The Investment Perspective – February 2023

“Neither the investing method nor the fundamentals of the business are right or wrong because the mood of the market is favourable or unfavourable toward the “stock”. That is because when you really think about it, “stocks” (shares) are all about the financials and the trading price, the share price… the cash up value. What matters more is the economics of the business” 

Peter Flannery

Key Points:

• Why do share prices rise and fall?
• If intrinsic value is important, what drives it?
• How are free cash flow and profit different?
• Establishing the quality of a company’s earnings (profit).

What drives trading prices?

There are a multitude of different drivers for trading prices.

Some are market driven and broad.

Others are company-specific.

Other drivers of trading prices are simply the weight of money.  For example, traders strongly buying a particular stock or sector can drive prices up.

Then, when they’ve made profits they can sell leaving those who bought at the top with losses (sometimes known as ‘pass the parcel’).

As the Coronavirus emerged and continued to spread, markets became concerned about possible global recession and therefore company earnings declining.

Currently among other drivers, (the traders continue no matter what) markets are focused on the inflation number out of the US, the pace of interest rate rises, any signal of interest rate cuts in the US, earnings announcements currently underway and indications of recession.

Specifically with regard to recession, it is the depth and length of it that the market will be keeping an eye on.

The point here is that there are lots of drivers.  As investors you and I are wise to keep one eye trading prices – not difficult to do.  Trading prices are widely publicised and indeed strongly publicised when prices rise sharply or when they decline unexpectedly.  This type of event is great storyline for the popular media.

Company specific pricing

When the market takes a view on a particular business, it is not always wrong, but is not always right, which is the dilemma.

It’s easy simply to follow the lead of the market so that when it likes something we can just buy it and when it does not like a particular business we can just sell it.  Unfortunately that approach to investing is less than prudent.  I know it’s easy to transact that way but becomes increasingly difficult to make money over time.

Our response?

Trading prices are one thing.  How we respond is another.

One difficult way to respond is to react every time prices move or try to second guess what’s coming up.  It can work from time-to-time and feels real good when it does.  Equally it can be quite demoralising when it doesn’t.

A better way, is to invest on the basis of a particular strategy or framework so that you have some simple guidelines to follow.

At WISEplanning we use value investing as that framework.  As you know this has in recent times morphed into eco-Investing and eBiz investing.  In simple terms, investing in the economics of the business along with the financials.

More specifically though, it is adopting a fundamental business approach to investing rather than a “play the markets” approach to investing in the stock, which is the default position for many.

The trouble is, it feels somehow normal and right to follow the crowd and respond the way everyone else responds …e.g. when the market is selling, to sell.  When the market is buying, to buy.  In reality even though it’s counterintuitive the opposite works best.

One catch though is that patience is required.  In Charlie Munger’s words, “That long attention span.” 

What drives value?

When we invest in the business we have some different metrics that we can use to help get a sense of value.

In an ideal world we can come up with a specific number that reflects the intrinsic value – actually difficult to do.  At WISEplanning we work in value ranges rather than simply relying on a specific number.

Anyway a fundamental approach provides that framework that helps us to look through trading price gyrations.

This is especially important when unexpected trading price moves are also significant.

Business economics

As you know this involves the strength of the brand, the competitive advantage and the ecosystem, each of which is a valuable indicator of the strength of a business.

Quality earnings

A ratio that’s commonly used across the markets is the price to earnings ratio (P/E ratio).  It can be useful although has shortcomings.

To get around this we sometimes focus on free cash flow instead of earnings per share.

Think of earnings as the profit the company makes (keeping things simple) and think of cash flow as the surplus cash after, for example dividends paid out and other requirements.

Put simply, a business that can take care of everyday operations, achieve a higher return on capital invested and can grow the amount of cash in the bank every year is the kind of business that’s good to invest in where possible – not always easy to find.

To put this another way, when profitability is low or a business needs to allocate profits to capital expenditure, then the quality of earnings in theory is diminished.

Where a business continues to grow inventory (stock) and receivables (the amount of money that customers owe the business) year after year but does not have the ability to grow its cash balance, this demonstrates low quality earnings.

Free cash flow vs earnings

Free cash flow after other requirements are met is how we can get an idea of the quality of earnings.

A low level of free cash flow compared to the level of earnings or earnings per share indicates poor quality earnings.

Quality earnings, the next step

So, a low level of cash compared to earnings can indicate poor quality earnings.

The next factor to consider is how the free cash flow is allocated or invested.  If it is reinvested in the business and generates a return that is the same or higher as that which generated the cash flow originally, then this indicates quality earnings.

On the other hand, if the free cash flow is allocated either to this business or to another business that generate a lower return, then this again is an example of poor quality earnings.

It’s all about value creation.  It’s about the incremental return on free cash flow once it is redeployed.

For example where a business buys back its own shares, this can help enhance the quality of earnings, especially when the business continues to achieve the same or better return on shareholders’ funds in the future.

One catch here is that paying too much for those shares when trading prices are high diminishes the quality of those earnings.

Sometimes it’s not as it seems

Sometimes things that sound good are not always what they appear to be.

For example earnings per share in a large business that makes a lot of acquisitions or buys back their own stock when it’s overpriced or pays off debt that’s quite low cost is actually not a good way for us to invest.

I know, it sounds as though the company is growing.  Buying back its own shares or even paying down debt, sound like good things to do.

They may well be good things to do however for us, when we’re thinking about quality earnings, it’s about how much of each dollar of earnings is converted to free cash flow.

In simple terms, companies with low quality or difficult to assess earnings quality would ideally be purchased when their P/E ratio is relatively low.

It sounds simple when we say it.  Pay more for quality and less for lack of quality.

The obvious comment

The obvious comment here that I know you are expecting is that an overemphasis on the trading price, whether it be a surprise on the upside or the downside, is potentially a low quality way to assess the value of a business and where it’s heading, compared to an assessment of the quality of a business’s earnings.

“I put a dollar in one of those change machines.  Nothing changed.”

– George Carlin