How is economic worth determined?
Business Perspective Investors have a strong focus on free cash generation. We believe that economic worth is the present value of the future stream of free cash flows. Once cash becomes distributable, it does not matter from what product or service the cash is generated; all that matters is the volume of cash likely to be generated between now and Judgement Day.
John Burr Williams first championed this proposition in his 1938 book, ‘The Theory of Investment Value’. In it, he said:
“The purchase of a stock or bond, like other transactions which give rise to the phenomenon of interest, represents the exchange of present goods for future goods – dividends, or coupons, and principal – in this case being the claim on future goods. To appraise the investment value, then, it is necessary to estimate future payments. The annuity of payments, adjusted for changes in the value of money itself, may then be discounted at the pure interest rate demanded by the investor.”
In committing to an investment, the investor gives up a scarce resource – cash. In return, he expects cash back in the future; in dividends and/or capital appreciation, which can be crystallised into cash. The value of any investment is the stream of future cash flows that an investor can expect, discounted back to a lower present value in recognition of the fact that cash received today is worth more than cash received tomorrow.
Margin of Safety
The difference between market price paid and economic value received is Ben Graham’s famous ‘Margin of Safety’ – three of the most important words in the investment lexicon. Graham likened the stockmarket to a voting machine in the short-term but a weighing machine in the long-term.³
Long-term, there is a direct correlation between the success of a business and its stockmarket price. The unknowable is the time it will take for this to be reflected.
Once an investment has been made, we rely upon the operating performance of the company to inform us of how successful the investment has been, not the share price. That is because we believe that the principal risk for investors is economic (business based), as distinct from quotational (stockmarket price based).
Be Disciplined about Selling
When it comes to selling, we tend towards Philip Fisher’s dictum that there are three fundamental reasons only:
The first is that there has been a permanent deterioration of the franchise, its growth prospects or its management.
The second is that an alternative superior investment proposition has been discovered at a time when sufficient cash for investment is not available.
The third is that a mistake has been made and the reality is a lot less favourable than originally envisaged.⁴
A fourth might be that market prices have become detached from economic reality in the midst of an asset bubble.
Of course, we shall not be able to take quite such a purist's approach. The regulations that govern authorised investment funds in the UK require that a collective fund, such as a unit trust or open-ended investment company, may invest no more than 10% of its assets in any single company’s shares and no more than 40% of the fund may be made up of companies’ shares that each represent up to 5% or more of its net assets – the so-called ‘5/10/40’ rule. We have some sympathy with those who see having to sell down a successful company to invest elsewhere as a little like ‘pulling up the roses to water the weeds’. But rules are rules.
And sometimes funds have to sell to meet redemptions.
Summing it all up
A share represents a part ownership interest in a real business. We limit our efforts to identifying superior businesses for potential investment. We wait for the shares to come ‘on sale’ in the stockmarket. We focus on the long-term. And we don’t sell out just because the share price has risen and there is a profit to be taken.
³ Benjamin Graham & David Dodd, Security Analysis, Second Edition 1940
⁴ Philip A. Fisher, Common Stocks And Uncommon Profits, 1958