Recently a friend of mine forwarded a report presented by an analyst, who is quite popular in the investing community. It was about buying quality stocks and getting excess returns. The key points of the report were: Investors tend to use higher discount rates to bring the estimated cash flows to the present value. All high quality stocks trade at large premiums. And because of that, their expected buy price never comes across. As a result, they miss high returns over the long period. And therefore investors should instead use a lower discount rate. Then they will have a higher present value for their stock; and lo and behold, they can buy the stock, and make make higher returns for a long time. It appeared cool to many, and why not?
I was surprised after I read the report; it was an interesting thought indeed, except there was a catch. The whole idea of discount rate and expected returns was pushed apart, and how. I have written about expected returns in the past. Expected returns are never precise. The aim should be to increase the purchasing power over time, rather than asking for more than what is warranted. CAPM is great, but has its limitations. Although it starts with the right footing, it falters when we come to measuring risk in cash flows, and unnecessarily looks for precision. And so does the concept of margin of safety, which is both overrated and getting more due than it deserves. Perhaps I will have to do a more detailed post on both CAPM and margin of safety.
Value of any business is the present value of its cash flows over its lifetime. We need two things: Cash flows for the entire period; and a discount rate to bring them to present. Simple, profound, but a complicated affair. How do we know what cash our favorite business will throw until its liquidation? The size of cash flows and their timing have a significant effect on present value. Therefore, our estimation task is futile to that extent. This is one reason why it is prudent to stick to businesses which are more likely to be stable over the period of our investment. Stable businesses tend to throw out stable cash flows; so our work is that much easier; but not as easy, because it still involves estimation.
If our cash flows estimation is getting difficult because the business is complex, or is subject to disruptions, or because of some shit, we cannot compensate it with either higher margin of safety (which all value investors do) or higher discount rate (which all other investors do). It doesn't really matter whether you try to eat shit with a spoon or hand, you are still eating shit. Most value investors don't get it.
Once we have our estimated cash flows, we need a discount rate. CAPM provides some framework on that, which is still the best tool available with us. It requires one adjustment though. Let's start with a risk free rate, and say that our investment returns will have to be higher than that. How much higher, is a great question. It is not volatility as measured by beta times equity risk premium. It should rather be based upon qualitative analysis and our own expectations. Short term volatility is investor's best friend for it helps in picking stocks at the right price, and then proves that often markets are inefficient. And yeah, beta is shit; period.
When our expected returns are 15%, we discount cash flows at that rate, and our expected returns will be 15%. In reality though it could be 10% or 25% because of at least two things: One, our estimated cash flows are wrong always. Two, markets can be more pessimistic or optimistic than our own estimates. The key point, however, is that when we expect to make 15%, we discount the cash flows at 15%, not 10%. This is the flaw in the aforesaid report of the analyst.
The guy is making a point that we should discount the cash flows at a lower rate so that we can make returns higher than that over the period. How profound...
What I would do for a quality stock is what I do for not a high quality stock too. A business that is not high quality may have cash flows that are visible for a short period of time. Why shouldn't we use those cash flows and discount them based upon our expected returns over that (short) period? Why should we use lower discount rate for a high quality business when we want much higher returns?
The analyst missed another key point. It is to be able to play the waiting game. What you do is analyze the business, and have a rate of return expected from the stock; and then wait for the markets to offer you a chance to get that. If that means waiting for more time, so be it. There is another way to play this as well. If you think that markets are not willing to give in, and your patience is running out, you can lower your expected returns, discount the cash flows at that rate, and see if the stock can be bought at that price. Again, these decisions are made based upon quality of business and interest rate environment. When risk free rates are 5%, your expected returns can be lower than when they are 10%. Long term interest rates change the course of our expectations.
A better game to play is to check the implied rate of return in the market price, and see if that is suitable for us. If not, we have to play the waiting game, and rely on the market's histrionics. I do know that there are times when markets are too kind to us; and a better investor waits for such times of cuddling.
For quality stocks, we can use lower discount rates for minimum acceptable rate of return, and then say that anything higher is icing. What we cannot do is, use lower discount rate, and then say we want returns higher than that.
The truth is that markets set higher premiums for stocks as long as they remain high quality. That means what we should be doing is look for those stocks that are high quality in terms of business and management, and then discount the cash flows, which are usually large and growing, with a rate, which is higher than risk free rates. And, how much higher is again a great question...
Value of any business is the present value of its cash flows over its lifetime. We need two things: Cash flows for the entire period; and a discount rate to bring them to present. Simple, profound, but a complicated affair. How do we know what cash our favorite business will throw until its liquidation? The size of cash flows and their timing have a significant effect on present value. Therefore, our estimation task is futile to that extent. This is one reason why it is prudent to stick to businesses which are more likely to be stable over the period of our investment. Stable businesses tend to throw out stable cash flows; so our work is that much easier; but not as easy, because it still involves estimation.
If our cash flows estimation is getting difficult because the business is complex, or is subject to disruptions, or because of some shit, we cannot compensate it with either higher margin of safety (which all value investors do) or higher discount rate (which all other investors do). It doesn't really matter whether you try to eat shit with a spoon or hand, you are still eating shit. Most value investors don't get it.
Once we have our estimated cash flows, we need a discount rate. CAPM provides some framework on that, which is still the best tool available with us. It requires one adjustment though. Let's start with a risk free rate, and say that our investment returns will have to be higher than that. How much higher, is a great question. It is not volatility as measured by beta times equity risk premium. It should rather be based upon qualitative analysis and our own expectations. Short term volatility is investor's best friend for it helps in picking stocks at the right price, and then proves that often markets are inefficient. And yeah, beta is shit; period.
When our expected returns are 15%, we discount cash flows at that rate, and our expected returns will be 15%. In reality though it could be 10% or 25% because of at least two things: One, our estimated cash flows are wrong always. Two, markets can be more pessimistic or optimistic than our own estimates. The key point, however, is that when we expect to make 15%, we discount the cash flows at 15%, not 10%. This is the flaw in the aforesaid report of the analyst.
The guy is making a point that we should discount the cash flows at a lower rate so that we can make returns higher than that over the period. How profound...
What I would do for a quality stock is what I do for not a high quality stock too. A business that is not high quality may have cash flows that are visible for a short period of time. Why shouldn't we use those cash flows and discount them based upon our expected returns over that (short) period? Why should we use lower discount rate for a high quality business when we want much higher returns?
The analyst missed another key point. It is to be able to play the waiting game. What you do is analyze the business, and have a rate of return expected from the stock; and then wait for the markets to offer you a chance to get that. If that means waiting for more time, so be it. There is another way to play this as well. If you think that markets are not willing to give in, and your patience is running out, you can lower your expected returns, discount the cash flows at that rate, and see if the stock can be bought at that price. Again, these decisions are made based upon quality of business and interest rate environment. When risk free rates are 5%, your expected returns can be lower than when they are 10%. Long term interest rates change the course of our expectations.
A better game to play is to check the implied rate of return in the market price, and see if that is suitable for us. If not, we have to play the waiting game, and rely on the market's histrionics. I do know that there are times when markets are too kind to us; and a better investor waits for such times of cuddling.
For quality stocks, we can use lower discount rates for minimum acceptable rate of return, and then say that anything higher is icing. What we cannot do is, use lower discount rate, and then say we want returns higher than that.
The truth is that markets set higher premiums for stocks as long as they remain high quality. That means what we should be doing is look for those stocks that are high quality in terms of business and management, and then discount the cash flows, which are usually large and growing, with a rate, which is higher than risk free rates. And, how much higher is again a great question...
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