What valuation is too high to buy a great compounder?

[tnathan]

Hi all -- 

 

I've posted a few times but relatively new to the board and to investing. To me there's two clear camps in value investing: 1) cigar butt and 2) investing in longer term compounders. It seems that #2 is the way to go, especially as it lends itself to less stress - I look at Akre's portfolio as a good example of this strategy. However, I find myself having trouble understanding at what p/e or fcf multiple I should be buying at. Obviously the lower the better, BUT WHAT LEVEL IS TOO HIGH?

 

Looking at a couple long term winners such as BFAM, Che, AMED, WSO, KMX, USPH, Goog, MSFT is paying 30x earnings or cash flow too high? I believe all of these plays have the opportunity to reinvest for many years (Decades) at high returns on capital, so does the price today even matter?

[KJP]

You can google something like "reinvestment rate, ROIC and multiple" and get examples of the math underlying forward returns at various current mulitples.  See, e.g., https://sabercapitalmgt.com/importance-of-roic-part-4-the-math-of-compounding/

[mcliu]

I think price matters because there are constraints in any ecosystem.

How many multi-trillion dollar companies can grow at high 15% rates for decades before they takeover the world?

15% for 20 years = 16x. FAANGM market cap around $10T so if they compound at 15% for 20Y they'll be at 160T. Maybe less cause of buybacks & reduced share counts. But still a huge #. World GDP today is maybe $80T compound at 3% for 20Y = $140T

[tede02]

I always think about this in terms of simple compounding math. For example, how much will profits grow over 10-years if a company compounds at 15%, 20% or 30%? The numbers are pretty amazing:

 

1. At 15%, earnings are up 3.5X

2. At 20%, earnings are up over 5X

3. At 30%, earnings are up over 10X

 

To me, this illustrates why rapidly growing companies are worth very high multiples. If you paid 30X earnings for a business growing at 30% annually for a decade, by year 10 you'd be earning 33% on your original investment. Even if the growth rate really slowed in the second decade, you'd still come out very good. This math, as basic as it is, really has helped me evolve after being indoctrinated with value investing principles very early on (and as a consequence, missing a lot of great businesses because the multiple looked rich). 

[SharperDingaan]

The best one can do is estimate how long a company will continue to perform at its current level, and whether that will be enough to double your money.

If the current ROE is 12%, it will take roughly 6 years to double (72/12). If you think the company can maintain its current competitive advantage for another 6 years, maybe its a good investment. If you expect competitors to appear and screw up the party - maybe it's time to look elsewhere.

 

If the company ends up growing faster .. you just get to a double sooner than expected.

If you're not getting the 12% YoY growth? sell and invest the money elsewhere.

 

No rocket science required.

 

SD

 

 

 

[Dave86ch]

This chart from a Terry Smith presentation could be interesting.

Even if in my opinion great results require a contrarian attitude.

[Spekulatius]

^ Well, 7% since 1973 are a disaster though. The hurdle rate should be equal to the returns from an index fund during the same timeframe. An online calculator I found states that the return for the SP500  since 1973 were 11.5% with dividends.

 

EDIT: I see he compared this with the MSCI world index, but most stocks are US listings, so SP500 would have been more adequate.

https://dqydj.com/sp-500-return-calculator/

Edited December 30, 2021 by Spekulatius

[glider3834]

I think the trick is to pick up a great compounder at a reasonable multiple- MSFT, AAPL have all had periods where they sold at or below 15x earnings & so you get both multiple expansion plus earnings growth plus downside protection.

 

When you pay 30-40x earnings then you can't afford for anything to go wrong - BABA is a classic example - it looked like a great compounder when the PE was in the 40s from 2016-2018 & now shares are trading well below avg 2018 levels, because you have had multiple compression!

[glider3834]

Just now, glider3834 said:

I think the trick is to pick up a great compounder at a reasonable multiple- MSFT, AAPL have all had periods where they sold at or below 15x earnings & so you get both multiple expansion plus earnings growth plus downside protection.

 

When you pay 30-40x earnings then you can't afford for anything to go wrong - BABA is a classic example - it looked like a great compounder when the PE was in the 40s from 2016-2018 & now shares are trading well below avg 2018 levels, because you have had multiple compression!

I think extremely low interest rates have fueled some very high PE multiples & I think we are moving to higher rates of 2% plus next year & so I think we all need to be careful. But I am generalising with above comments, if you find a company selling for 30x earnings & you have done your research & you are extremely confident it can continue powering away at 30% per annum earnings growth for the next 5 years then sure 30x earnings is reasonable. And if you can get the same company at 20-25x PE then you will do even better.

[Gregmal]

Whatever Costco is trading at…

[mcliu]

re:Terry Smith's chart, hindsight bias

[SharperDingaan]

On 12/30/2021 at 2:40 PM, SharperDingaan said:

The best one can do is estimate how long a company will continue to perform at its current level, and whether that will be enough to double your money.

If the current ROE is 12%, it will take roughly 6 years to double (72/12). If you think the company can maintain its current competitive advantage for another 6 years, maybe its a good investment. If you expect competitors to appear and screw up the party - maybe it's time to look elsewhere.

 

If the company ends up growing faster .. you just get to a double sooner than expected.

If you're not getting the 12% YoY growth? sell and invest the money elsewhere.

 

No rocket science required.

 

SD

 

 

 

 

Just to expand on this .....

What if you were willing to go long on a dividend paying XYZ, at 50% margin? i.e. Two shares of XYZ, one share paid for in full, one share entirely on margin; dividends on the two shares owned > interest on the margin debt incurred. At a leverage ratio of 2:1, a double in 6 yrs only requires a ROE of 6% (72/doubling period/leverage ratio), and this is a great many dividend paying companies.

 

FFH has a ROE > 6%. Closed at CAD 623 and a CAD/USD FX rate of 1.2705 yesterday. USD 10/yr dividend. Assume a margin cost of 4%  

Annual interest cost would be CAD 623 x 4%; CAD 24.92. Annual dividend would be 2 x USD 10 x 1.2705; CAD 25.41. Net positive carry.

 

If you  believe the current ROE (>6%) will continue for at least 6 yrs, and that FFH will trade at roughly 1.0X BV, you will more than double your money.

Your margin of safety is also the current ((ROE-6%)/ROE x100%. If you think the historic CAGR holds up, and assumed 10%; the MOS is roughly 67%.

And .... this is the baseline expectation.

 

Higher dividends, trading round-trip gains/losses, better pricing metrics ... and the margin debt declines.

Improving expectations.

 

Obviously there is risk here, as FFH is not a Sched-A (DSIB) issued Guaranteed Investment Certificate (GIC)

However. substitute FFH for any one of those Sched-A Banks, and would get multiple times the GIC return; on the same risk 

 

Happy New Year!

 

SD

 

 

 

 

Edited January 3, 2022 by SharperDingaan

[K2SO]

It will be time to buy stocks again, in size, when the term "compounder" is forever shunned. 

[scorpioncapital]

I am very confused about one point. Say you calculate the fair value (intrinsic value) of a stock to be $100. This incudes a discounted guess of future cash flows.

Does it mean that I MUST buy the stock BELOW $100 if I want to receive *any* return at all? Or does it mean if I buy it at $100 I get only the growth from the profits based on ROIC? In other words, do I have to buy the stock at $50 to get a 20% return over 3.4 years (assuming it re-rates to IV in 3.5 years) or I can buy it at $100 and get say the 10% rate of return that is implied in the IV calculation?

[Gregmal]

Just now, scorpioncapital said:

I am very confused about one point. Say you calculate the fair value (intrinsic value) of a stock to be $100. This incudes a discounted guess of future cash flows.

Does it mean that I MUST buy the stock BELOW $100 if I want to receive *any* return at all? Or does it mean if I buy it at $100 I get only the growth from the profits based on ROIC? In other words, do I have to buy the stock at $50 to get a 20% return over 3.4 years (assuming it re-rates to IV in 3.5 years) or I can buy it at $100 and get say the 10% rate of return that is implied in the IV calculation?

 

Personally I think this sort of framework is ALL wrong. Similar to the other thread where @Parsad mentioned how if you dont follow macro, you are just guessing...bc guess what? Show me a macro guy who's consistently forecasting every twist and turn of the market, consistently....there's none. Buffett even says dont waste time on some of this stuff. Anybody who is pretending to calculate an IV on a company and tells you its anything but guesswork is lying. Is there ONE person out there who can show me a PRE blastoff DCF correctly calling AAPL, DPZ, GOOG, COST, WM, V, etc? Everyone I know who has tried using that framework..missed them entirely, or bought them, and then sold many bags ago....at best being delegated to rebuying at higher prices trying to squeeze out the next "forecasted" 25% to IV. Its a sham. I mean didnt we just see a hedge fund dude pitch PTON at $90 AT SOHN! using a DCF or some crap model?

 

A better approach is to try and get familiar with where a company is in its growth cycle. What type of brand and earnings power there may be; and also triangulate the qualitative state of things. TAM is relevant to the extent the brand and management are top notch. Where are the moats or advantages? Will they need capital to grow? 

 

I would also throw in that the spread sheet analysis isnt useless, but probably better suited for private investment and relevant to those buying whole companies and thus expecting to rely on the cashflow and all that good stuff. But investing in public markets is a different game. Too few people realize this. 

 

There's no right answer but there's certainly wrong ones. Key is staying flexible and managing your positions and risk through sizing. Would also recommend reading through the COST thread. That one is enlightening. 

[scorpioncapital]

Insensitivity to price may not be a disaster on a quality name but it surely risks disappointing returns.

I remember Buffett said you should be in the same neighborhood for IV, the same order of magnitude even if you are off by 50% its fine, as long as you are not off by 1000%.

 

 

[Kupotea]

Take VC investing. The average investment may be at 10x-100x sales or whatever but at the correct growth rate an investor can still make huge returns. To Gregmal's point there is no multiple too high and no multiple too low depending on the specific company in question.

 

https://future.a16z.com/entry-multiples-dont-matter/

 

Now the better question is can you reasonably forecast for massive growth? Many value investors would say that's too hard and so they stick to cigar butt investing. There's nothing inherently wrong with either approach as long as you're good at it.

[scorpioncapital]

8 hours ago, Kupotea said:

Take VC investing. The average investment may be at 10x-100x sales or whatever but at the correct growth rate an investor can still make huge returns. To Gregmal's point there is no multiple too high and no multiple too low depending on the specific company in question.

 

https://future.a16z.com/entry-multiples-dont-matter/

 

Now the better question is can you reasonably forecast for massive growth? Many value investors would say that's too hard and so they stick to cigar butt investing. There's nothing inherently wrong with either approach as long as you're good at it.

 

This is too extreme. Neither VC nor cigar butts are desirable for me. What's wrong with being balanced and doing GARP? Garp has been very successful for me with low risk. But my question was more about estimating IV and how wide a range it can be to trigger a purchase today. If I do a range analysis and it comes back $2000 to $4000, and the stock is at $2700, I should not expect a great return no matter how Sexy a business it is. I would have to be massively wrong.

[ValueArb]

Imagine there were only two types of investments available, and you have to pick one at the beginning of each year and hold it for a year before switching.  The "safe" types usually pay 10% a year, but they go to zero 1% of time. The "yolo" types return 100% but go to zero 50% of the time.

 

Now you analyze expected value, and see that the safe type is by far the most profitable over time. The safe expectation is 9% a year, while the yolo expectation is to break even. Being a smart, conservative investor, you only pick safe investments. So every year your portfolio increases 10% a year and after 4 years your up almost 50%. But meanwhile, many people (who are evidently less smart than you) pick yolo investments, and some of them have won every year and are up 800%. 

 

You decide you want more income, but don't want to take more risk. So you decide to start a podcast to talk about how to steadily generate solid returns. But few listen because they all subscribe to YOLO podcasts by investors up 800% named Chamath. And worse, the 1 in 25 "value" investors who chose your same approach but were unlucky enough to go broke keep calling into your podcast and berating you for saying safe investments are safe, and calling you a charlatan.

 

Thats when you realize you should have been a YOLO investor.

[Blugolds]

25 minutes ago, ValueArb said:

Imagine there were only two types of investments available, and you have to pick one at the beginning of each year and hold it for a year before switching.  The "safe" types usually pay 10% a year, but they go to zero 1% of time. The "yolo" types return 100% but go to zero 50% of the time.

 

Now you analyze expected value, and see that the safe type is by far the most profitable over time. The safe expectation is 9% a year, while the yolo expectation is to break even. Being a smart, conservative investor, you only pick safe investments. So every year your portfolio increases 10% a year and after 4 years your up almost 50%. But meanwhile, many people (who are evidently less smart than you) pick yolo investments, and some of them have won every year and are up 800%. 

 

You decide you want more income, but don't want to take more risk. So you decide to start a podcast to talk about how to steadily generate solid returns. But few listen because they all subscribe to YOLO podcasts by investors up 800% named Chamath. And worse, the 1 in 25 "value" investors who chose your same approach but were unlucky enough to go broke keep calling into your podcast and berating you for saying safe investments are safe, and calling you a charlatan.

 

Thats when you realize you should have been a YOLO investor.

This cracked me up…and its irritating…not the fact that some kids stuck some money in a YOLO stock and hit big…thats just dumb luck, there are people every day that go down to the casino and bet red/black at the wheel…its the plethora of YouTube channels ie XYZ FINANCE all proclaiming to have the inside tip, and evidently they are all technical experts..I’ve never heard so many people that couldn’t read a basic balance sheet talking about investing in MEME stonks and crypto…from the waitress at the cafe to the neighbor kid next door and everyone in between…they all KNOW what their talking about…ask them in conversation what they thought about the I-bond yield at 7% and they Bert stare you..ask them any basic question and no clue. If/when we ever get more volatility (tongue in cheek) there are gonna be a TON of people in for a ride. I have heard that things were similar during the dot com era, but I don’t remember it, or at least it wasnt the discussion among my cohorts..it would be interesting to know the percentage increase of folks in the markets today, dot com we didn’t have robinhood trading from everyone’s cellphones, reddit, social media (A girl I went to HS with that works at GreatClips posting stock tips on her FB srs )  this all ads to the irrational exuberance. 

[scorpioncapital]

sometimes I think YOLO markets accelerate financial instability and lead to much bigger crashes. Maybe that argues for holding more cash equivalents.

[Kupotea]

15 hours ago, scorpioncapital said:

 

This is too extreme. Neither VC nor cigar butts are desirable for me. What's wrong with being balanced and doing GARP? Garp has been very successful for me with low risk. But my question was more about estimating IV and how wide a range it can be to trigger a purchase today. If I do a range analysis and it comes back $2000 to $4000, and the stock is at $2700, I should not expect a great return no matter how Sexy a business it is. I would have to be massively wrong.

I agree with what you're saying and was just using extreme examples to make a point. At the end of the day what matters is how confident you are in the IV and discount to that valuation given your projected time-frame. If you have a wide range in value then you should size the position accordingly.