The Investment Perspective – September 2022

“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:

• Bear markets signify worry and declining share prices. 

• Bear markets also present opportunities for investors.

• Which one do you choose?

• What does history say about bear markets?  

• How can the current bear market make you a better investor?

The market delivers the price, the business delivers the opportunity

If you’ve read that any less than fifty times over the last decade then you haven’t been reading my material!  Ben Graham made that comment long ago.

It’s a classic old cliché.  The trouble with clichés is that people become numb to them.  They forget what they really mean sometimes.

It’s almost as though, because I’ve heard it before it offers no interest or value.

The thing about lower prices

Low prices don’t always represent better value.  Sometimes lower prices just represent less worse value.

So how do we know the difference then?

Intrinsic value

We all look for simple mechanisms to solve complex issues.

Many try to apply that same approach to working out the intrinsic value puzzle.  Is it a simple formula? Is it simply a number.  Is it a comparison of two numbers?

The reality is that any numbers are only a guide to what’s really going on because well… (to steal a phrase from the Labour Party) it’s complicated!

As Warren Buffett has mentioned on more than one occasion, establishing the intrinsic value number is difficult.

However, that’s what provides us with a reliable reference point.

We can look at the intrinsic value once we’ve established it and then see where the trading price is in relation.

At WISEplanning, as we’ve developed the approach to establishing intrinsic value over many years, it has become ever more complex.

Intrinsic value is more than just the net tangible assets or the price to earnings P/E ratio or the price to sales ratio or the price to earnings growth ratio or the discounted cash flow.  Indeed all of these ratios are useful.

The trouble is, they need to be applied where they are appropriate.  I’ll avoid getting into ‘the weeds’ so to speak, but at WISEplanning we do indeed look at those financial ratios along with the economics of the business.

That’s because, financial ratios are useful however they don’t tell the full story.

The financials

The ratios I outlined above are part of what I refer to as ‘the financials’.

They come from the income statement and the balance sheet.

Information in the income statement and the balance sheet tends to record what has happened in the past.  Good to know but of course not a guarantee of what lies ahead.

The economics of the business

Probably the most popular of the economics and easy to grasp is the competitive advantage.  Simply, a business is dominant either in its niche, a particular sector, or globally.

For example, dotDigital is a small cap that is arguably strong in its niche but of course has significant and much larger competitors.

dotDigital has seen its stock trading price shoot to the moon and come back down to earth again.  Its trading price is arguably not cheap but then as the business continues to grow, all things considered, the current buy price may look cheap when we look back in the fulness of time.

By contrast, Alphabet (the owner of Google) apart from its other divisions that are really in development, the Google operation is one of the best examples of a competitive advantage.  Not many businesses can say that they control over 80% of their sector.  Google controls well over 80% of search engine activity – all around the world.

The competitive advantage helps drive some of the useful numbers that flow out of the income statement and the balance sheet.  The point is that the numbers don’t drive the competitive advantage.

Perhaps the other point worth mentioning is the fact that numbers are derived from historical events and can be considered factual provided they’re reported properly.

When we get to the economics of the business, this starts to become somewhat of a value judgment made by the analyst and could not be considered mathematics or an exact science.  Hence Warren Buffett’s comment around intrinsic value being difficult to establish.

That said, whilst at WISEplanning we prefer to use a range for the intrinsic value rather than an exact number, it has proven to be useful over a variety of market circles over several decades.

The market delivers the price  

So, the market delivers the price.

Happy markets generally remove favourable pricing.

Unhappy markets generally deliver favourable pricing.

Joining the dots

Something that may not be obvious to some is the importance of linking the decline in the cash up value of their portfolio with better buying value.  The portfolio cash up value declines, better buy prices emerge at the same time – great, right!?

Usually, a broad market decline in trading prices will be reflected across investment portfolios.  It’s the same for me, you, Berkshire Hathaway, Warren Buffett, everyone else who is investing directly.

As we know though, short-term market variations don’t provide much of an insight into the actual business, but can give us some clues around pricing and how it compares to the intrinsic value of the business.

TIP: Intrinsic value is a measure of underlying business performance. The higher the intrinsic value, the better the business performance.

The business delivers the opportunity

The business provides the opportunity by way of strong underlying economics which in turn should deliver strong financials.  It doesn’t work in reverse.

Strong business economics generally means business growth.   Business growth can deliver strong compounding growth long term for investors. The better the quality of the business, the more reliable and the better the growth long term.

Popular stocks can be tempting, especially when they remain popular for quite some time.  It’s almost as though their expensive trading price continuing to rise and rise is normal and right.

In the long run though, sticking to the methodology and being mindful of intrinsic value, the trading price and more importantly the opportunity that each business delivers, helps support investment performance.

Performance versus performance(?)

The market generally talks about performance as being the rise or decline in the trading price of a stock or an investment portfolio.  In other words, when the cash up value has increased by say 12% for the year, people talk about the performance of the portfolio being 12%.

In reality they’re really only measuring the popularity of the portfolio. In the example above, the portfolio is 12% more popular. The performance of the underlying businesses that make up the portfolio may or may not have improved by 12%.

Longer term though the cash up value of investment portfolios and the trading price of individual stocks reflect the real underlying value.  Short term, not so much.

The performance, at least at WISEplanning, is about the performance of the business (as distinct from the rise or fall in the share price).  Return on shareholders’ funds and return on capital provide some clarity about the performance of the business.

Indeed, it’s not profit but rather profitability (return on shareholders’ funds and return on capital) that gives us real insights into performance.  Performance of the business that is – as distinct from the popularity or the unpopularity of a stock.

The price and the opportunity

And so we complete the full circle starting with the market delivering favourable pricing (market corrections, bear markets), the intrinsic value, the real measure of performance and then to the business providing the opportunity through sound and consistent business economics.

Perhaps one other thought worth mentioning in this environment is the fact that, the market, because it’s volatile is not broken.

Indeed the market being volatile confirms the market is alive and well and functioning as it is supposed to.  Recession and lower trading prices don’t last forever.  They are just part of the credit cycle shift currently underway – normal.

The challenge for some could be that we may see several more months of indecision around interest rates and recession by the market.

However, lower prices simply mean better pricing, and possibly the opportunity for some to practice their patience skillset 🙂

“Governments don’t solve problems, they subsidise them.”

Ronald Reagan – former American President