Intrinsic Value–Objective or Subjectively Determined?

A Discussion about Whether Austrian Economists and Value Investors Agree on How Intrinsic Value is Determined.

CSInvesting: Understand that Intrinsic Value is SUBJECTIVELY determined while prices are set by the marginal buyer and seller.  All an investor does is compare price to value.

Essentially, value investing focuses on the comparison of a good’s intrinsic value and its market price and recommends investing in it as long as the asset’s value exceeds its price given a margin of safety.

The first article says in summary: value investing and Austrian economics are nevertheless incompatible, particularly given that value investing’s definition of value contradicts the Austrian value concept.

End-the-Myth-On-Value-Investing’s-Incompatibility-with-Austrian-Economics-by-Olbrich-et-al   I would skim this article.

An Austrian economist who is also a value investor, Chris Leithner rebuts the above statement: “Value investors’ conception and assessment of value are congruent with the Austrian School’s.”

“A value investor” measures value by one of two methods:

  1. First, he/she values a company according to the external prices of its assets. He/she observes, for example, that X Ltd owns quantity Y of land, and that such land has a market price of $Z per hectacre.
  2. Second, the value investor makes plausible (based, perhaps, upon past experience and/or domain specific expertise) assumptions about a company’s future cash flows and, using some rate, discounts them to the present.  He might do these calculations in his head or on a spreadsheet.

The Hinge between the theory of Value and the Practice of Value Investing.

John Burr Williams in his The Theory of Investment Value, 1938 wrote, “With bonds, as with stocks, prices are determined by marginal opinion…..Concerning the right and proper interest rate (discount rate), however, opinions can easily differ, and differ widely….Hence those who believe in a low rate will consent to pay high prices for bonds…while those who believe in a high rate will insist on low prices…Thus investors will be bullish or bearish on bonds according to whether they believe low or high interest rates to be suitable under prevailing economic conditions.   As a result, the actual price of bonds….will thus be only an expression of opinion, not a statement of fact.  Today’s opinion will make today’s rate; tomorrow’ opinion, tomorrow’s rate; tomorrow’s opinion, tomorrow’s rate; and seldom if ever will any rate be exactly right as proved by the event.

How then does Warren Buffett define and measure value? In his 1994 Letter to Shareholders he writes:

We (Charlie Munger and I) define intrinsic value as the discounted value of the cash that can be taken out of a business during its remaining life.  Anyone’s calculation intrinsic value necessarily comes up with a highly subjective figure that will change both as estimates of future cash flows are revised and as interest rates move.  Despite its fuzziness, however, intrinsic value is all-important and is the only logical way to evaluate the relative attractiveness of investments and businesses.

Graham, by the way, would agree with the definition of intrinsic value but he would doubt whether investors could usefully apply it. (Ben Graham, 1939)  “The rub,” writes James Grant in the 6th Edition of Security Analysis (2009), page 18, “was that, in order to apply Williams’s method, one needed to make some very large assumptions about the future course of interest rates, the growth of profit, and the terminal value of the shares when growth stops.”

The entire article by Chris Leithner is an important read: Value Investing and Austrian Economics Leithner

The video below–though choppy in the first few minutes–is worth hearing about the psychology of market bubbles.   The interviewer of Bob Moriarty is ignorant of basic economics (Can prices EVER go below the cost pf producing a useful/needed product? Yes or No), but you can follow the discussion.  Note the pushback of the interviewer who is also an owner of bitcoins to Moriarty’s questions.  The psychology is fascinating–the will to believe and suspend judgment.

The ART of Contrary Thinking

When everyone thinks alike, everyone is likely to be wrong.

If you wish to keep from guessing wrong, learn to think contrarily.  –Humphrey Neill

CSInvesting: Humphrey Neill wasn’t advising to blindly go against the “crowd” but to think things through rationally.   For example, investors might be excited by the new invention of the air conditioner, but the second-order effects were more powerful like increase in demand for real estate in Southern cities in the USA.

The BOOK: NEILL(H_B_)-The_Art_of_Contrary_Thinking_(1985)

Critique of the book 2016-07-29_BR_ML

Contrary thinking in action….

Has Apple Stock Peaked?
December 3, 2012|by Timothy Lutts

Has Apple (AAPL) Stock Peaked?
In the Footsteps of Coca-Cola
The Next Apple?

Everybody knows Apple.
With more than 85 million iPhones sold, $156 billion in annual revenues and a market capitalization that recently hit $660 billion, Apple is the second most respected brand on the planet. Number one is Coca-Cola.

But what does that mean for investors?

It means there’s a chance that investor perception of the company is so high that all the big investors already own as much Apple as they can carry. It means there’s more potential selling pressure on Apple’s stock than buying pressure. And that means there’s a good chance the stock has topped!

Now, some investors, looking at numbers alone, will disagree.

They’ll point out that the company is still growing fast, that the third quarter saw revenues grow 27%, and earnings grow 23%, and that analysts are expecting 12% growth in 2013 and 18% in 2014. Then they’ll point to the stock’s forward PE ratio of 12 and say, “Apple is cheap!”

But using numbers alone is a mistake in evaluating growth stocks, particularly exceptional growth stocks like Apple.

For example, we at Cabot did very well recommending Amazon.com way back when the company (selling only books) was still unprofitable, and most bean-counters wouldn’t touch it with a 10-foot pole. We jumped on little Crocs (plastic shoes!) and rode it to the moon. And we did very well with ridiculously “expensive” First Solar, in part because we sold early, while its business was still booming, but its stock was on the skids. We could have justified owning none of those stocks if all we looked at were numbers.

Bottom line: to make money in exceptional growth stocks, you can’t just look at numbers; you’ve also got to look at momentum and sentiment.

But before I get deeper into Apple’s case, I want you to study this long-term chart of Coca-Cola (KO–see above) (the number one brand in the world today), spanning the years from 1965 to the end of 1985.  See at the top of this article.Note the earnings line, with each dot marking a quarterly earnings figure. It’s a steady uptrend, with the exception of a sharp dip in late 1974 and a stumble in 1981-1982. Then look at the dividend line; Coke’s dividends were increased every year, like clockwork. Finally, observe the price line, noting that Coke’s price peaked in late 1972 and didn’t exceed that level until late 1985, 13 years later.

The explanation for those “lost 13 years” lies not in the numbers; it lies in crowd psychology, and specifically, in the investing environment of the times. Coca-Cola was one of the Nifty Fifty, popularly regarded as one-decision stocks that you would simply buy and hold forever. (Others in this august group included Digital Equipment, Eastman Kodak, J.C. Penney and Simplicity Pattern).
Well, for investors who truly had the patience and guts to hold Coke through those lost 13 years, it worked out okay. But most investors don’t work with that kind of time horizon. Most investors can’t hold five years without seeing a profit—and they shouldn’t have to!

The truth is, the extreme popularity of those stocks (call it reverence, even), was a sign of their potential to top. But it was very hard for investors to see it then!
So, getting back to Apple, I’ve already mentioned the stock’s high regard among the general public; it’s the number two brand in the world. Among institutional investors, it’s regarded as royalty, providing both a dividend and spectacular growth. In fact, if you manage institutional money, owning AAPL has become almost a requirement in recent years, and the result of all that buying power is that even after the recent correction, AAPL is still up 45% for the year!
But when everyone who might buy a stock has bought it, what happens?
The same thing that happened to Coca-Cola in 1972.

It stops going up, and to some extent—every stock is different—it goes down.
Now, I have no doubt that Apple (the company) will continue to grow revenues and earnings for years to come. I’ve been an Apple user since 1987, when I bought a Macintosh SE for Cabot (to join our IBM Displaywriter—Google that!). Today I use a MacBook Pro, an iPad and an iPhone on a daily basis, and I expect to be an Apple user to the day I die, benefiting from the company’s legendary ability to make complicated technological interactions simple.

Nevertheless, I’m bearish on Apple (AAPL) stock today and here’s why.
There’s a dirty word to describe what happens when a company’s growth slows, and when the perception of the company’s future becomes just slightly tarnished. As that word spreads, and as those perceptions spread, the stock slowly collapses, as the supply of stock (potential sellers) overwhelms demand (potential buyers).


The Dirty Word
The word is deceleration, which is a fancy phrase for slowing down. And Apple is decelerating! That third quarter earnings growth of 23% followed second quarter earnings growth of 20%. Those were the slowest quarters since mid-2009! And looking forward, the projected 12% growth in 2013 is even slower, though 18% for 2014 provides hope.

Now, 12% growth is nothing to sneeze at; many companies would kill for 12% growth. And 18% is excellent! But it’s quite a comedown from the nine consecutive quarters from 2010 into 2012 where Apple’s earnings grew more than 50%! It’s deceleration.

And that brings us to the stock’s performance, which is where the rubber meets the road. Because more important than numbers, more important than sentiment, is the stock’s actual performance. So here’s Apple’s chart, since the 2009 bottom.

As on Coke’s chart, you see the earnings line, trending higher, but rounding somewhat recently; that’s the deceleration of earnings. There’s no dividend line on this chart; Apple’s dividend history is short but healthy. But there is another line on this chart and that’s the RP line. RP stands for Relative Performance; it depicts the performance of the stock relative to the broad market.

Note that over the past four years, whenever AAPL corrected, its RP line basically flattened out (ignoring the tiny weekly movements). But in this year’s correction, AAPL’s RP line turned down, and for eight weeks, AAPL performed worse than the overall market.

Now, this underperformance alone is not the kiss of death. Many stocks can pull out of similar corrections and move out to new highs.

But look back at Coke’s chart. If you look at the RP line, you’ll see the same pattern! From 1964 through 1973, KO was pretty healthy, beating the broad market overall, and holding its own in corrections. But after 1973, as sentiment turned, and the selling pressures slowly overwhelmed buying pressures, KO’s RP turned clearly negative, beginning a pattern that lasted many years longer than most investors could stomach.

And that’s very likely where AAPL is today.
So when you put it all together…
• The extremely high market cap
• The extremely positive public opinion
•The extremely high level of institutional ownership
• The deceleration of earnings growth
• The weakening relative performance line
…it looks ominous.

Now, big, well-respected stocks don’t collapse overnight. To the contrary; when a high-quality stock like Apple pulls back, you’ll hear a new chorus of “It’s a great value down here” and “Buy the dips.” But as time goes by, and the stock fails to return to its old highs, those choruses fade, and the stock falls slowly out of the limelight—just like Coca-Cola did in the 1970s.

Stepping back to look at the big picture, it’s worth remembering that investing is not a science. Uncertainty is a given.

But to be a successful investor, you need to put the odds in your favor, and today, the odds are not good for investors in Apple.  See more  http://www.timothylutts.com/

ALAS, NEVER CEASE TO DO YOUR OWN THINKING.

You might have sold out of a uniquely profitable company as AAPL went on to triple over the next five years!~

 

Excellent Investing Video (Templeton, Buffett & Wilson)

HAPPY THANKSGIVING HOLIDAY for American readers.

Yes, I will still post on Sandstrom Gold (SAND) but another day.

The interviewer, “Adam Smith,” says the similarities among the investors are:

  • They have independence of mind
  • They trust their perceptions
  • They stick to what they know
  • They are intelligent
  • They have fun

After viewing the video, whip out a piece of paper and quickly jot down what EXACTLY can YOU use in your own investing approach?  Be specific! STOP! Take a walk for 20 minutes, then write down some more thoughts.   See the video again.  What can YOU implement?

I will post my thoughts next week.

A WWII Soldier Writes Home 1944

Happy Veterans Day

Two letters from a WWII veteran who won the Silver Star (disturbing descriptions of war) Letter 5 Silver Star Letter Feb 24th 1944

February 1, 1944 Letter rpc to Dash and Mother Flame Thrower


Facing Death

Sandstorm Gold Analysis; Other Readings

A reader (the ONLY one) presented his valuation below:

The analysis is in response to http://csinvesting.org/2017/10/27/sandstorm-gold-so-whats-it-worth/

Business Model

Sandstorm provides financing for other junior, mid-tiers and major gold producers. In exchange for a principal amount provided by Sandstorm, gold producers exchange a royalty stream on their gold production. This royalty stream can take different forms, the most common being a percentage of Net Smelter Revenue (“NSR”) or by offering an off-take agreement at discounted prices. In addition, Sandstorm may receive warrants or other traded securities.

Sandstorm offers their shareholders a diversified portfolio of royalty streams, which offers some benefits over investing in a gold exploration/producing company: 1) predictable cash flows, 2) very low cost structure, 3) replacement capex (investment in new projects) typically much lower than for a gold producer.

In my view, this kind of investment should benefit from a lower cost of capital because of its lower risk, so therefore investors would be willing to pay more for this cash flow stream vs. a cash flow stream coming out directly from a mine.

Valuation

I’m looking at 3 main buckets of value here.

1) Producing assets – currently generate ~US$50mm of cash flows each year. My rough assumption here is that these cash flows should be relatively stable over the next 10 years. I assume no terminal value as these mines are winded-down over time. Discounting this at a cost of equity of ~8% yields ~US$335mm

2) Advanced exploration / explo / investment portfolio – I’m assuming no value to the exploration projects and assuming a 10% discount to the FMV of the investment portfolio. This yields ~US$70mm.

3) Development projects – this one is certainly tougher to ascribe value. If we look at the SSL presentation, we see that the majority of future cash flows will come out from Hot Maden which was paid US$175mm. Assuming there was a market check done on the sale of the stream, we can assume this is market value. Other projects from the development portfolio will also yield future cash flows, but it can be assume to be somewhat captured in the above DCF.

So overall, I compute US$335mm + US$70mm + US$175mm = US$580 which is far from the current market cap of the company.

One needs to believe that the development portfolio will materialize into sustainable cash flows (which would essentially translate into the addition of a terminal value in my DCF) before investing in this business.

Let me know your thoughts and feel free to share my response on your website!

CSInvesting: I will be posting my thoughts soon.

Interesting readings

https://thefelderreport.com/2017/10/31/tobias-carlisle-on-beating-the-little-book-that-beats-the-market/     Worth a listen!

 

Workshop in NYC (Nov. 17th) and The Arb. Mindset

I have no affiliation, but NYC readers may wish to be aware of the following:

Friday, November 17, 2017: Stock pitch workshop in NYC.  Details: http://www.pitchtheperfectinvestment.com/upcoming-events/

Also, check out the articles at the above website and on the link below…

The importance of the arbitrage mindset

The arbitrage mindset is critical for a great investor. When you have the arbitrage mindset, your mind instinctively identifies arbitrage relationships in normal, everyday situations.  In the link below, we discuss examples involving gold, Dunkin’ Donuts gift cards, pennies, pudding cups and 19th-century Nepalese firearms. We think you will find it an entertaining and informative read.  Click below:

http://www.pitchtheperfectinvestment.com/2017/10/28/the-arbitrage-mindset-gold-coffee-pennies-pudding-cups-and-19th-century-nepalese-rifles/

P.S. Let me know how the valuation on Sandstorm Gold is progressing

Sandstorm Gold–So What’s it Worth?

If am able to provide an investing course, then once the fundamentals are covered, we could study cases.  Let me know your thoughts.

The Life of an Analyst

Your boss slaps these documents on your desk.  “Let me know what you think. I want a back-of-the-envelope valuation and a sixty-second summary of this business by this afternoon.”

What’s the essence of this business? Hannibal Lecter will guide you:  https://youtu.be/UhDZPYu8piQ?t=58s

Your analysis should be clear and simple:

How can the portfolio manager expect YOU to answer quickly with this deluge of info? That’s what we will learn here today.

I will post my “answer” by Tuesday of next week.   Email me at aldridge56@aol.com if you wish to share your thoughts or do so at the deep-value group at Google Groups (sign up here: http://csinvesting.org/2015/01/14/deep-value-group-at-google/) rather than post in the comments section, because readers shouldn’t be influenced by others.  No help!   This case illustrates the reality at investment firms.   Your boss dumps a 500-page prospectus and says get back to me in two hours–“What’s it worth?”

Have fun!

Whining about Chipotle

This makes an interesting psychological study.  Who holds the stock and how they react.   ($CMG last at $278, down 14.5%)  Many conversations below show no interest in discussing the valuation of CMG, but just the price (and if the price is declining, the pitiful management).

Also, note the focus on P/E ratio for valuation.   What about the flaws in using P/Es as a valuation metric?   No discussion about the business, cash flows or discount rate.

CMG will probably trade north of 6 million shares today or about 20% of the 28.5 million outstanding shares.  Where are the long-term shareholders?  One in five investors will sell based on one quarterly report.

If you have done your homework on valuation, then unreflective sellers who are throwing in the towel may mean an attractive price over the next few weeks.

I don’t know much about Chipotle, but management should be able to right the ship OVER TIME–the next 24 months–not next quarter. I don’t own any CMG currently.

Time to pile on (rats falling from the ceiling!):   https://www.bloomberg.com/news/articles/2017-10-25/ackman-s-lost-a-lot-of-queso-on-his-stake-in-chipotle

An interesting article on the struggle within the turnaround efforts.

“Every chain restaurant, he says, goes through this rite of passage. For every success like Starbucks, there are former high-flyers like Baja Fresh and Boston Market that no longer have cultural currency and are slowly fading.
Moran (Chipotle founder) remains confident that Chipotle will not end up an afterthought dotting the strip malls of America, but he preaches patience. “Will we climb out of it and get back to our former greatness? I absolutely believe we will,” he told me in June. “But will that take a year or two or three or four? I don’t know. The full recovery from this is going to take a long time.” https://www.fastcompany.com/3064068/chipotle-eats-itself

  • AlabamaHobo

    Why does a burrito company trades for 70 PE.

    Lots of room all the way down to 15 PE. 

    DowPete

    DowPete    yesterday
    Ackman has been unusually quiet about his position in Shipotle. For someone who is forever whining, the silence is golden. Glad he’s underwater in $CMG.

    Mad

    Mad

    13 hours ago

    200$ may not be that impossible tomorrow or later.

    CowboyFan

    CowboyFan

    13 hours ago

    Overvalued stock , for a burrito company.
  • CowboyFan

    CowboyFan

    14 hours ago

    What a POS! Seriously , this is a $40 stock
  • BB
    BB

    16 hours ago

    Why does almost every retail restaurant or fast food chain trade at 15-25xs earnings and Chipotle get to trade at >60xs? Its still way overpriced, should be $100/share or less. Concept is easily duplicatable and has been many times now. Theres plenty of fast food burrito places out there now..

    Tenley

    Tenley

    10 hours ago

    I want a refund on my burrito. It taste weird…
  •  DaveR
    DaveR

    20 hours ago

    Even a lemonade stand could beat the latest benchmark for CMG earnings. If they miss this bunny forget about it.
  • Jh

    Jh

    14 hours ago

    Fair market value $50
  • joe

    joe

    16 hours ago

    Hundreds of high school students chow down at these restaurants every day. Me too
  • liberal

    liberal

    1 hour ago

    I’m loving this fall, hope it goes on through the day and we see 270s today. Make some mulla on those put options from yesterday
  • CT

    CT

    4 hours ago

    The battle line is drawn at $295 ps. Buyers must buy at this previously held level – otherwise, it is abandoned and a new lower strength level is found. But holding this level will be difficult as it represents a triple bottom.

    My bet is that the shares go lower. Once the dam at $295 is broken, the selling will accelerate and we may end up the day at -20%.

  • Jerome R

    Jerome R

    23 hours ago

    20% short interest on a 25 mill float, see you at $400 after ER
  • Jerome R
    Jerome R

    23 hours ago

    20% short interest on a 25 mill float, see you at $400 after ER
  • S.P.
    S.P.

    17 hours ago

    Owning this stock is like having CMG’s molten cheese poured on
  • george

    george

    20 hours ago

    Bloodbath coming after hours. The bombs start decimating your portfolio at 4:30 PM. Get your shovel out to dig your own grave. Just jump in, we’ll kick some dirt on top of you.
  • Mocula

    Mocula

    13 hours ago

    What was the total compensation for the CEO this year? The small amount of money I lost on this stock, means nothing to the officers. As long as they car drive a fancy car or pay a lot for a douchebag haircut, they will just continue to make excuses and take as much as they can.
  • Robert
    Robert

    15 hours ago

    Jerome, Hope you didn’t get killed too bad. This stock is a pig. Over priced. Should see $250 in a week. Cannot beat same stores off a week quarter to comp. McDonald’s had stores close in Houston and Florida. Face it. Bad food, overpriced, competition. The shorts won’t cover until $275.00.
  • WIZARD1973

    WIZARD1973

    16 hours ago

    I can’t believe they think remodeling the restaurants and raising prices are going to bring people back. I hope they have a better plan than that!’
    • Bay Area

      8 hours ago

      This burrito seller is still trading at insanely high PE. Fools find 300 cheap because they are comparing with the peak of 2015. That was a pure scam by Kramer type people. Giving the mess and slumped earnings, risky low margin business, very specific narrow menu, this stock should be trading at no more than PE =10
    • Ahh Haa

      Ahh Haa

      19 hours ago

      About to be Bill Ackholed.
    • Andre

      Andre

      12 hours ago

      I’m hoping this dips sub $290ish for a quick trade. The most brutal selloff periods are in the first hour of trading. Don’t fall in love with a position whether long or short. Volatility in any stock makes it great to spot a trend and make a great trade.
    • kevin

      kevin

      39 minutes ago

      Spoiled foods. Empty stores. Flopping queso. Run and sell!!!

Poking Holes in the Market Bubble Hypothesis

Nygren Commentary September 30, 2017

CSInvesting: We can’t increase our IQ but we can try to improve our critical thinking skills by seeking out opposing views to the now current din of pundits screaming that this “over-valued market is set to crash.”  1987 here we come.  What do you think of his arguments?  I certainly agree about how GAAP accounting punishes growth investments.  

At Oakmark, we are long-term investors. We attempt to identify growing businesses that are managed to benefit their shareholders. We will purchase stock in those businesses only when priced substantially below our estimate of intrinsic value. After purchase, we patiently wait for the gap between stock price and intrinsic value to close.

“All the company would have to do is raise prices 50% and the P/E ratio would fall to the low-teens.”   -Analyst recommending a new stock purchase

We are nine years into an economic and stock market recovery and P/E ratios are elevated somewhat beyond historic averages. So when an experienced portfolio manager hears a young analyst make the above comment, he hears alarm bells. But instead of seeing this as a sign that the market has peaked, we purchased the stock for the Oakmark Fund. But, more on that later.

For several years, the financial media has been dominated by pronouncements that the bull market is over. Throughout my career, I can’t remember a more hated bull market. Many state that a recession is “overdue” since past economic booms have almost never lasted as long as this one. But do nine years of sub-normal economic growth even constitute a recovery, much less a boom? If recessions occur to correct excesses in the economy, has this recovery even been strong enough to create any? Maybe recessions are less about duration of the recoveries they follow and more about the magnitude. If so, earnings might not even be above trend levels.

Bears will also point to the very high CAPE ratio—or the cyclically adjusted P/E. That metric averages corporate earnings over the past decade in an attempt to smooth out peaks and valleys. But remember that the past decade includes 2008 and 2009, frequently referred to as the “Great Recession” because of how unusually bad corporate earnings were. I’ll be the first to say that if you think an economic decline of that magnitude is a once-in-a-decade event, you should not own stocks today. But if it is more like a once-in-a-generation event, then that event is weighted much too heavily in the CAPE ratio. If the stock market and corporate profits maintained their current levels for the next two years—an outcome we would find disappointing—simply rolling off the Great Recession would result in a large decline in the CAPE ratio.

Higher P/E ratios are also caused by near-zero short-term interest rates because corporate cash now barely adds to the “E” in the P/E ratio. When I started in this business in the early 1980s, cash earned 8-9% after tax. Consider a simple example of a company whose only asset is $100 of cash and the market price is also $100. In the early 1980s, the $8 or $9 of interest income would generate a P/E ratio of about 12 times. Today, $100 would produce less than $1 of after-tax income, driving the P/E ratio north of 100 times. There is, of course, uncertainty as to whether that cash will eventually be returned to shareholders or invested in plants or acquisitions, but it seems that making a reasoned guess about the value of cash is more appropriate than valuing it at almost nothing.

A less obvious factor that is producing higher P/E ratios today is how accounting practices penalize certain growth investments. When a company builds a new plant, GAAP accounting spreads that cost over its useful life—often 40 years—so the cost gets expensed through 40 years of depreciation as opposed to just flowing through the current income statement.

But when Amazon hires engineers and programmers to help it prepare for sales that could double over the next four years, those costs get immediately charged to the income statement. When Facebook decides to limit the ad load on WhatsApp to allow it to quickly gain market share, the forgone revenue immediately penalizes the income statement. And when Alphabet invests venture capital in autonomous vehicles for rewards that are years and years away, the costs are expensed now and current earnings are reduced.

The media is obsessed with supposedly bubble-like valuations of the FANG stocks—Facebook, Amazon, Netflix and Google (Alphabet). The FANG companies account for over 7% of the S&P 500 and sell at a weighted average P/E of 39 times consensus 2017 earnings. In our opinion, the P/E ratio is a very poor indicator of the value of these companies. Alphabet is one of our largest holdings, and our valuation estimate is certainly not based on its search division being worth 40 times earnings. If one removed the FANG stocks from the S&P multiple calculation—not because their multiples are high, but because they misrepresent value—the market P/E would fall by nearly a full point. And, clearly, more companies than these four are affected by income statement growth spending.

In addition, no discussion of stock valuations would be complete without some consideration of opportunities available in fixed income. Many experts argue that investors should sell their stocks because the current S&P 500 P/E of 19 times is higher than the 17 times average of the past 30 years. By comparison, if we think of a long U.S. Treasury bond—say, 30 years—in P/E terms, the current yield of 2.9% results in a P/E of 34 times. The average yield on long Treasuries over the past 30 years has been 5.5%, which translates to a P/E of 18 times. Relative to the past 30 years, the long bond P/E is now 90% higher than average. We don’t think the bond market at current yields is any less risky than equities.

The point of this is not to advance a bullish case for stocks, but rather to poke holes in the argument that stocks are clearly overvalued.

We think our investors would also fare best by limiting their in-and-out trading. We suggest establishing a personal asset allocation target based on your financial position and risk tolerance. Then limit your trading to occasionally rebalancing your portfolio to your target. If the strong market has pushed your current equity weighting above your target, by all means take advantage of this strength to reduce your exposure to stocks.

Now, back to the P/E ratio distortions caused by investing for growth. This highlights a costly decision we made six years ago. In 2011, when Netflix traded at less than $10 per share, one of our analysts recommended purchase because the price-per-subscriber for Netflix was a fraction of the price-per-subscriber for HBO. Given the similarity of the product offerings and Netflix’s rapid growth, it seemed wrong to value the company’s subscribers at less than HBO’s. But, at the time, streaming was a relatively new technology, HBO subscribers had access to a much higher programming spend than Netflix subscribers and Netflix was primarily an online Blockbuster store, providing access to a library of very old movies. Netflix had only one original show that subscribers cared about, House of Cards, and churn was huge as they would cancel the service after a month of binging on the show. Despite the attractive price-per-sub, we concluded that the future of Netflix was too uncertain to make an investment.

Today, Netflix trades at $180 per share and has more global subscribers than the entire U.S. pay-TV industry. Netflix provides its subscribers access to more than two times the content spending that HBO offers, making it very hard for HBO to ever match the Netflix value proposition. Finally, Netflix is no longer just a reseller of old movies. The company has doubled its Emmy awards for original programming in each of the past two years and now ranks as the second most awarded “network.” On valuation, Netflix is still priced similarly to the price-per-subscriber implied by AT&T’s acquisition of HBO’s parent company Time Warner, despite Netflix subscribers more than quadrupling over the past four years while HBO subscribers have grown by less than one third.

Last quarter, when our analyst began his presentation recommending Netflix, selling at more than 100 times estimated 2017 earnings, I was more skeptical than usual. His opening comment was that Netflix charges about $10 per month while HBO Now, Spotify and Sirius XM each charge about $15. “All the company would have to do is raise prices 50% and the P/E ratio would fall to the low teens,” he argued. Anecdotally, those who subscribe to several of these services tend to value their Netflix subscription much higher despite its lower cost. Quantitatively, revenue-per-hour-watched suggests Netflix is about half the cost (subscription fees plus ad revenue) of other forms of video. Netflix probably could raise its price to at least $15 without losing many of its subscribers. For those reasons, Netflix is now in the Oakmark portfolio.

So, is Netflix hurting its shareholders by underpricing its product? We don’t think so. Like many network-effect businesses, scale is a large competitive advantage for content providers. Scale creates a nearly impenetrable moat for new entrants to cross. With more subscribers than any other video service, Netflix can pay more for programming and still achieve the lowest cost-per-subscriber. As shareholders of the company, we are perfectly amenable to Netflix’s decision to forfeit current income to rapidly increase scale.

Because we are value investors, when companies like Alphabet or Netflix show up in our portfolio, it raises eyebrows. Investors and advisors alike are full of questions when investors like us buy rapidly growing companies, or when growth investors buy companies with low P/Es. Portfolio managers generally don’t like to be questioned about their investment style purity, so they often avoid owning those stocks. We believe our portfolios benefit from owning stocks in the overlapping area between growth and value. Therefore, we welcome your questions about our purchases and are happy to discuss the shortcomings of using P/E ratio alone to define value.

Scamming the Scamer–Funny!

and

SURPRISE! Look what just landed in my inbox today.  I wonder if THIS is FINALLY my chance to get rich.  Lucky me:

ZENITH BANK COMPENSATION UNIT, IN AFFILIATION WITH THE UNITED NATIONS.

ATTN: aldridge56@aol.com

How are you today? Hope all is well with you and family?, You may not understand why this mail came to you.

In regards to the recent meeting between the United Nations and the
Present United States Government to restore the dignity and Economy of the Nations. Base on the Agreement with the World Bank Assistance to help and make the world a better place for all with the sole aim of abolishing poverty.

We have been having a meeting for the passed 7 months which ended 2 days ago with the then secretary to the UNITED NATIONS.

This email is to all the people that have been scammed in any part of the world, the UNITED NATIONS have agreed to compensate them with
the sum of US$ 250,000.00 (Two Hundred and Fifty Thousand United States Dollars). This includes every foreign contractors that may have not received their contract sum, and people that have had an unfinished transaction or international businesses that failed due to Government problems etc.

Your name and email was in the list submitted by our Monitoring Team of Economic and Financial Crime Commission observers  (Creepy!  Is someone spying on me?) and this is why we are contacting you, this have been agreed upon and have been signed.

You are advised to contact Mr. Jim Ovia of ZENITH BANK NIGERIA PLC, as he is our representative in Nigeria, contact him immediately for your Cheque/ International Bank Draft of USD$ 250,000.00 (Two Hundred and Fifty Thousand United States Dollars) This funds are in a Bank Draft for security purpose OK? So he will send it to you and you can clear it in any bank of your choice.

This meeting was first held on the 8th of April 2003. You can view
this page for your perusal:  http://www.un.org/News/Press/docs/2003/ik344.doc.htm

Therefore, you should send him your full Name and telephone number/your correct mailing address where you want him to send the Draft to you.

Contact Mr. Jim Ovia immediately for your Cheque:

Person to Mr. Jim Ovia
Email: 1634150898@qq.com

Good luck and kind regards,

Any ideas of what I should reply?  I will split the profits!