Today's Market Is Missing Valuation, Fundamental Metrics
Are value investors like Warren Buffett long gone?
For those of us who grew up with a nod to Graham and Dodd, efficient market theory, or even discounted cash flow, this is one tough time, as increased volatility, whipsaw-like moves, and technical “tells” seem to be in ascension. Perhaps this is the inevitable volatility reflecting the combined uncertainty about the upcoming elections, the outlook for global recovery, and general economic uncertainty, and Mr. Market is merely going through the inevitable digestion required after the gluttony of the last decade; but I'd posit that there's a bigger risk sitting in the wings. Should investors and professional money managers come to believe that metrics like P/E ratios, TEV to EBITDA, book values, hurdle rates, or WACC are meaningless and antiquated tools in the current post-Armageddon financial meltdown, it may be a long time before folks come back to the market and provide the necessary liquidity to break us out of the doldrums.
This is different than the maelstrom surrounding the last bubble, when Internet and tech analysts became enamored of revenues per click, or unsustainable and astronomic growth rates, and traditional value investors who had done their homework were able to avoid the meltdown. Math, like gravity, brought us all back to earth. So too, in the junk-bond meltdown in the late '80s, analysts who understood coverage ratios avoided the carnage and made out well by investing in bonds at 50 cents on the dollar in companies with strong fundamental cash flows. In each case fundamentals prevailed and there were enough market participants who used and analyzed accounting metrics to drive the market. The question today is whether or not that generation of investors has been discredited and has disappeared. Have Edwards and Magee finally beaten Graham and Dodd? Have momentum investing, computers, and flash trading killed the value investor?
At base, valuation is a function of estimating expected growth rates, required returns, and capital structure. The value of the firm is no more than the present value of the cash flows that can be realized by a reasonable management team managing an enterprise to rational expectations, with those cash flows accruing to either debt or equity holders, based on tax policy or capital structure decisions. Equity returns are a function of operating leverage (reading earnings growth) and financial leverage (read debt), with, believe it or not, some industries appropriately driven by the latter (think cable television or private equity) as much as the former (think technology or pharmaceuticals). Debt isn't necessarily a bad thing if you can generate the cash to pay the interest.
In the media industry (which I've spent a little time looking at) revenue expectations are driven by such drivers as taste, technology, macro economics, internal capital structure, or regulation. How management approaches the shifts in those drivers is the differentiator between high-flying stocks and laggards. Differing industries and sectors may be more impacted by one of those drivers, but interestingly we have yet to determine another industry other than Media which must respond to all five.
The challenge for the analyst and the investor is to determine the cash flows that can be realized (the real numbers behind “analysts estimates”) and then estimate the present value of the firm based on an investor’s required return. Comparing the estimated present value of the equity to the current market price establishes whether a stock is cheap or dear. This is hard work and requires a thorough understanding of industry dynamics, accounting and capital structures. Unfortunately many of these skills appear to be out of favor as too many analysts and traders spend time reading and reacting to the latest press release rather than digging into the latest 10-Q.
Now historically this has been good news, as it's just that kind of trigger finger that has enabled such value investors as Warren Buffett or Mario Gabelli to zig when every body else is zagging. Those investors come up with an estimate for the private market value of the firm and compare it to the public trading value. Some look for great managements and businesses that are out of favor, some for industries that will consolidate, arguing that those companies with the deepest discount to public market values in a consolidating industry are most likely to be taken over. Still other, more proactive LBO artists look to recapitalize a company by adding debt, improving cash flow, and then flipping the company to another buyer when the new value becomes apparent.
The problem is that it takes patience, a virtue that appears to be held in ever-diminishing amounts in a world seeking instant gratification and by investors with 200% turnover. For now we still continue to back the tortoise and look for opportunity where we can find it, but boy is that rabbit kickin’ up a lot of dust!
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