Thursday, September 25, 2014

Price And Value

I’m going to start this article with the eternal words of Warren Buffett, as written in Berkshire Hathaway Inc.’s (BRK.B) 2008 shareholder letter:
Long ago, Ben Graham taught me that “Price is what you pay; value is what you get.” Whether we’re talking about socks or stocks, I like buying quality merchandise when it is marked down.
If you want to be a successful long-term investor in stocks, it’s imperative that you develop and maintain an ability to decipher between price and value. Automatically assuming the sticker price on a stock corresponds precisely with its intrinsic value is a practice that will very likely lead you to disappointment and lost wealth.
I wanted to take a little time today to discuss price, value, and what to do when the prices on stocks change.

Price

What is price? 
Price is simply the amount of money that is expected for something.
Anything with a price on it is available to exchange for money.
You might go down to your local grocery store and see price tags on everything. $1.50 for a loaf of bread. $3.99 for a box of cereal. You get the gist.
All the same, stocks have prices on them as well. They range from pennies all the way up to hundreds of thousands of dollars. Obviously, one might look at stocks at face value and assume that a stock that sells for $10.00 is cheaper than a stock that is trading for $20.00. And at face value, that is correct. In absolute terms, a stock that is selling for ten dollars will cost you less money than a stock that is trading for twenty dollars.
But is the cheaper stock worth less than the more expensive stock?
Not necessarily.
To determine the worth of a stock, one must look beyond the price. One must be able to reasonably come to some kind of conclusion or range about the intrinsic value of a stock to determine whether or not the asking price is a good or bad deal.

Value

What is value?
Value is the monetary or material worth of something.
It’s important to remember here that price and value seldom, if ever, exhibit a 1:1 ratio. There are some people out there that believe all stocks at all times are fairly valued; that is to say, every stock’s price and intrinsic value are always one and the same. However, if that were true how would you explain successful investors that were able to routinely take advantage of mismatches between price and value for years on end? A certain man by the name of Warren Buffett comes to mind here. Buffett himself has argued thismany times before, so I won’t belabor the point.
So if price and value aren’t necessarily one and the same, what do we do?
Well, we develop a system that can be used to regularly and reliably value stocks. There are many systems out there. You can look at the price against various performance figures, like the price-to-earnings ratio or price-to-sales ratio. You can compare the price to the earnings growth rate. You can use a discounted cash flow model analysis or dividend discount model analysis. I’ve discussed my methods in-depth already, but you’ll want to develop a system that makes sense for you.
I try to keep in mind that valuing a stock is part art and part science. You’re using hard numbers like sales figures and debt, but you’re also trying to predict growth rates and how sustainable competitive advantages might be. As such, the best one can do is come up with a reasonable range of fair value, and try to buy a stock as far under that range as possible. Doing so would be building in a margin of safety, ensuring that even if a stock is actually worth less than what you predicted you still got a good deal.

What To Do When A Stock’s Price Falls

Now that we’ve established what price and value are, and how they’re not necessarily associated with one another, we can approach stock investing with a rational and logical perspective.
I often talk about averaging down on a stock. This is basically taking advantage of further spreads between price and value, whereby I buy more of a stock at a cheaper price than the previous purchase. If I value a stock at $50 per share and the market is offering each share at $40 I’m a happy camper. So let’s say I buy 100 shares of this stock. And let’s say a month later the market is now offering the stock at $35, but the original thesis hasn’t changed. Meaning, the fundamentals of the company are the same as they were a month ago. What is my state of mind?
Well, I should be celebrating!
I just paid $40 for something that I believe is worth $50. And now you’re telling me I can get it for $35? I must be the luckiest man on earth. At this point, I’m most likely buying more shares.
And I’m not just writing this. You can see that I did this with Target Corporation (TGT) in January andFebruary of this year. And before that I averaged down on Digital Realty Trust, Inc. (DLR) in August andOctober of last year.
But one must consider capital availability and overall portfolio construction, as I wouldn’t recommend loading up one stock (even if you thought it was a deal) to where it’s an overwhelming portion of the portfolio. Diversification is always important, because it’s always possible that your valuation was incorrect, or the business does not perform as expected.
I’ve also discussed before why I look forward to seeing the shares on stocks I already own fall in price. Even if I don’t have capital or portfolio space for a particular stock at the time, a cheaper stock still has benefits.
However, not every stock pullback is an opportunity. Just because a stock falls by a certain percentage does not necessarily make it a good purchase.
For instance, let’s say Company ABC’s stock is selling for $50 today. Tomorrow, there’s a storm in Idaho or something else equally meaningless to the issue at hand and Company ABC’s stock is now selling at $40. That’s a 20% haircut overnight. Must be a steal now, right?
Not necessarily.
You have no idea what the stock’s worth, or intrinsic value, is. So you cannot possibly know if it’s a good deal or not. You have to fully analyze the company and come to some kind of reasonable range of value before expounding on its worthiness as an investment at the new price.
Be careful with that. 
Furthermore, a stock may fall substantially in price due to deteriorating fundamentals. This can be an opportunity, or a trap. It all depends on whether or not these deteriorating fundamentals are the result of a long-term problem with the company or market they operate in, or if it’s just a bump in the road. It can be exceedingly difficult to differentiate between real, lasting problems and short-term hiccups, which further places importance on diversification.
For example, my aforementioned averaging down on shares in Target occurred after the company announced a major data hack and disappointing results in their Canadian segment. I felt these issues were rather transient, but others might disagree. I believe the data breach will be far behind us in a year or two, and the Canadian stores represent a fraction of their overall business. But there’s still the lingering issue where consumers are increasingly shopping online.
So there’s uncertainty and risk there. But that’s exactly where some of the best investments can be had. The greater the risk, the greater the potential reward. However, it’s important to weigh these risks and potential rewards, and diversify your portfolio accordingly. Furthermore, one major benefit of investing in companies that pay increasing dividends (like Target) is that you’re paid to wait while operations (hopefully) improve. Every dividend payment is a collection of cash, and a reduction of your capital at riskin the market.

What To Do When A Stock’s Price Rises

Averaging down is probably easy, right? If you like a stock enough at $X to buy it, then you probably love it at less than $X.
But what do you do when a stock goes up in price?
It’s funny because us value investors that focus on rising dividend income generally look forward to falling stock prices, as I described above. This allows those accumulating assets to buy cheaper stocks with higher yields on them (price and yield are inversely correlated). A higher yield means more dividend income for the same amount of money. And more dividend income gives your future compounding a bigger tailwind, effectively allowing you to roll your snowball downhill at a faster rate.
This is probably strange to casual onlookers. It would seem that most investors out there are focused only on the value of their collective investments. As such, an increasing value is good and a decreasing value is bad. This rather simple approach doesn’t really get at the heart of true long-term wealth creation, where one would do well to accumulate high-quality assets at prices cheaper than what they’re truly worth. A reassuring feeling that can wash over you when times are good and your accounts are all up can be very expensive, relatively speaking.
When stocks go up, us value investors might cringe a little. And that’s simply because we know that great assets are harder to purchase, as they would then require more hard-earned capital.
But not all is lost. Great businesses will sell more products and/or services as time goes on, as we would expect them to. As such, their profits will rise, and the businesses will become more valuable. This is what we want when we invest in high-quality companies. So it is inevitable that the market will recognize this quality and assign a higher price to equity in these businesses. This is a natural course of life and investing.
However, the key is to pay attention to fundamentals, not prices. As always, you should rationally decide for yourself what an asset is worth, instead of relying on the market to tell you this.
I’ll show you how this works in real life.
I initiated a position (before this blog went public) in Philip Morris International Inc. (PM) on 1/7/11 for $56.22 per share. Meanwhile, the previous twelve months of earnings were $3.92. So I paid $14.34 for every dollar in profit Philip Morris was able to generate over the prior twelve months of operations.
I then added to my position in the company in October 2011 for $62.51 per share. So PM went up, which caused me to pay more for further equity in the company. However, profitability had also increased. The prior twelves months of earnings had increased to $4.72. So I paid $13.24 for every dollar in profit that the company had generated over the prior twelve months of operations. I paid more per share in absolute price, but less on a basis relative to underlying profitability.
I built my position in Philip Morris International over the course of five separate transactions, with the last one seeing me pay $79.14 per share in January of this year. We can see that PM finished 2013 with earnings per share of $5.26. So I paid $15.04 for every dollar in profit the company had generated over the prior twelve months.
So you can see how even though PM’s share price had advanced substantially over the years along with the broader market, so had its earnings power. I was happy to pay just a little more for every dollar in earnings in early 2014 over what I paid in late 2011, considering how much the broader stock market, and PM’s share price with it, had gone up. We keep hearing about how expensive the stock market is and how a correction is coming any day now, but you can see here that I paid a very similar price relative to earnings power and value for PM’s stock in both early 2011 and early 2014.
Price is meaningless without some relativity to value. Price is but a number. Value tells you how much a stock is actually worth.
In the above example, I paid attention to Philip Morris International’s fundamentals rather than absolute price, and felt its intrinsic value had increased over the past few years, thus rationalizing a higher price. Its earnings power had increased substantially, and the company had gone from paying $2.44 in dividends during the year of 2010 to $3.58 throughout the year of 2013. That’s an increase of 46.7%, or a compound annual growth rate of 13.63% over that four-year stretch.
So of course I was willing to pay more for the company. The fundamentals were better. The company was earning more, and paying me more of that increased profitability via larger dividends. Now, there is more to a company’s fundamentals than just earnings and dividends, as I’ve discussed numerous times. But you can see here why PM’s stock was worth more, thus making me feel comfortable with paying more. The price had increased, but so had the value. Thus, on a relative basis it wasn’t a lot more expensive.
Now, if a stock’s price rises to a point where it’s irrational and the underlying value has not increased in a likewise fashion, then it would obviously not be advantageous to buy more shares. In fact, if the price becomes too irrational one might be better served selling, while looking for a better opportunity later to re-enter that investment when price and value are more advantageously correlated.
You always have to weigh your risk against the potential reward. And the lowest risk and greatest reward is present when the price and value are furthest apart to your favor.

Conclusion

Price is just a number, an amount of money that is expected for something. Without value, it’s impossible to quantify whether a price is fair, cheap, or expensive.
However, I also don’t believe it’s possible to exactly and precisely determine the value on a stock. Rather, you will want to reasonably estimate the intrinsic value on a company, and what each share might be worth. A tight range is probably appropriate, though I use a dividend discount model analysis to put a round number on it. Although, one should always strive to buy even below this range, as it ensures a margin of safety in case your growth estimates are wrong, the company does not perform as predicted, or the broader market all of the sudden decides to discount that particular stock or all stocks in general.
Furthermore, one should always strive to diversify. Diversification allows you to not only enjoy a wide variety of business partnerships across markets and sectors, but also diversifies your income sources. Furthermore, diversification reduces risk against business failure and permanent capital loss. Avoiding monetary loss should be your primary responsibility.
Don’t fear price changes. Volatility is opportunity, especially for those still accumulating assets. Furthermore, the focus should be on fundamentals, not price fluctuations. Pay attention to improving and deteriorating fundamentals, rather than rising and falling prices. If the fundamentals are strong and you determine a stock’s price to be lower than its intrinsic value, you shouldn’t fear buying. Consensus isn’t necessary. Be an independent thinker.
Full Disclosure: Long TGT, DLR, and PM.
How about you? Do you fear volatility? Do you think price and value are rarely correlated? 
Thanks for reading.

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