about value investing at a high level.
Example
To ground all of this in an example, I thought it worth recapping an investment I made over the last year and a half that illustrates the above. I’m going to leave a lot of details out to keep this more illustrative of the above and less of a formal stock write-up.
I have followed Alliance Data Systems (ticker ADS) for 4 years or so. It has/had a few other segments, but its core business is partnering with various retail businesses and driving incremental retail sales by providing and managing credit card/reward programs. As a financial firm, ADS is a spread business that earns a high rate of interest on outstanding credit card receivables that it finances at a lower rate a debt. The gap of these two is large, but it has to cover credit card defaults and operating costs before anything is left over as profit.
ADS has undergone a lot of changes in the last several years including selling off one of its segments, completing large share repurchases, losing some ground in its legacy mall retailer clients but gaining some in other segments, and paying down debt. But, just a few years ago it earned $17/share, with “core” earnings estimated closer to $20. What was the right value for ADS? Hard to say. It used to be a growth company with excellent capital allocation and traded above 20 times earnings (a Price/Earnings, or PE ratio). But its credit card businesses had stalled to no growth and other segments had struggled, too. The PE ratio fell hugely in addition to the business troubles, and the stock had fallen from a peak of $275 a few years ago to $110 coming into 2020.
Then the pandemic hit. Imagine the concern investors had over a credit card company (i.e., leveraged) that had outsized exposure to brick and mortar retail in a period where the discretionary physical economy was shut down with a hugely uncertain future. In the span of a month, the stock fell from $100 to nearly $20.
Did this make sense? Well, it caught my eyes, as the stock was trading just over 1x what it had earned a few years ago, and likely could again in a post-pandemic world.
There were a few legitimate concerns as far as I was concerned. How long would the pandemic last, and therefore brick and mortar retail be hammered? Well, first ADS clients do not purely sell in brick and mortar, a detail seemingly glossed over, so its credit card businesses was not seeing $0 retail sales. A meaningfully reduced number, yes, but not zero. Presumably at some point the world would go back to something approaching previous normal with some brick and mortar sales, maybe 2-3 years in a negative scenario. The implication of this is the stock of credit card receivables would not be having additional balance added for a while.
But what about on the payment side? Would ADS see horrific credit card defaults, wiping out the equity? Well, the average ADS card holder is a woman with middle-upper class income. Historical charge off data is available. In the global financial crisis, charge offs hit a certain level, the worst in their history. Even under worse assumptions than that, ADS still had meaningful breathing room. And would the government step in and help consumers with some sort of stimulus, indirectly backstopping credit card defaults? A possibility, but unsure at the time.
So I looked at a situation where you could buy a business at a 1-2x what it was likely to earn again at some point in the future assuming the business could survive the next 2-3 years, which, given the composition and financial situation of its average cardholder and its past financial history, seemed extremely likely. I knew ADS was likely to report poor results for 2020, 2021, and even 2022 wasn’t likely to be great. But even if I assumed the pandemic took 3 years to recover, and no stimulus or assistance came, ADS would be able to survive its debt situation and shareholders buying at said prices would see earnings nearly equal to their purchase price in a year.
I went long around $29 and added more in the upper $30s. The pandemic progressed. Stimulus came. Governments responded, or didn’t. Management confirmed my views that even using the worst economic conditions modeled by credit agencies, they would be fine.
By February 2021, the stock was trading around $95. What was it worth? Should I continue to hold?
Well, one thing is for sure, it was less attractive than it was at $30. Whether I should hold was a hard thing to be sure of, the sort of classic "gray zone" situation that intellectually honest value investors will find themselves in the vast majority of the time.
Credit card balances are surprisingly stable, and ADS has managed the decline of its brick and mortar receivables well by moving into other verticals like Beauty and Pets. Maybe (but I wouldn't bet on it) a world exists in 15 years where people don’t carry nearly so much consumer debt, but even at $95 this thing was trading at a price where investors break even in 5-6 years, so we don’t need to model the future out that far, and even so there is a lot of data to suggest durability well beyond that.
I ended it closing my position out at an average price of around $95. I still thought it was cheap. I think it’s reasonable that ADS could get to $15 or higher of earnings per share again in a few years, but under my conservative modeling I thought $12 was highly certain. At a measly 10x multiple, this implied equity value of $120/share. At $95, ADS was trading at ~80% of my conservative estimate of its value. Attractive, yes. But taking the opportunity cost of other, less economically sensitive businesses on my watch list into consideration ADS was no longer was one of the highest uses of capital. So I moved on.
It’s worth noting that while many stocks had similar performance over that period, the risk involved in this one as compared with many others (say an airline or cruise line or movie theater chain that had extremely reduced revenue and material debt loads that would be defaulted on abruptly barring outside capital) was significantly lower, as this business did not face existential threat or massive equity impairment risk. This wasn’t a risky bet that worked out because of rapid vaccine development or government corporate/consumer assistance or shareholder optimism, but rather excessive pessimism brought on by a misunderstanding of the business. Ironically, stimulus checks and other assistance have hurt ADS to a degree as payment rates on credit card balances have been elevated, lowering the amount of interest collected.
This situation illustrates my value investing philosophy. I had followed ADS for several years before 2020, and understood its business well. I believe it to be fairly durable over the next 5-15 years that matter for this investing horizon. At pandemic lows, market pessimism pushed it down to something like 1-2x what the business was likely to earn again under mistaken assumptions of bankruptcy, which were not supported by historical performance or an understanding of their credit card receivable credit profile. I didn’t know exactly what intrinsic value was when I bought, but I was certain it was north of $75 under even horrendously negative projections, as in just a few years the cash flows of the business would cover my purchase price. So I put ~30% of my portfolio into a business at <50% of an extremely conservative estimate of value/20% of a more reasonable estimate of value, and then held on as market sentiment changed.
Takeaway and Reflections
Estimate value for what you can, buy for a lot less than that, wait for it to go up, sell. Repeat.
That’s value investing to me.
Happy to talk about this stuff if folks are interested. I don't participate in the Trading Log as it's sort of a different game, but this is what I try to spend a good chunk of my time doing - compounding financial capital while living off as little as possible, with the medium/long-term goal of reallocating profits/capital back into broader/non-self uses as I learn more about how financial capital can be best utilized to assist causes I support.
This quote of Lucky C's is an interesting take, related to what I'm doing (with the substitution in the first paragraph of "value investor" for "successful trader"), and the risks of what I'm trying to do if I fail:
Lucky C wrote: ↑Mon Feb 01, 2021 7:35 pmIf I can become a successful trader rather than investor, i.e. make more money than I would have buying & holding a traditional portfolio for the long term, then effectively I will be taking money from other investors and traders over time. At the end of our lives, I will have more wealth to spend as I see fit, and they will have less. If I spend more to benefit the environment (or at least harm it less) than they would have, then my involvement in trading is potentially a better impact to the world than if I just held bonds/cash/gold with little growth.
Similarly, trying to get better interest rates, investment returns, etc. can benefit the planet in the end if that's what you intend to do with your winnings. I wouldn't worry about my little contribution to money/banking while it's invested vs. what could be done when it's eventually put to good use outside of financial markets.
On the other hand, if I fail to beat the average investor, they will accumulate more wealth than me over time and I'm guessing will not use it in as environmentally-friendly ways as I would. So it's up to me to outcompete other investors/traders as well as I can, not for my own consumption or scorekeeping, but for the good of the planet! That's the way I see it over the long term anyway.
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. Hopefully those problems go away sooner than the standard ~12 weeks!