Can buying over-valued stocks be value investing?

[jfan]

A Thought Experiment

 

It is common occurrence where overvalued companies often issue shares to purchase other businesses. If the other business is cheap, you can create a roll-up strategy that incrementally puts the expensive multiple on the cheaply valued acquisition cash flows (if there is any). The problem is that most of these acquirers, overpay, over-estimate the synergies, under-estimate the integration costs, and with ever enlarging human capital, there are diseconomies of scale aka bureaucracy.

 

Now what happens if you do have a good capital allocator, who does actually use their expensive shares to buy truly inexpensive/undervalued assets and has the ability to do this over and over again?

 

Most of these stocks are often expensive and have a price chart that is up and to the right. But most value investors want to pay for things that are cheap, with low expectations. It is quite comfortable for them to pay for a business that has a declining price, and with some work, decided that the consensus is wrong, and expectations are far too low, and cheer when the business buys back its stock.

 

However, this former over-valued case, it too creates value, just in the opposite direction. But it feels really weird for traditional value investors to buy such things. 

 

So let's accept this weirdness for a moment, what sort of asset characteristics would be a great purchase?

1) requires little maintenance capex

2) has potential to appreciate by adding adjacent revenue streams, increasing network effects for the acquiring business, allows you to marginalize other competitors

3) low risk for integration

4) high certainty of synergies

4) truly undervalued/underappreciated at the current purchase price.

 

Now let's say, this company can keep doing this, and eventually get taken up into a major index. Now the index investors who are not price conscious, are forced to keep buying the marginal shares. This increases the stock price further, which allows the capital allocator to issue more shares to purchase more undervalued assets. So from an asset/share point-of-view, you the minority shareholder, gets more assets/share incrementally despite more absolute shares joining the float.

 

a) Should you entertain investing in these businesses?

b) Would you pay a premium to Net asset value for such a business? And if so, how much of a premium?

c) How and when would you decide to buy them?

 

Examples of the top of my head

- Facebook buying WhatsApp and Instagram

- Franco Nevada issuing shares to purchase more royalties

- MicroStrategy issuing shares to buy BTC

 

[Xerxes]

Best example would be Bill Miller considering Amazon deep-value in the late 1990s and paying up. 
 

He was not pitching it as a “growth investment”, a term that is more associated with the big technology names today. 

[brobro777]

Well what I can say is I bought TTD years ago and in a typical moronic fashion I sold out too soon. And it keeps going and going - of course it does - while being overvalued and overvalued, leaving me in the dust

 

What I can add to this topic is maybe that the pace of adoption/distribution/increase in total addressable market/whatever other factors that I'm too stupid to recognize are way faster than I realize so that these "overvaluation" is not overvalued at all

 

This is probably a bit of the beer talking but hey, John Daly said he did play his best golf when he was drunk...

 

 

[nwoodman]

Really interesting topic. Not sure you should overpay but just as importantly not getting shaken out unless they become severely overvalued.  I think these situations work best when management has dignificant skin in the game.

[Haryana]

Cathie Wood would say that you are guys are so yesterday as to be proving that the overvalued is the new undervalued when really the brave new future is where the value lies in crypto as it cannot be valued at all! 

[Haryana]

2 hours ago, nwoodman said:

... I think these situations work best when management has dignificant skin in the game.

So when you said "dignificant skin in the game", were you thinking of significant dick in the game? 

[james22]

All investing is value investing.

[nwoodman]

1 hour ago, Haryana said:

So when you said "dignificant skin in the game", were you thinking of significant dick in the game? 

I stand by my spell checker encouraging such ambiguity

Edited November 23 by nwoodman

[frommi]

You are putting yourself into a very vulnerable spot if you do your investing that way. Of course it can go right and you make tons of money. But what most investors these days forget is that stocks can also go down and for long timeframes. And in these times this type of stock will often get crushed down to realistic valuations. Just look what happened 2000-2003. On top of now holding a stock with losses, it can also not use its stock as a currency. Good example is KMI, it took years until it recovered and it pretty much followed your playbook for a long time. Heck even Kraft Heinz was playing that game and look how that ended.

Edited November 23 by frommi

[dealraker]

Back in the 1990's and even early 2000-2001 Abbey Joseph Cohen was chanting up the big caps and that included even non tech names like AIG, GE, and a few others.  She had many years of fame and the last 5 or 6 of those years the stocks she was famously successful at promoting...

 

...well those stocks were already, in 2001 onward as to valuation, over-valued 6 years previously.  Yep prices gained after 1996 didn't hold by late 2001.

 

And those were the stocks with real earnings and valuations what weren't part of the dot com.  So years of fame and earnings "growth" were of the temp category.

 

Interesting Abbey didn't lose her fabulous fame until 2008-ish.  And even if you took the earnings from Abbey's bunch just before the financial crisis, some ten full years later, the prices of 1996 were over-valued.

Edited November 23 by dealraker

[nwoodman]

Surely the differentiator is rational capital allocators.  Sometimes it may not be evident for say “six years” or so.  

[Spekulatius]

This type of “investing” is what Graham calls speculation. It can be done in an intelligent way but it’s not investing. It’s not a new thing either and has been done pretty much since the stock market was invented. John Law and the Mississippi company is the first example I know, but he probably wasn’t the first one. Ponzi did not invent the Ponzi scheme either.

Edited November 23 by Spekulatius

[Dalal.Holdings]

The fact that this thread exists probably says more about the times than anything

[jfan]

Purchasing over-valued stocks in businesses that use their shares as currency is fought with risk and I would agree that most of the time this does not work in the long run. I think the primary danger of these roll-ups is the people element ie it gets really addictive to see those revenues, cash flows, and stock prices go up and to the right over time. Doing this as the only business strategy will most likely end in failure ie conglomerates in the 1960s (ITT, Litton), Mississippi Bubble, South Seas Bubble, etc.

 

Similarly, Cathie Woods' business of pumping world-changing tech companies based on a story, is also not investing but gambling/speculating. However, that said, I think we can learn something from everyone including her (ie she introduced me to the mental model of Wright's law which I later read in Bionomics - which was an interesting read btw).  

 

But for the few truly good allocators out there, using their stock as an acquisition currency, is a lever that can be sometimes pulled or repetitively pulled in the right situation for the long-term. Other examples that come to mind (please correct me if I'm wrong about the details)

- Buffett issuing shares to purchase GenRe during the height of the dot.com mania

- Prem issuing shares to purchase undervalued insurance companies during the early 2000s

- Singleton during the 1960s using Teledyne shares to serially acquire companies (see link below)

 

The reason I started this thread was not promote buying over-valued growth stocks especially when the market feels toppy (and Buffett is a net seller, holding lots of cash), but better understand the rare situations when this is actually rational and why.

 

Just like buying low PE stocks without discrimination and concentrating them in your portfolio, isn't intelligent either. Eliminating ALL over-valued growth stocks without discrimination could result in a significant opportunity cost. 

 

PS: found this case study about Teledyne that people might enjoy reading

Teledyne Technologies—A Conglomerate Phoenix That Rose from the Ashes with Henry Singleton’s Corporate DNA Intact

 

 

[jfan]

Quote from William Thorndike's Outsider chapter on Singleton

 

"Singleton took full advantage of this extended arbitrage opportunity (lofty conglomerate P/E ratios, low competition for acquisitions), and between 1961 and 1969, he purchased 130 companies in industries ranging from aviation electronics to specialty metals and insurance. All but 2 of these companies were acquired using Teledyne's pricey stock."

 

Reading the above 2023 case study, and excerpts from Thorndike's book, this was just one capital allocation factor, he also utilized purchase price discipline, targeted specific technological niches, and ran a particular decentralized organization (that later was deemed inefficient) in addition to focus on cash flows. 

 

It seems known when to growth, how to grow, the environment that you operate in, and financial levers that can be pulled, in addition to management incentives/motivation are all key decision factors. 

[Red Lion]

2 hours ago, jfan said:

Just like buying low PE stocks without discrimination and concentrating them in your portfolio, isn't intelligent either. Eliminating ALL over-valued growth stocks without discrimination could result in a significant opportunity cost.

 

I think this is all somewhat semantic. A growth stock isn't overvalued in the first place if you think you should be including it in your portfolio, right? 

 

It's all value investing, there's just room for disagreement about whether that exists. The long term prospects of a business and its ability to return capital to shareholders should determine its value. A company trading at 50x earnings that grows earnings 50% annually for 10 years while returning all capital to shareholders is undervalued. A company trading at 50x earnings that can grow its earnings for 20% a year and return capital for 20 years is still undervalued. A company trading at 4X earnings that continues to plow money back into losing investments at a low ROIC, and never returns capital to shareholders....that might be overvalued.

 

Capital light businesses trading at high multiples will often appear to be overvalued based on book value especially, but if they have growth prospects they can still turn out to be great investments without going to the capital markets to raise capital. 

 

Management really can make a huge difference, and it seems like perpetual "undervaluation" seems to be highly correlated with entrenched bad management without aligned incentives. 

[John Hjorth]

10 hours ago, Haryana said:

Cathie Wood would say that you are guys are so yesterday as to be proving that the overvalued is the new undervalued when really the brave new future is where the value lies in crypto as it cannot be valued at all! 

 

I'll steal that line!, @Haryana - Have you considered sending it to Chris Bloomstran? - No, - by futher consideration -, please don't - he will end up in an emergency room with an oxygen mask, if you did. 

Edited November 23 by John Hjorth

[John Hjorth]

36 minutes ago, Red Lion said:

I think this is all somewhat semantic. A growth stock isn't overvalued in the first place if you think you should be including it in your portfolio, right? 

 

It's all value investing, there's just room for disagreement about whether that exists. The long term prospects of a business and its ability to return capital to shareholders should determine its value. A company trading at 50x earnings that grows earnings 50% annually for 10 years while returning all capital to shareholders is undervalued. A company trading at 50x earnings that can grow its earnings for 20% a year and return capital for 20 years is still undervalued. A company trading at 4X earnings that continues to plow money back into losing investments at a low ROIC, and never returns capital to shareholders....that might be overvalued.

 

Capital light businesses trading at high multiples will often appear to be overvalued based on book value especially, but if they have growth prospects they can still turn out to be great investments without going to the capital markets to raise capital. 

 

Management really can make a huge difference, and it seems like perpetual "undervaluation" seems to be highly correlated with entrenched bad management without aligned incentives. 

 

I personally think the vibes by @Red Lion here are very good.

 

There is an element of what I would call 'pure math and logic' to investing, and then there is the all rest, there is to investing.

 

The best book about the mathematical part about investing in companies embraced in this topic [part of the book] I have ever read and own personally is :

 

Oddbjørn Dyvad : Investing in Value Creators - Time Tested Principles for Long Term Stock Investments.

 

Oddbjørn Dybvad is Portfolio Manager at REQ Capital up in Oslo,  Norway.

 

I have certainly felt that stuff like that is or can be considered controversial here on CoBF as of lately expressing my opinion about one of Jim Collins books.

 

But each to their own, with regard to style, temper, time and energy available for and interest in investing, individual mental loads and drags tolerable by getting engaged here, and all that. I'm a firm believer there exist a personal fitting style for everyone of us, and that you find yours, if you haven't already.

[brobro777]

This is all nice talk but TTD from Jan 2018 to now is 62% CAGR 

 

And that hurts me deeply

 

[Gregmal]

More often than not the stocks people think and claim are overvalued tend to result in a hindsite outcome where the stock wasn’t overvalued and the observer was simply wrong and looking at the wrong metrics. 
 

Honestly, valuation is probably the last thing I look at when underwriting an investment. If everything else during the process is flawless, I’m much less concerned about valuations. Whereas there’s plenty of people whom buy abysmal businesses and assets because the PE looks good, and that more often than not tends to end in tears…

 

 

 

[bizaro86]

One example of this type of investment (that has worked out great for some on this board) is Constellation Software. Although they haven't really issued many shares, which maybe disqualifies them from this list  

[james22]

2 hours ago, John Hjorth said:

I'm a firm believer there exist a personal fitting style for everyone of us, and that you find yours, if you haven't already.

 

And it is very, very difficult to recognize opportunities outside one's style.

[John Hjorth]

2 hours ago, Gregmal said:

More often than not the stocks people think and claim are overvalued tend to result in a hindsite outcome where the stock wasn’t overvalued and the observer was simply wrong and looking at the wrong metrics. 
 

Honestly, valuation is probably the last thing I look at when underwriting an investment. If everything else during the process is flawless, I’m much less concerned about valuations. Whereas there’s plenty of people whom buy abysmal businesses and assets because the PE looks good, and that more often than not tends to end in tears…

 

Then there is the relativity of investment process and attitude towards investing with regard to the time dimension, meant as 'change over time'.

 

I see you registered here on CoBF on 28^th September 2016, now more than 8 years ago. Eight years are so-so medium time-frame for an old bugger like me, 8 years for a relatively young person like you are 8 light years in time distance.

 

I personally did consider you in your early innings here on CoBF very transactional oriented, and ambitious, hungry to get ahead. Do you remember that you actually once posted here on CoBF about : 'Don't pay for even a a lawn mower cash on delivery, if you can't get a discount on it, unpaid bills pulling no interest before due according to payment terms are your float, - Hold on to your shares, and do not reduce the amount of cash you are able to buy stocks for!' Do you remember it?

 

Personally, I still remember running 'montly closings' on every last Saturday in every month in the last part of the accumulation phase ('14 and '15), being a PITA on The Lady of House by asking questions such as 'What have you spent, that is still not added as future payments in the bank interface?', to get totally anal about how much money is actually avaible for buying stocks, by anal [<- is this even  a word in English?] doing monthly liquidity forecasts.

Edited November 23 by John Hjorth

[james22]

Supposing value is a woman, what then?

[John Hjorth]

36 minutes ago, james22 said:

And it is very, very difficult to recognize opportunities outside one's style.

 

You are right, James [ @james22 ],

 

To stay mentally flexible and responsible for new input is key. Don't freeze. Try to find your own way towards all these World and Market dynamics so you don't make your own life miserable by investing. The above statement by you is also the reason why I consider CoBF 'my classroom', the best place to learn a <fill in specimen here> new tricks, that actually works.