Thursday, June 7, 2018

Paying for Growth, and Public vs. Private Companies

"The number one idea is to view a stock as an ownership of the business and to judge the staying quality of the business in terms of its competitive advantage. Look for more value in terms of discounted future cash-flow than you are paying for. Move only when you have an advantage." --Charlie Munger

There are a couple of mistakes I often see investors (myself included) make when investing in small, public companies: 1) Paying too much for expected growth; and 2) Applying a large-company earnings multiple to a micro-cap company's earnings. Of course, if it's a small company that is growing and that growth is occurring at a durably high return on capital—likely due to some kind of competitive advantage—then paying up can be justified. But all too often the upside story gets more attention than the downside risk, and with small companies, the risk of overpaying for earnings that may not prove sustainable in a changing economic or competitive environment is very real. 

I recently finished the HBR Guide to Buying a Small Business, which I believe I came across in one of Brent Beshore's appearances on Patrick O'Shaughnessy's Invest Like The Best Podcast. I was struck by how similar the process for buying a small business is to doing fundamental, scuttlebutt-type of research. This isn't surprising given Buffett, Munger and Graham's advice to view stocks for what they really are (pieces of real businesses) and their lessons that investing is most intelligent when it is most businesslike. But the book was a great reminder of the work that needs to go into something before one should act, and the prices that are paid for small, private businesses.

Now, there are plenty of advantages to buying and investing in public equities, especially easier access to more and usually better organized information, and the liquidity that allows one to more readily reverse a decision when a mistake has been made. But what are those advantages worth? As I've been thinking about this question, as well as the difference one should pay for a "boring" business compared to a "non-boring" business, I have also been re-reading Security Analysis and, as is often the case with Graham and Dodd, came across this great excerpt on the topics above:
Characteristically, stocks thought to have good prospects sell at relatively high prices. How can the investor tell whether or not the price is too high? We think that there is no good answer to this question—in fact we are inclined to think that even if one knew for a certainty just what a company is fated to earn over a long period of years, it would still be impossible to tell what is a fair price to pay for it today. It follows that once the investor pays a substantial amount for the growth factor, he is inevitably assuming certain kinds of risk; viz., that the growth will be less than he anticipates, that over the long pull he will have paid too much for what he gets, that for a considerable period the market will value the stock less optimistically than he does. 
On the other hand, assume that the investor strives to avoid paying a high premium for future prospects by choosing companies about which he is personally optimistic, although they are not favorites of the stock market. No doubt this is the type of judgment that, if sound, will prove most remunerative. But, by the very nature of the case, it must represent the activity of strong-minded and daring individuals rather than investment in accordance with accepted rules and standards. 
May Such Purchases Be Described as Investment Commitments? This has been a longish discussion because the subject is important and not too well comprehended in Wall Street. Our emphasis has been laid more on the pitfalls of investing for future growth than on its advantages. But we repeat that this method may be followed successfully if it is pursued with skill, intelligence and diligent study. If so, is it appropriate to call such purchases by the name of “investment”? Our answer is “yes,” provided that two factors are present: the first, already mentioned, that the elements affecting the future are examined with real care and a wholesome scepticism, rather than accepted quickly via some easy generalization; the second, that the price paid be not substantially different from what a prudent business man would be willing to pay for a similar opportunity presented to him to invest in a private undertaking over which he could exercise control.  
We believe that the second criterion will supply a useful touchstone to determine whether the buyer is making a well-considered and legitimate commitment in an enterprise with an attractive future, or instead, under the guise of “investment,” he is really taking a flier in a popular stock or else letting his private enthusiasm run away with his judgment. 
It will be argued, perhaps, that common-stock investments such as we have been discussing may properly be made at a considerably higher price than would be justified in the case of a private business, first, because of the great advantage of marketability that attaches to listed stocks and, second, because the large size and financial power of publicly owned companies make them inherently more attractive than any private enterprise could be. As to the second point, the price to be paid should suitably reflect any advantages accruing by reason of size and financial strength, but this criterion does not really depend on whether the company is publicly or privately owned. On the first point, there is room for some difference of opinion whether or not the ability to control a private business affords a full counterweight (in value analysis) to the advantage of marketability enjoyed by a listed stock. To those who believe marketability is more valuable than control, we might suggest that in any event the premium to be paid for this advantage cannot well be placed above, say, 20% of the value otherwise justified without danger of introducing a definitely speculative element into the picture.