My Approach to Valuation
On July 07, 2020, Charlie Songhurst, former Head of Strategy at Microsoft, appeared at Patrick O’Shaughnessy’s podcast “Invest Like the Best”. Mr. Songhurst invested in 483 companies, and it is one of the best episodes I have listened to in this year. At one point he mentioned the following on how analysts based on the East Coast and the West Coast look at businesses differently:
“And then I think there's some interesting little sort of cultural foibles possibly with an actual dress by the East and West Coast, but more by the nature of investing, maybe what people do as analysts between the age of 21 and 23. So if you spend your time between 21 and 23 building Excel models, you tend to think more about numbers. And so you tend to have a much better intuition for margin economics. And so where is the East coast often right over the West about the way they look at businesses, it's they correctly identify businesses with shaky unit economics, but fast revenue growth and “good” product market fit. And they're like: “Look, you have product-market fit, but only because you're giving away $100 to 90. So of course you've got good product market fit.”
I'll give the sort of counterpoint where West Coast investors do very well, is where you have a product lead that doesn't get evinced in the numbers immediately, but it's such a sort of tactile and visceral experience when you use it, you have to make an imaginative leap to turn that into numbers. And there are two examples. One is the iPhone, and I was doing some investigations for Microsoft at the time. And it was always easier to talk back competitors than talk about yourself because you're less likely to say something you shouldn't. So you always try and steer the conversation to talking about Apple, Google or something. And one of the things you realized is there was a bunch of investors that sort of thought Apple was overvalued when it was sort of a hundred, 200 billion market cap, because they took the TAM of Nokia and said, even if they take all Nokia's market share, this business can't be big because phones only sell whatever it was back then. And they couldn't intuit the increase in pricing power that you are going to get from turning the phone into a computer. And the West Coast, VC community immediately intuited that.
And then you see the same in this sort of almost comic battle over Tesla as a stock. The Apple one, we can say it's a win on the West Coast. The Tesla story isn't fully written yet. But again, it's this difference between a culture that says look, this product is so amazing, it will define its own category, and other investors saying, when you look at this in a spreadsheet, it just doesn't work.”
I often think about this quote, and while I do believe I am naturally more inclined to the narrative, I was trained to focus on the numbers (spreadsheet) in business school and at my former role in the buy-side. As a result, my approach to businesses or valuation is somewhat mixed. If I hazard a guess, it is perhaps 60/70% East coast, and 30/40% West coast. The east coast approach is likely to stop you from investing in companies that will eventually go to zero, but the west coast approach is likely to help you invest in the moonshots which can potentially not only recover all those zeros but also generate outsized returns. So, there is certainly a place and time for both these approaches.
I come across arguments every now and then on twitter how Buffett/Munger never builds any excel model and how analysis paralysis leads to destruction of alpha. Analysis paralysis is real, and it is important to avoid it.
So, what does exactly Buffett do? “Take the probability of loss times the amount of possible loss from the probability of gain times the amount of possible gain. That is what we’re trying to do. It’s imperfect, but that’s what it’s all about.”
If you have read either of my deep dives published so far (Uber, and Etsy), you know that I do build spreadsheet models. It’s a fair question why we even bother to build these models when such investing legends don’t bother to do it.
I think most people seriously underestimate the distance between our intelligence/skill and Buffett/Munger’s skills. They may act like two friendly grandpas, but can you sit for a while and think who are we talking about? We are talking about two nonagenarians who are somehow still intellectually capable of managing a ~$500 Bn market cap company. These are the people who made their greatest dollar return investment (Apple) in the History of investing at the very late stage of their lives. You and I would be lucky to speak a full intelligible sentence when we are 90 years old. Buffett reads 500 pages a day, and most of us will probably find it difficult to read 500 tweets every day. The more I read about him, the more convinced I am that people do not understand just how downright incredible these two guys are. What they do is certainly worth noticing, and perhaps even copying. But imitating bits and pieces and conveniently ignoring other important details can be potentially dangerous. Let’s not kid ourselves thinking that coming up with probability of losses/gains or the amount of gains/losses will be any less difficult or will work any better for us than building an excel model.
I build the model because it suits me. Not because I believe I am going to generate massive alpha by building beautiful excel models, but because I genuinely believe it helps me understand and visualize the business a little better than just by consuming 10-ks or earnings transcripts.
Here is my first and most important rule while building an excel model: Do not take your model too seriously. Anyone can make a DCF sing. And I also do not believe I have any special ability to come up with long-term forecasts for any company in any industry. Anyone who feels confident about long-term forecasting should take a peek at this.
It’s good to explicitly outline your limitations. Once you know the limitations, it is easier to figure out how to tackle the shortcomings. My approach to valuation is simple. I call it a “belief+ thinking” approach. Broadly speaking, there are two steps:
Step 1: What do I have to believe to generate a decent IRR from this investment?
Step 2: Do I think the assumptions I need to believe to generate such IRR are reasonable?
Let’s unpack a little on each of these steps now.
The first question that comes to one’s mind in step 1, what is a decent IRR?
In a ZIRP world when trillions of dollars of bonds are trading at negative yield, it is indeed a hard question to answer with strong conviction.
Nonetheless, every asset class is interconnected. No asset class trades in a vacuum and what happens in one asset class influences other ones as well.
If the company I am looking at has a long-dated (5-10 years) senior unsecured bond trading in the market, I look at its current Yield-to-Worst (YTW). Since shareholders are at the bottom of the capital structure waterfall, shareholders should obviously demand more return than long-dated senior unsecured bondholder. I typically add 300-400 bps to longer dated senior unsecured bond’s YTW.
While there’s no hard and fast rule in terms of how much you want to add, 300-400 bps is typically a reasonable range.
What if there is no publicly traded bond for the company? I would then take a look at the default spread for Baa rated bonds in Investment Grade (IG) credit market. Historically, in addition to treasury yields, equity market priced 2-2.5 times the spread of IG Baa rated bonds. This currently implies 6-7% IRR as “decent” return. Damodaran had a paper on this (See pages 116-120). We don’t have to get it right on the decimal level; I try to just get to a ballpark figure.
Once I figure out what a decent IRR should be for a company, I try to build a model to derive such IRR. This is essentially known as reverse DCF or Expectations Investing. Although in theory it may sound easy to build a reverse DCF, it can be tricky too.
There are many ways to generate a particular IRR. If you grow topline faster, your margin assumptions may not have to be aggressive to generate that IRR. Alternately, if you aggressively expand margins, you can afford to grow the topline slower. There are nuances like this in other areas of the model as well (capex and working capital management assumptions for example). So even in a reverse DCF, there is space to reflect some (although not fully) of your opinions on the business in the model.
I want to emphasize that DCF or reverse DCF is, of course, not without its limitations. Things such as resilience of the business, optionality (potential S-curves), or perhaps the CEO being the force of nature are not easy to capture in a DCF/reverse DCF framework. So, I strongly discourage blindly following whatever number the model spits out.
The reason I lean to reverse DCF rather than a typical DCF model is I do not have high confidence on anyone’s, let alone my ability to forecast what will happen 5-10 years down the line. Therefore, a reverse DCF tends to explicitly tell me what I need to *believe* to generate a decent IRR. It’s not what I think will happen rather it is what I need to believe before investing in this business. It is an important distinction that may not sound all that different the first time you read it.
In the Step 2, I eyeball the assumptions and I ask myself based on my readings and understanding of the business, how comfortable I am with these assumptions. When I am very comfortable with the assumptions and grow some conviction for the business to beat these assumptions (although I don’t spend too much time on by how much), I end up buying the businesses.
If I were a subscriber to “MBI Deep Dives”, this is how I would try to utilize the models and deep dives. I would read the deep dives, write down the questions that were raised or/and the issues/points that were not well explained, and dig deep into those questions/points to try to figure out those answers myself to find more conviction. I would then download the models, and build my own narrative by incorporating my own assumptions into the model to come up with probable IRR estimates on an investment. I would most certainly not make it a habit of buying/selling stocks because someone else on the internet is bullish/bearish on them. It’s certainly not a bad idea to borrow ideas from others, but if you do not do the work yourself, it is impossible to build conviction. Without conviction, you would be tempted to sell stocks at the first sign of turbulence. If that continues over your investing career, you are likely to generate subpar investment returns.
My level of comfort, understanding of the business, competitive dynamics, management quality, their incentives, and capital allocation policies will eventually dictate weighting in my portfolio. These are more qualitative than quantitative process. Since I am an individual investor, I want to have a portfolio of 10-20 stocks (currently I have 11) so that I can actually follow these stocks and listen to their earnings calls. I try to initiate positions at 5-10% weights, with 10% typically implying more conviction than the one initiating at 5%.
As you can see, I do not come up with any price targets. I truly believe most of us will own the great businesses of our time at some point in our portfolios. Unfortunately, most of us will sell those fantastic businesses too soon.
This may sound a bit counterintuitive but while I may not want to buy a stock because of lofty valuation, I would *almost* never want to sell a stock that I already own because of valuation reasons. Lawrence Hamtil recently mentioned in one of his tweets that he sees investment as “business collecting” endeavor. I loved that term, and perhaps that is what I am trying to do as well. We would be foolish to think we can come up with target prices for stocks with any level of accuracy over the long term, but I am more optimistic about our prospects of finding great businesses at reasonable valuation and then hold onto it unless fundamentals start deteriorating. Akre capital mentions three specific reasons for selling a business that they own:
“Even with the power of compounding firmly in mind, there may be times when we believe it is appropriate and necessary to sell. These include, but are not limited to, when a business (1) is no longer growing at an above-average rate, (2) has had its competitive advantage impaired, or (3) has had an adverse change in management.”
While I am not an esteemed member of the #NeverSell community, my approach is much closer to them than it is to hyper-focused valuation community. There is no perfect way to approach valuation, but we need to find one that suits us and an approach that we can stick to across different market cycles.
I will publish my deep dive on Lululemon Athletica soon (likely Friday next week). Subscribe here to stay updated. Thank you for reading.