A Great Individual Investor’s Investment Letter; A Reader’s Questions


A successful individual investor recaps 2013 (Must Read) David Collum_2013_year_in_review  

Note how few long-term decisions he made. Owning long-term bonds from 1980 to 1988, etc.  Buying precious metals in 2001 and STILL holding on through 2013–now that is long-term investing! 2013 was only his second losing year in several decades thanks to gold and silver being down 39% and 55% this year.


A Reader’s Question

I have a couple of valuation questions that I have been wrestling with recently.  I would love to hear your take.

First, do you ever use a PE ratio for valuation?  I have always used a EV to EBIT or something ratio whether pre-tax or after-tax.  (I have an idea of the multiples that interest me in both cases.)  Sometimes I come across something that has a low PE but not so low EV/EBIT.  I think this is when the company has financial leverage and is paying an interest rate substantially below the earnings yield.  If it’s a high quality business and the leverage does not harm the company is it sometimes better to use a PE?
John Chew: No, I would use EV (enterprise value which includes net debt) rather than “P” or market cap because debt is part of the price that you pay. Also, look at the terms and conditions of the debt. Note the quality as well as the quantity of the debt. Bank debt is more onerous than say company-issued bonds. 
Also, if you are normalizing earnings, and current earnings are depressed and may be for a while, do you account for this in the valuation, perhaps as a liability?  Or is this an effort to be overly precise?  This quote from Jean-Marie Eveillard in The Value Investors suggests that the former method is overly precise because the future is uncertain:
  “There is no point asking about a company’s earnings outlook because if we are investing for the long-term, then short-term earnings never affect our intrinsic value calculation. Asking management about long-term plans is also pointless to me because the world changes. No one can predict what will happen, and so what is important for us as analysts is to discover the underlying strengths and weaknesses of the business ourselves.”
John Chew: You do not count this as a liability when you normalize earnings.  You look back over a long enough history 12 to 15 years (including the 2008/09 credit crisis) to sense what normal earnings are.  Part of normalizing earning would be assessing the competitive advantage of the business or the uniqueness of the assets.  For example, you should be able to have confidence in the earnings power of the assets owned by Compass Minerals (rock salt positioned near the Great Lakes giving a cost advantage). 
Finally, I want to share a quote from Dylan Grice that I recently found and thought you may find interesting:
Dylan Grice in the July 17, 2012, Popular Delusions
The power of a discounted cashflow model is that it allows us to achieve a value which is objective. With a model based on discounted future cashflow we can arrive at intrinsic value.
But is this correct? Can cash flows be objectively valued? Suppose I’m a fund manager worried that if I underperform the market over a twelve-month period I’ll be out of a job. What value would I attach to a boring business with dependable and robust cash flows, and therefore represents an excellent place to allocate preserve and grow my client’s capital over time but which, nevertheless, is unlikely to ‘perform’ over the next twelve months? The likelihood is that I will value such cash flows less than an investor who considers himself the custodian of his family’s wealth, who attached great importance to the protection of existing wealth for future generations, values permanence highly, and is largely uninterested in the next twelve months.
In other words, an institutional fund manager might apply a ‘higher discount rate’ to those same expected cash flows than the investor of family wealth. They arrive at different answers to the same problem. The same cash flows are being valued subjectively and there is no such thing as an objective or ‘intrinsic value’ embedded in the asset, even though it has cash flows.
John Chew: Well, I agree that investors have different discount rates. You need to use one that fits your situation.  We are discussing human beings making decisions under uncertainty or human action.  All value is subjective. To learn more go to: http://mises.org/austecon/chap4.asp
Thanks for the questions and to all a Happy, Healthy and Prosperous New Year in 2014


6 responses to “A Great Individual Investor’s Investment Letter; A Reader’s Questions

  1. John,

    Thanks for the interesting post. In your first comment you say that you would not use a P/E multiple because debt is part of the price you pay. I’m not sure what exactly you’re saying but the price of debt is taken into account as interest is an expense item in earnings. EV/EBIT is an extremely useful multiple and represents an important advancement in valuation but at the end of the day, you’re buying the equity- not the enterprise. If an EV multiple looks about right but the P/E is way too low you’ve still got yourself an undervalued security (all things held equal). That’s why companies can lever up and fetch a higher enterprise valuation. Actually, I think that Greenblatt mentions this phenomenon in his first book if I remember correctly. Probably the part on recaps.

    Regarding the last question, I’ve never agreed with Mises on this point. Here is, in my opinion, the correct way to think about market value: http://aynrandlexicon.com/lexicon/market_value.html

    • There is a philosophical reason for using enterprise value (EV) because, as Buffett preaches, you are buying a business not a stock. To think about buying the entire business you must include all liabilities including debt.

      Yes, you see the interest cost on the balance sheet, but you might not be aware of the amount of debt or the terms of that debt unless you look at the footnotes.

      Depending upon the stability of the business and conditions, adding debt that has repayment terms and interest cost below the earnings power of the business can enhance the equity value of the companies shares. However, beyond a certain point, debt can damage the value of equity. Financial risk overtakes equity returns. There is a trade-off.

      Under-leveraged businesses can have a greater margin of safety. But everything has a context. An experienced investor knows the context.

      I think that each person has different subjective values. What you will spend your ten dollars on will probably be different than what I would expend money on. But we may both agree on the value of money (a common exchange medium).

      Or I may as an investor require a 15% return on my purchase of Coke shares, so the price may be at a level relative to intrinsic value that would allow for a 15% return upon a return to intrinsic value but I would not have my 35% margin of safety because the price is not currently trading lower. But the majority of institutional investors may be quite happy with a 9% required return. IF the majority of investors are willing to accept a 9% return, there might be my margin of safety.

      • Hi John,

        Thanks for the reply.

        “There is a philosophical reason for using enterprise value (EV) because, as Buffett preaches, you are buying a business not a stock. To think about buying the entire business you must include all liabilities including debt.”

        Unless I’m misunderstanding you I think you’re conflating two very different ideas. When Buffett says that you’re buying a business and not a stock he’s highlighting that the fundamentals matter. Consequently, I agree it’s important to understand the capital structure. However, Buffett is definitely not saying that you’re buying the entire enterprise. Stock is equity, not the enterprise. That’s just a fact so P/Es are not irrelevant. It seems like we’re in agreement but since you provided further explanation I guess we’re not. If I could only use one multiple I’d use an EV multiple but we don’t have to make that choice.

        Rand’s point was that even though what you will spend your ten dollars on is different than what I will spend my ten dollars on, the value of the goods to each of us is still objective. Using her example, in the context of a stenographer struggling to make ends meet, a tube of lipstick will have objectively more value to her life than a microscope she will never use. This is really a very deep and fundamental disagreement with Mises, although as far as I can tell, his error doesn’t manifest itself in his economic conclusions. Mises believes values are subjective to the core. In his view something can be a value to me just because I will it to be. In Rand’s view, things are objectively good or bad for you. Stated in these terms I think it’s clear that Rand was right and Mises was not.

  2. Merry Christmas,

    One question. I have seen recent posts of yours on valuewalk that do not show up on this blog. The posts are worthwhile and informative. However, these posts only show up on valuewalk. Is there a reason that your valuewalk posts cannot also be posted on your blog?

  3. I am not aware of the difference. Perhaps a link I could compare. Thanks.

    • My error (I will blame it on my ipad). Valuewalk is reposting some of your blog posts from a while back, so there is a timing difference. I follow your blog regularly, so when I saw some recent posts by “csinvesting” on valuewalk that were not recent posts on your blog, I “assumed” (I know, this is dangerous) that these were new/different posts.

      I forgot my Ayn Rand: “whenever you find a contradiction, check your premises, because you will discover that one of them is wrong.”


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