In a classic episode of 1990’s sitcom Seinfeld, one of the main characters, George Constanza, finds himself in a quandary: the fantastic new woman he has started dating gets diagnosed with mono, and is thus temporarily unable to take their romantic relationship to the next level. Somehow, as a result of this personal frustration, George develops remarkable cognitive abilities: he is able to learn new languages, aces TV quiz shows, and finds himself enthused about lecturing local high school kids on the wonders of modern physics.

In an iconic scene, Jerry cracks the nut of George’s newfound mental prowess: holding up a lettuce, he explains that, ordinarily, *this* part of your brain is thinking about the pursuit of carnal passions (representing almost all the large lettuce), whilst *this* part remains free to think clearly about anything else (represented by a comically small scrap of a leaf). Now that George is undergoing a period of enforced celibacy, his mental capacity is suddenly sharply improved. In recent years, it has felt as though a similar dynamic has played itself out in the investment world – only in reverse.

We believe there are two main judgements that an investor needs to make when assessing the attractiveness of any particular investment option. First, there is the business analysis: what does the company do, and how much money does it make? How much money does it take for the company to build, market and sell the products and services that it does (return on capital), and how has the company shown a good track record of deciding where to spend the money it earns on new growth opportunities, versus returning capital to shareholders? Who are its end customers, and who else competes for their business? How does the company finance itself? If it uses debt, how many years of cashflow would it take for the company to pay down that debt?

These, among many others, are the critical questions we believe investors must understand when getting to know a business and getting a sense of its suitability for their investment needs. Answers to these questions allow investors to understand the company’s ability to produce surplus cash for shareholders, and give some idea about the longevity and sustainability of those cashflows through time.

The second judgement that investors should assess, however, is much more subtle, and more often misunderstood (and, we will argue, under-utilised): how much to pay. Once we have a sense of what the likely cashflows are for a given investment, what should we pay for them today, and are we being offered a suitably attractive price for them, versus what we think they are truly worth? 

Often, people forget that publicly traded stocks represent part-ownership of real companies, earning real money. Instead, investors can easily substitute the first judgement – is this a great company? – for the entire judgement – is this a good investment?. To quote Charlie Munger, the legendary Vice Chairman of Warren Buffett’s Berkshire Hathaway, “a majority of life’s errors are caused by forgetting what one is really trying to do”. Those in the investment business would do well to remember that they are investors – not business school students.

A perfect example is Tesla: anyone who gets into one of their cars is almost immediately impressed by the unique look and feel, the attention to detail, and the futuristic nature of the car that looks and drives like few others. They conclude, reasonably, that the folks at Tesla know how to design and build a car, and their European and Japanese competition should be right to worry about losing some market share. What happens next, though, is puzzling: they jump to the conclusion that they should buy Tesla stock – namely, that, at today’s stock prices, the company is a good investment. What they fail to ask is how the price they are paying stacks up against the money the company is making, and what assumptions about the future it has already built into it. They simply fail to consider that there is a bad price – or, to put it another way, that there could be any price too high, given the quality of the company.

Even more puzzling is that those investors lulled by this reasoning would not make the same mistake with the car itself: after an unquestionably impressive test drive, it seems unlikely that they would pay £10m for the privilege of driving the car home (even assuming they could afford it). There would be an immediate recognition that there is a price too high, even after accounting for the quality of the product. Yet, when it comes to the company itself, there is all too often no such recognition.

Getting either one of these judgements wrong – business analysis, and valuation – can be the source of significant investment underperformance, and it is therefore paramount that we as investors focus what intellectual capacity and research resources we have at our disposal to get the answers as right as we can on both of these points.  

However, the indiscriminate bull market over the past decade has squeezed the second discipline out of investors: no longer needing to care particularly about valuation (why bother when multiples only go up?), investors were instead rewarded for identifying – and eloquently describing in investor letters – attractive business models with seemingly superior return on capital prospects than peers in the same industry. What never really featured in these investment pitches was whether the investment would generate superior returns for investors, taking into account all the assumed growth that was being paid for up front, and in cash. The portion of the mental lettuce dedicated to creating a Harvard Business School case study of a great business simply grew and grew, whilst the Columbia Business School[1] method of coming up with a reasonable valuation withered into insignificance – George Constanza’s pathetic scrap of lettuce leaf.

Indeed, this critique is not applicable to any one group of investors more than another: even many managers who described their approach as “value” have, of late, snapped up one of Warren Buffett’s aphorisms as an excuse to jump on the bandwagon of buying market darlings at ever-expanding multiples, lauding their brilliant business analysis, and ignoring the old-fashioned practice of valuation.

The classic quote paraded around is that the Oracle of Omaha prefers to buy “wonderful businesses at a fair price than fair business at wonderful prices”. What is commonly dropped from the marketing materials, however, is any nod towards the “fair price” part of Buffett’s quip. For some, if they have demonstrated to themselves and their investors that the business is sufficiently wonderful, then there is seemingly no price too high as to be unfair. Even a surface level examination of some pertinent facts can illustrate how fundamental an error this is.

Take Coca-Cola: a company we all know, and most of us love (dentists, surely, must have a soft spot for such a reliable source of revenue). One of the most incredible aspects of Coke’s business is the fact that so much of the value of the business is in the brand: go into a café in almost any part of the globe, and you can order a Diet Coke with no need for translation. The wonderful part of that brand value, from a shareholder’s perspective, is the limited capital required to maintain this fabulous asset – mainly just advertising expenses – allowing for high and sustainable returns on capital.

Nonetheless, paying too much for what is clearly a fabulous company is a demonstrably bad idea: buying Coke at its peak in July 1998 ($43.9/share) would have yielded, to October 2023, a 3.5% annualised return, with dividends reinvested in shares (or 2.3%, with dividends held as cash). A dollar invested in Coke in 1998 would have resulted in $2.4 of value in October 2023: a dollar similarly invested in the S&P500 would be worth $5.8, or $4.5 if invested in the MSCI World[2]. The only framework by which to understand this huge wealth gap is that investors in 1998 wildly overpaid for the company, then changing hands at 59x earnings. Buffett himself, reflecting in his 2003 Letter to Shareholders, lamented his decision to not sell his substantial ownership stake at overtly elevated prices:

“We own pieces of excellent businesses – all of which had good gains in intrinsic value last year – but their current prices reflect their excellence. The unpleasant corollary to this conclusion is that I made a big mistake in not selling several of our larger holdings during The Great Bubble. If these stocks are fully priced now, you may wonder what I was thinking four years ago when their intrinsic value was lower and their prices far higher. So do I” – Berkshire Hathaway Chairman’s Letter to Shareholders, 2003

Do the low subsequent returns to shareholders mean that those business analysts fuelling high prices in 1993 were wrong about the quality of the company? Absolutely not – they simply neglected the other piece of lettuce. Not paying attention to valuation, it turned out, matters – and matters a lot.

In the preceding decade or so, a period forming a substantial part of many track records, valuation multiples have climbed steadily higher: today, the S&P 500 sports a price/earnings of 21.6x, having taken a bumpy upwards trip from the 12.8x at the end of 2011 (and peaking at almost 32x in the frenzy of 2021); the same pattern held true for the MSCI World Index, which climbed from 11.8x to 18.7x over the same period, peaking at 30x in 2021[3]. For the same dollar of corporate income, the market would obligingly pay an increasing price, flattering returns all round. All an investor needed to do was find a company that was of reasonable quality, and perhaps grew earnings (or at least did not see earnings decline), and a rising tide of multiple expansion would do the rest.

The upshot is that, over the past ten years or so, it has been practically impossible for allocators to distinguish between those managers able to master both investment skills – business analysis on the one hand, and valuation on the other – and those managers utilising only one half of the analytical toolkit, leaving their unflexed valuation muscles untested. In the drastically different conditions investors face today (we might suggest more normal conditions, in the context of history) investors may find themselves discovering whether or not they have the requisite valuation approaches to complement their analytical capabilities. Those who do not may find their glowing performance numbers rudely interrupted. We believe that valuation, after all, will always matter.

Sources:

[1] The home of Benjamin Graham, the father of value investing

[2] Bloomberg, all data as of 17/10/23

[3] Bloomberg