If I were asked to characterize my investment philosophy, I would describe myself an investor who believes in value, but I would be lying if I told you that it has always come easily or naturally. My faith in value is tested constantly, not only by the recognition that there is far more that I don't know about value than I do, but also by the market, which seems to have an uncanny ability to sense my doubts and find ways to probe them.
The Market Test
To see if we share some of the same weaknesses, let's try an experiment. Assume that you value a stock at $20 and it is trading
at $30. What would you do? If you are a value-based investor, the answer is easy, right? Don't buy the stock, or perhaps, sell it short! Now let's say it is three months later. You value the same stock again at $20 but it is now trading at $50. What would you do now? Rationally, the choice is simple, but psychologically, your decision just got more difficult for two reasons. The first stems from second guessing
. Even if you believe that markets are not always rational, you worry that the market knows something that you don't. The second is envy
. Watching other people make money, even if their methods are haphazard and their reasoning suspect, is difficult. You are being tested as an investor, and there are three paths that you can take.
- Keep the faith that your estimate of value is correct, that the market is wrong and that the market will correct its mistakes within your time horizon. That may be what every value investing bible suggests, but your righteousness comes with no guarantees of profits.
- Abandon your belief in value and play the pricing game openly, either because your faith was never strong in the first place or because you are being judged (by your bosses, clients and peers) on your success as a trader, not an investor.
- Preserve the value illusion and look for "intrinsic" ways to justify the price, using one of at least three methods. The first is to tweak your value metrics, until you get the answer you want. Thus, if the stock looks expensive, based on PE ratios, you try EV/EBITDA multiples and if it still looks expensive, you move on to revenue multiples. As I argued in my post on the pricing of social media companies, you will eventually find a metric that will make your stock look cheap. The second is to claim to do a discounted cash flow valuation, paying no heed to internal consistency or valuation first principles, making it a DCF more in name than in spirit. The third is to use buzzwords, with sufficient power to explain away the difference between the price and the value.
If you choose the first path, I respect you for your principles. If you pick the second one, I understand your pragmatism. If you pick the third path, I think that you are on dangerous ground, as you wander the netherworld between trading and investing. Unfortunately, though, it seems to be the path most often taken and in this post, I would like to shine a spotlight on the buzzwords that are most frequently used by investors to distract and delude themselves and others.
The deadliest buzzwords
As someone who teaches at a business school, I am aware of both the ubiquity of buzzwords and their power in decision making. The most powerful buzzwords can still discussion, stifle dissent and overwhelm common sense and they share three characteristics. The first is that at their core, they are built around undeniable truths, even though those truths might get stretched in practice. The second is that they come with highbrow backing from academics and/or well-known practitioners, skilled at packaging and presenting these concepts to broad audiences. (An academic paper is nice, a book is better and an appearance on national TV show cements the deal). The third is that they tie into the world views of many investors and thus provide an intellectual rationale for anecdotal evidence and story telling. So, with no further ado, here are my five deadliest buzzwords, ranked from least to most potent (based upon my subjective judgment). I would hasten to add that I have been guilty of using some of these buzzwords myself and promise to be more careful in the future in both when and how I use them.
What it really means: Success in a particular product or market may give a company the option to enter a different market (product-wise or geographically). Thus, Apple's success with the iPod allowed it to enter the music retailing market (with iTunes) and led eventually to the iPhone and the iPad. From a valuation perspective, these possibilities could not have been foreseen (explicitly) in 1999, but the optionality could have been incorporated into the value.
In Buzzword form: You use the existence of a large market as a rationale for giving a company an option premium, often subjectively determined to be whatever you need it to be to justify buying the stock. In the late 1990s, some analysts used the potential of a large e-commerce market as justification for attaching option premiums to dot-com company valuations, just as many analysts are using the online advertising market as a reason for attaching option premiums to social media companies.
The key test: Exclusivity. In its generic form, a call (put) option gives its holder the right to buy (sell) an asset. In the same vein, any optionality argument has to be built around exclusivity, where the company in question has the exclusive or close-to-exclusive right to expand into new markets. This exclusivity can come from owning a proprietary technology or possessing an exclusive license to operate in a market. The e-commerce companies of the late 1990s had no such exclusivity, and while the social media companies of today use their large user bases to stake out exclusivity, it is on shaky ground, since these users are fickle and quick to move to the "next big thing". With Apple, the exclusivity derived from the company's control of the operating system, making it very difficult for competitors to enter their very profitable ecosystem.
If you really mean it: If you are going to use an optionality argument, you have to be comfortable with both option pricing fundamentals and models. However, option valuation is not an alternative to traditional valuation, but an addendum. Thus, to value the optionality in a company, you have to do a discounted cash flow valuation first, make judgments on the size and uncertainty in potential markets next and then value the option.
4. Growth potential
What is really means
: There is a large potential market for the firm's goods and services, which will allow the company to to scale up revenues and profits over time, without running into market capacity constraints. This argument has resonance when valuing small companies that operate in large markets, since high growth can be accommodated with ease. In my valuation of Tesla in September 2013
, it was the magnitude of the automobile market that allowed me to make generous assumptions about revenue growth in the future.
In Buzzword form
: You argue that a company has high value because it has growth potential, but you refuse to be specific about the market that your company is operating in, how big the market is today and how much of that market your company will capture over time. (This is my bone of contention with analysts who use the online advertising market
to justify high growth in social media companies, without clarifying their assumptions about the overall market.)
The key test
: Excess returns.
I may be beating a dead horse here, but growth, by itself, has no value. To create value, you need to earn excess returns while growing
, and to earn those excess returns, you need barriers to entry and competition. Thus, if you are going to make an argument for growth potential, you have to twin that argument with one that explains what the company's competitive advantages will be that will allow it to create value from that growth.
If you really mean it: To value growth potential, you have to do the grunt work of defining the market, determining your company's competive advantages and forecasting how much you will have to reinvest to deliver that growth.
Links (perhaps helpful, perhaps not): (1) A spreadsheet to value growth
3. Strategic considerations
What it really means: Taking the action (investment, acquisition) is critical to the company's long term growth and profitability, though the short term effects may be negative.
In Buzzword form: You use strategic as prefix for any action where the numbers don't add up but you want to take anyway. Thus, a strategic acquisition is one where you pay too much for a sought-after target company, a strategic investment is one where you know you will never make money but is indispensable (at least to you) and in its most cringe-inducing form, you are a strategic buyer, i.e., one who will pay any price to buy something.
The key test
: Show me the money
. You cannot pay dividends with strategic victories or nice sounding stories. All decisions, no matter how strategic and long term they might be, are ultimately financial decisions. Consequently, if you make the strategic argument, the onus is on you to then convert the qualitative benefits into earnings and cash flows. If you cannot show me the money
, I am afraid that there is nothing strategic about this decision, other that the prefix.
If you really mean it: Start converting stories to numbers, dreams into plans and deal makers into managers. No matter how much uncertainty you face or how far in the future the benefits may lie, you need to put your best estimates down on paper, before you take action. Not only will that put some discipline into the process but it will also become the basis for organizing and planning to deliver those benefits and holding someone (perhaps you, since you pushed for it so hard) accountable.
Links (perhaps helpful, perhaps not): (1) My paper on valuing synergy (2) A spreadsheet to value synergy.
What it really means
: A new entrant in an existing business uses a new or unorthodox business model to lower the costs of production (Southwest) or the delivery/distribution system (Amazon
) or even the product/service (Apple). In the process of doing so, the disruptor finds way to be profitable at the expense of the status quo.
In buzzword form: You view any new entrant in a business as a disruptor, even if that entrant brings little of value to the process, no cost savings innovations or no game changing products, and is unlikely to change the way the business is run.
The key test: Status Quo. While disruption takes many forms and has happened in different markets, the common feature that allows it to succeed is dissatisfaction with the status quo, either on the consumer side (because consumers are not getting the products and services they want or are getting them at prices that they believe are too high) or on the producer side (because producers are unable to generate the economic profits they need to make to stay in business).
If you really mean it: You have to complete the story of disruption by fleshing out the details. In particular, you have to map out a pathway for the disruptor to grow in the disrupted business, with realistic estimates of the challenges and costs that will be faced along the way. It is worth noting that most disruptors fail to change the status quo, and that the few that succeed often have setbacks along the way. It is easy to point to Amazon and Apple as successful disruptors, but these companies are the exceptions, not the rule.
What it really means: A billion plus people, with rising incomes, is a very large market and any company that succeeds in this market should be able to generate large revenues and perhaps large profits.
In buzzword form: For many people, especially those not from Asia, the notion of a billion plus people in a market addles the brain. Thus, investors are quick to give a company that is China-based, one that has entered China or one that is even thinking about China a boost in market value. Companies, recognizing this impulse, are quick to play the China card, slipping it into investment announcements and earnings reports.
The key test: Preferred Competitor The Chinese economy is neither free nor open. The game is tilted towards one competitor over others, and that tilt does not necessarily reflect product quality. If you are the competitor preferred by the Chinese government, you will be a big winner. If not, you are just an also-ran, destined to invest large amounts of money in the Chinese market, with little benefit to show for it. For instance, in the contest between Google and Baidu to be the search engine for the Chinese market, Baidu starts off with a decided advantage as the preferred competitor and that translates into significant market share and large profits.
If you really mean it: Quantify the preferred competitor status, which will require you to understand political reality on the ground. You can start off with few presumptions. A Chinese company will be preferred over a non-Chinese one, and a Chinese company with good political connections will beat one without those connections. Analyzing the value of expanding into China requires you to be as much political analyst as valuation assessor.
There are sensible uses for all of the terms that I have listed above, but unfortunately, the buzzword versions are the ones that I see more often in practice. In fact, I find that the people who are quickest to bring up a buzzword or use it to justify a premium often are the ones who have the shakiest understanding of it, leading me to put forth two propositions about buzzwords:
- The Buzzword Count Proposition: My exposure to both equity research and buzzwords leads me to conclude that there is a negative correlation between buzzword usage and valuation quality. In other words, the more an analyst uses words like real options, disruption and China in talking about a company, the less substance there seems to be the actual research.
- The Buzzword Swarm Proposition: The most dangerous challenge that you will face as investor will be when multiple buzzwords come together in the same news story. We have two IPOs coming up in the near future, Alibaba and Weibo, which will qualify under multiple buzzwords (strategic, growth potential and China at the minimum) and will undoubtedly be priced to deliver multiple premiums.
My resolutions for the near future are that I will use buzzwords sparingly, that I will not them use as a substitute for analysis, and that when I do use them, I will go the extra distance and try to work through the consequences.