We’ve covered a lot of ground—accounting, capital costs, and competitive advantages that help companies earn economic profits. But if we want to invest, we ultimately have to translate that from an opinion on the business to an opinion on the stock. Is a good business always a good stock? My contention would be an emphatic “no”.
I’m by no means the first person (nor the most insightful) to address this topic. Burton Malkiel, Philip Fisher, Howard Marks, Joel Greenblatt, Michael Mauboussin and Benjamin Graham—to name but a few—have all contributed mightily to the pool of wisdom from which we can drink. Each of these writers have different perspectives and conclusions, but a sampling of their works is certainly helpful. I’m convinced that a diligent study of this literature will yield far more value than I can here—but if you want a condensed version from my perspective, read on.
How Stocks Work (In Brief)
In terms of what drives stock markets, I like to think of two basic ideas:
- Liquidity theory. All markets are driven by supply and demand, and stocks are no exception. Every day, for a given stock, there will be some buyers, and some sellers. When the buyers dominate (either more numerous or more eager), prices will get bid up to convince holders to sell. When the sellers dominate (either more numerous or more desperate), prices will get pushed down to convince outsiders to buy. A stock’s short-term movements reflect relative buyer and seller interests over brief intervals. Stocks that are less liquid (that is, with fewer shares, more expensive shares, listed on an obscure exchange, or otherwise difficult to trade easily in large amounts) will typically have higher sensitivity to an imbalance of buyers and sellers. Thus, the liquidity theory could also be called the “supply and demand” theory of stock prices.
- Fundamental theory. The fundamental theory sees shares of stock for what they’re supposed to represent—formal claims to a proportionate ownership in the underlying company, and thus a long-run claim on that proportion of income. Under this theory, investors value stocks based on the value of the underlying business—and value the business based on their expectations of how the company will perform in the future: how much they expect earnings to grow, be cyclical, or be paid out in dividends to shareholders. Therefore, the fundamental theory could also be called the “expectations” theory.
These two theories give different explanations for how stock prices move. However, they are both true. Short-term movements are determined by current liquidity conditions in the market for a given stock, while in the longer run, prices will move toward the collective estimate of value (even if long-term holders have disparate views about what the estimate is). We shouldn’t interpret this to mean that short-term moves based on today’s supply and demand have no import for long-term oriented holders—after all, the long-term is simply the sum of many short-terms in sequence—and fundamental investors should keep up to date on risks and issues reflected in the market price that they may have overlooked.
Many forms of investing rely almost exclusively on one theory or the other. Day trading is driven heavily by liquidity factors, while committing to buying a stock and holding it to 20 years would entail a greater focus on long-term business performance. We must acknowledge that there is a spectrum of combinations between these two theories, each forming a different investment strategy, and that it’s possible to make and lose money in myriad different ways. Like we mentioned at the start of this series, it’s easier to follow one of these paths if it’s one that you feel philosophically aligned with. Therefore, because this is a series about finding good businesses, we are going to think about investing in the same way—through the lens of underlying business results and value.
The Efficient Markets Hypothesis states that all information is reflected fully and quickly into the prices of stocks. If a company reports a quarter’s results, the stock price will update rapidly. Many professional investors spend heavily on computing power and speed trying to be the first movers when such changes occur. It’s unlikely that we will beat them to the punch. Instead, we have to read the market prices we see as a signal of how investors expect the market to perform.
Expectations: Create Your Own Reality?
One form of expectation is called a multiple, essentially, the multiple to some future year’s estimated earnings (a lot depends on the quality of this estimate, of course) at which the stock is trading. The most common form is the forward Price/Earnings, or P/E: a stock with $10 estimated earnings per share trades at $200 a share, or a 20 times P/E. Another form is the forward Enterprise Value/NOPAT. This requires a couple extra steps. Enterprise Value equals the total market value of the stock plus the market value of the debt the company owes, while NOPAT is the same calculation of after-tax operating profit that we used in our accounting overview post. The same company that trades at $200/share may have $100/share in outstanding debt and have an estimated NOPAT next year of $20/share. Therefore, the company that trades at 20 times earnings trades at 15 times NOPAT.
Whichever form of multiple you prefer to use, it’s essentially capturing a lot of variables at once: estimated business quality (returns on capital), cost of capital, and estimates of the company’s long-term growth. It’s a lot of work (and a lot of chances for error) to estimate a company’s profits for the next hundred years. A multiple is a much simpler way to capture the long-term. If a company trades at 15x, but you feel it should be worth 20x, you have a higher opinion of the stock than the market as a whole does—and vice versa if you feel it should be worth 10x.
Where this gets tricky is in scenarios like the following: a company is a great business—profitable, good prospects for growth, excellent returns on capital, honest and competent management. The stock has become a darling for many investors, performing incredibly over the last 15 years, and now trades at 50x next year’s estimated earnings. Social media is full of flexing from people who bought early and got rich, and full of cautionary tales of people who had a chance to jump in but ended up missing out. Should you buy this stock now?
The answer, of course, is that it depends. The company seems to be a good business, and the growth potential is there. But we have to think clearly about what the market is pricing in. If a company is likely to grow 5% a year forever (which is quite significant considering how long “forever” really is), the market may become exuberant and price in expected perpetual growth of 8%. If this is the case, the multiple of 50x is too high for actual fundamentals to justify. The company will keep performing well, earnings will keep growing, and dividends will still get paid out—but the stock price will eventually correct once investors realize that 8% growth just isn’t coming. The company is still a very good company, but we’re all human, and investors got carried away.
To me, Tesla is a quintessential example of the phenomenon above. The brand has high value, the cars offer innovative features, and it’s simply a fact that the future will have more electric cars than the past did. And despite the fact that nearly every major auto maker has committed billions of dollars into developing their own electric models, it’s possible that Tesla’s head start, branding, and features help it keep a dominant market share even as the EV market gets crowded. But Tesla’s P/E is 80x at the time of this writing, while other auto companies often trade in high single-digits or low double-digits. Plus, the same cult following that inspires Tesla buyers is infecting investors. Successful investing requires dispassionate thinking and analysis—things that cult members by definition are unable to do or prevented from doing.
The takeaway from this is simple. Business quality and investment opportunity are two different things. A good business at an excessive price can be a poor investment, while a poor business at a bargain price might be a good investment. We have to make careful judgements about what the market is likely expecting from a company, and even more careful judgements about why our expectations may be different. Put this way, buying a stock is just as much about buying an “expectations spread” than it is an underlying business.
There’s another distinction between a good business and a good stock that needs addressed: leverage. Our NOPAT & ROIC math is indifferent to how a business is funded—whether with debt or equity, it makes no difference to us. This is perfectly fine for its purpose, since our goal in calculating invested capital is to just look at the operating characteristics of the business, rather than to specifically value the debt or equity securities the company issues. However, once we enter the investing world, we have to acknowledge this distinction.
A couple of posts ago, we briefly acknowledged the relationship between cost of equity and cost of capital. Let’s expand on that using an example. Say we have two companies, identical in every way except that one of them uses debt, and the other doesn’t. In good years, the debt-user, Levered LLC, will have higher returns on equity than the no-debt firm, Independent Inc. Independent Inc. should always have an ROE equal to its ROIC (at least in this simple example—in the real world, invested capital should exclude all non-operating assets and liabilities and therefore the returns would not be the same). Levered LLC’s use of leverage is doing what it’s intended to do—act as a “lever” to boost returns to equity holders. But look at what happens in less profitable years. As operating profits are lower, the debt burden remains fixed. In this case, while both firms suffer and produce lower returns, Levered LLC’s ROE falls below its ROIC—meaning the use of debt is taking value away from shareholders.
This is the double-edged sword that leverage represents. It can improve returns in good times—it can improve returns consistently when employed prudently—but it amplifies downside as well, resulting in lower profitability or, at worst, bankruptcy.
If you’re curious where the break-even point is between these two firms, here it is (approximately). It’s interesting to note that the firms have the same ROE at the point when they both earn ROICs equal to the after-tax cost of debt, which is roughly 11.5%. Any ROIC above that threshold, and the levered firm does better on an equity basis, and vice versa for the unlevered.
So, all else equal, should you prefer a levered or unlevered stock? It depends on several things: your appetite for risk, your demand for high returns, and the volatility of business results. Bear in mind that because the leverage represents additional risk, market participants should assign a higher cost of equity to the levered firm—thereby preventing too identical operating businesses from trading at wildly different multiples. But whatever our preference, we have to understand that from an equity investor’s standpoint, these two companies simply aren’t the same.
We’ve taken a good look at what makes a good business—but what makes a good stock is a much different question. Being a good long-term investor requires understanding of both, but we must not confuse the two. Consistency is key—and clarity is too.