My Investing Philosophy - 1. Value

In the following posts I want to summarize my investment philosophy and strategies. As I told in previous texts, my early investment and trading days can be described as rather unorganized. It took me a long time to find my way but it was worth it. Please note that every investor has a personal investment style preference and risk tolerance. The most important thing isn't to have a high CAGR or Sharpe Ratio. The highest goal is to find a style you are comfortable with. You have to understand it and you have to trust it. Daniel Crosby often mentions the concept of “anxiety-adjusted” returns.

Another belief I have is that a working system has to fail from time to time! Why? A fail-proof system would quickly be discovered by the market and is arbitraged away. There have to be periods of low performance and enough “career risk” to purge the system frequently. If you can not guarantee to stay the course in those periods, the investment style is not YOUR investment style. It sounds cheesy but I came to the conclusion that an investor actually does not choose an investment style. The investment style chooses the investor instead.

My idea of Value.

One basic principle that did not change for me over the years and is basically present in my genes is the principle of Value Investing. Although I never really thought about why it should work, I always was convinced that a cheap stock is a better investment than an expensive one on average. Especially now after the major tech rally of the recen years, there is once again a hot-blooded fight between all sorts of value investors. Discretionary value investors fight with quantitative value investors. GARP investors fight with academic value investors. “Cigar butt” deep value investors fight with quality value investors. The list goes on.

The easiest and simultaneously most complicated answer to the quastion “What is Value Investing”: Value Investing is buying a business for less than its Intrinsic Value. The common way to determine intrinsic value is a Discounted Cashflow Model, which highly depends on the inputs. In simple terms, these are:

1. Starting Cashflow Yield

2. Growth prospects

3. Discount rate

As a “relative” equity investor, you are basically looking for the best alternative there is, whatever cards you are dealt with. If we simplify the “discount rate” to a personal “hurdle rate” which is the same for each alternative and if we accept that we can not predict the future, meaning the “growth prospects” are also identical for each alternative, we can reduce the DCF model to one simple metric: The starting yield.

Conclusion: The bet you make as a relative (growth-prospect-agnostic) Quantitative Value investor simply is that noone can predict the future and that uncertainty is your friend. As long as “forcasts” remain as bad as they are right now, a bag of low-multiple stocks should outperform a bag of high-multiple stocks.

There many reasons why investors overpay for growthy stocks and hate cyclical, ugly, unsexy low-multiple stocks with an “uncertain” business future:

• Basic psychological overreaction due to panic/fear of missing out stoked my media coverage. The core principle of behavioral finance.

• Career risk: Fund managers and asset management firms live from assets under management (AUM) and fund flows, not from investment returns. It is way harder to market a bombed out industry than to promote the hottest cannabis, crypto or fuel cell stocks. If your bonus or your job depends on it, you will sell snake oil to your customers.

• Momentum, Short-term Trading, Quality Investing, Buy and Hold, Hedging…

• and many more…

There is no ONE right way to invest. Imagine Tesla. I guess many TSLA buyers out there know that the price of the stock is unsustainable from a DCF valuation point of view. However, Tesla was a hot stock with a lot a momentum. Traders are making money by buying the stock, maybe on leverage, to hold it for 1 month, one 1 week, or even just minutes. There is a huge derivatives market, which can drive single stocks higher in the short term simply due to Delta Hedging and many other complicated interconnections, the average investor just can not grasp. Know your game and do not get lost in other people’s games.

So am I basically saying: “Noone can predict the future, so Apple should trade at the same multiple as Ford!” — Of course not. As mentioned already, there are many ways to value a company. While “pure Value” only looks at price multiples, multifactor approaches approaches take into account other factors like the balance sheet, fundamentel or stock price momentum, profitability, management, marekt trends to somewhat approximate the “growth prospects” part of the DCF model.

I also do use three other components in my system:

1. Past performance (Long-term reversal and recent momentum)

2. Accounting (asset growth, accruals, external financing, …)

3. Red flags (extreme short-term price movement, EPS growth, debt, …)

I will talk about each of those components in future posts.

Finally, concluding all my fews on Value, you might ask: “So, what is the best Value metric then?” And the answer is: “There is none”. To build a robust system, it is always best to combine correlated metrics of the same “style” to build a wisdom-of-the-crowds-type situation for factors. Larry Swedroe puts it like this on Twitter:

I personally use P/S, EV/S, P/E, EV/EBIT, EV/EBITDA, P/opCF, P/FCF, and several gurufocus.com model multiples including P/GrahamNumber, P/P@MedianP/S and some more. Following OSAM and Alphaarchitect, I do not use Price-to-book since it has some flaws in 21th century terms and does not properly depict the earnings power of a business. But more on that maybe later.

Thanks for reading,

Your Non-Prophet.