The Quality Qaundary
Randall Abramson, CFA Newsletter Excerpts
As value investors, we are always on the lookout for bargains—stocks or bonds that are trading at prices below our estimate of Fair Market Value (FMV). Both research and common sense dictate that the greater the discrepancy between price and FMV, the better—it provides a higher possible margin of safety and implied upside. However, securities are often detached from their FMVs because the business is suffering, leaving investors to figure out whether the issues at hand will be minor and temporary or debilitating and permanent.
Buying the most statistically undervalued companies can be quite lucrative but can also expose investors to deteriorating businesses—some are clearly cheap for a reason. On the other end of the spectrum, the highest quality businesses tend to be fully priced—some unduly, due to their popularity—so high quality investment opportunities can be scarce. Hence, the quality quandary.
Investors generally fall into two camps. Value investors usually dwell in the bargain basement bin. In the other camp, which comprises most investors, are growth or momentum investors, who tend to gloss over valuation work as they prize business metrics over all else. Our philosophy requires both—a high quality business at an attractive valuation. Simply stated but not easily executed, because it requires additional analysis to determine a company’s lasting competitive advantages and the patience to await a price sufficiently below our FMV estimate to justify a potential outsized rate of return.
Our own philosophy has evolved. In years past, we emphasized the more undervalued opportunities, still preferring good businesses but valuation was a key driver. In emphasizing undervaluation, we held some less predictable businesses. Our migration toward higher quality businesses was motivated by our desire to have fewer clunkers—to lower the number of losers and to shrink the size of the losses.
We aim for more winners than losers. Who wouldn’t? And, to maximize the gains from our winners while minimizing the losses from our losers. But, again, simple to say, harder to achieve.
The better the business, the more predictable are its earnings. The more predictable the earnings, the easier it is to estimate the value with relative confidence. Companies that are less susceptible to competitive threats, with higher returns on capital and efficient balance sheets, are usually the steady growers. Therefore, these companies are more likely to have consistently rising FMVs. While certain companies trade at low valuation multiples, appearing undervalued, and can provide tremendous upside should the business improve, the risk of erring in our analysis, we believe, is substantially increased when the business has less predictability. That’s the reason we often invest in companies trading at 20% discounts to our FMV appraisals, rather than those trading at perhaps larger discounts, as high quality companies typically don’t detach too far from intrinsic value.
In between unanalyzable companies—the impossible ones to predict—and the highly predictable ones, lie most businesses, a wide swath for whose trajectory is less certain. These companies often have too many moving parts, too many competitors, are too levered—both financially and operationally (from high fixed cost structures)—and therefore are overly vulnerable to sudden changes in the landscape (i.e., new entrants, falling demand, higher interest rates, or regulatory changes). For these reasons we find ourselves mostly passing over opportunities which are potentially high reward but equally, if not more so, high risk.
Even though, in the last few years, the markets have been much less volatile, there are still enough instances where the shares of high quality companies fall to at least a 20% discount, allowing us to build a diversified portfolio. Usually, a 20% discount is as good as it gets for high quality companies. Only at the depths of bear markets, when everything’s on sale, can one normally find superb companies at larger discounts.
This article has been excerpted and edited from our quarterly newsletter to clients dated September 7, 2018.
Randall Abramson, CFA
President & CEO,
Portfolio Manager
DISCLAIMER
The information contained herein is for informational and reference purposes only and shall not be construed to constitute any form of investment advice. Nothing contained herein shall constitute an offer, solicitation, recommendation or endorsement to buy or sell any security or other financial instrument. Investment accounts and funds managed by Generation PMCA Corp. may or may not continue to hold any of the securities mentioned. Generation PMCA Corp., its affiliates and/or their respective officers, directors, employees or shareholders may from time to time acquire, hold or sell securities mentioned.
The information contained herein may change at any time and we have no obligation to update the information contained herein and may make investment decisions that are inconsistent with the views expressed in this presentation. It should not be assumed that any of the securities transactions or holdings mentioned were or will prove to be profitable, or that the investment decisions we make in the future will be profitable or will equal the investment performance of the securities mentioned. Past performance is no guarantee of future results and future returns are not guaranteed.
The information contained herein does not take into consideration the investment objectives, financial situation or specific needs of any particular person. Generation PMCA Corp. has not taken any steps to ensure that any securities or investment strategies mentioned are suitable for any particular investor. The information contained herein must not be used, or relied upon, for the purposes of any investment decisions, in substitution for the exercise of independent judgment. The information contained herein has been drawn from sources which we believe to be reliable; however, its accuracy or completeness is not guaranteed. We make no representation or warranties as to the accuracy, completeness or timeliness of the information, text, graphics or other items contained herein. We expressly disclaim all liability for errors or omissions in, or the misuse or misinterpretation of, any information contained herein.
All products and services provided by Generation PMCA Corp. are subject to the respective agreements and applicable terms governing their use. The investment products and services referred to herein are only available to investors in certain jurisdictions where they may be legally offered and to certain investors who are qualified according to the laws of the applicable jurisdiction. Nothing herein shall constitute an offer or solicitation to anyone in any jurisdiction where such an offer or solicitation is not authorized or to any person to whom it is unlawful to make such a solicitation.
As value investors, we are always on the lookout for bargains—stocks or bonds that are trading at prices below our estimate of Fair Market Value (FMV). Both research and common sense dictate that the greater the discrepancy between price and FMV, the better—it provides a higher possible margin of safety and implied upside. However, securities are often detached from their FMVs because the business is suffering, leaving investors to figure out whether the issues at hand will be minor and temporary or debilitating and permanent.
Buying the most statistically undervalued companies can be quite lucrative but can also expose investors to deteriorating businesses—some are clearly cheap for a reason. On the other end of the spectrum, the highest quality businesses tend to be fully priced—some unduly, due to their popularity—so high quality investment opportunities can be scarce. Hence, the quality quandary.
Investors generally fall into two camps. Value investors usually dwell in the bargain basement bin. In the other camp, which comprises most investors, are growth or momentum investors, who tend to gloss over valuation work as they prize business metrics over all else. Our philosophy requires both—a high quality business at an attractive valuation. Simply stated but not easily executed, because it requires additional analysis to determine a company’s lasting competitive advantages and the patience to await a price sufficiently below our FMV estimate to justify a potential outsized rate of return.
Our own philosophy has evolved. In years past, we emphasized the more undervalued opportunities, still preferring good businesses but valuation was a key driver. In emphasizing undervaluation, we held some less predictable businesses. Our migration toward higher quality businesses was motivated by our desire to have fewer clunkers—to lower the number of losers and to shrink the size of the losses.
We aim for more winners than losers. Who wouldn’t? And, to maximize the gains from our winners while minimizing the losses from our losers. But, again, simple to say, harder to achieve.
The better the business, the more predictable are its earnings. The more predictable the earnings, the easier it is to estimate the value with relative confidence. Companies that are less susceptible to competitive threats, with higher returns on capital and efficient balance sheets, are usually the steady growers. Therefore, these companies are more likely to have consistently rising FMVs. While certain companies trade at low valuation multiples, appearing undervalued, and can provide tremendous upside should the business improve, the risk of erring in our analysis, we believe, is substantially increased when the business has less predictability. That’s the reason we often invest in companies trading at 20% discounts to our FMV appraisals, rather than those trading at perhaps larger discounts, as high quality companies typically don’t detach too far from intrinsic value.
In between unanalyzable companies—the impossible ones to predict—and the highly predictable ones, lie most businesses, a wide swath for whose trajectory is less certain. These companies often have too many moving parts, too many competitors, are too levered—both financially and operationally (from high fixed cost structures)—and therefore are overly vulnerable to sudden changes in the landscape (i.e., new entrants, falling demand, higher interest rates, or regulatory changes). For these reasons we find ourselves mostly passing over opportunities which are potentially high reward but equally, if not more so, high risk.
Even though, in the last few years, the markets have been much less volatile, there are still enough instances where the shares of high quality companies fall to at least a 20% discount, allowing us to build a diversified portfolio. Usually, a 20% discount is as good as it gets for high quality companies. Only at the depths of bear markets, when everything’s on sale, can one normally find superb companies at larger discounts.
DISCLAIMER
The information contained herein is for informational and reference purposes only and shall not be construed to constitute any form of investment advice. Nothing contained herein shall constitute an offer, solicitation, recommendation or endorsement to buy or sell any security or other financial instrument. Investment accounts and funds managed by Generation PMCA Corp. may or may not continue to hold any of the securities mentioned. Generation PMCA Corp., its affiliates and/or their respective officers, directors, employees or shareholders may from time to time acquire, hold or sell securities mentioned.
The information contained herein may change at any time and we have no obligation to update the information contained herein and may make investment decisions that are inconsistent with the views expressed in this presentation. It should not be assumed that any of the securities transactions or holdings mentioned were or will prove to be profitable, or that the investment decisions we make in the future will be profitable or will equal the investment performance of the securities mentioned. Past performance is no guarantee of future results and future returns are not guaranteed.
The information contained herein does not take into consideration the investment objectives, financial situation or specific needs of any particular person. Generation PMCA Corp. has not taken any steps to ensure that any securities or investment strategies mentioned are suitable for any particular investor. The information contained herein must not be used, or relied upon, for the purposes of any investment decisions, in substitution for the exercise of independent judgment. The information contained herein has been drawn from sources which we believe to be reliable; however, its accuracy or completeness is not guaranteed. We make no representation or warranties as to the accuracy, completeness or timeliness of the information, text, graphics or other items contained herein. We expressly disclaim all liability for errors or omissions in, or the misuse or misinterpretation of, any information contained herein.
All products and services provided by Generation PMCA Corp. are subject to the respective agreements and applicable terms governing their use. The investment products and services referred to herein are only available to investors in certain jurisdictions where they may be legally offered and to certain investors who are qualified according to the laws of the applicable jurisdiction. Nothing herein shall constitute an offer or solicitation to anyone in any jurisdiction where such an offer or solicitation is not authorized or to any person to whom it is unlawful to make such a solicitation.