Does valuation not matter for high quality businesses?
One characteristic of a high-quality business is its ability to grow its intrinsic value over time. So does that mean that it’s possible to overpay for a high quality business and then wait for it to “grow into its valuation”? This depends on a number of things which we will attempt to tease out.
At Montaka, we view a high-quality business as one that has characteristics that enable it to deploy capital at high rates of return and sustain this into the future. A company with the ability to reinvest large amounts of capital back into its business and earn a high rate of return on that incremental capital will see its intrinsic value grow (at the reinvestment rate x the return on incremental capital). If the intrinsic value of this high-quality business continues to grow, is it possible to initially overpay for the stock and then still do well with the investment over time? This depends on what we mean by overpay.
The term “overpay” is subjective. Paying a 30x earnings multiple, for example, might prima facie appear pricey, but there are some high growth businesses where a 30x P/E multiple represents a bargain purchase. However, we think about intrinsic value in terms of the discounted value of all future cash flows a business is likely to generate over its lifetime. If one were to pay a price that represents the present value of all the future cash flows that business will ever generate, then that investor can expect to earn a yearly return equal to the discount rate used – no more, and no less.
In this sense, if the magnitude of overpayment is great enough and the price paid captures the value of all future cash flows a business is capable of producing, then mathematically an investor will not benefit from the intrinsic value of the business increasing over time. Said another way, no matter how high quality the business is and how high the rate of intrinsic value growth, if you initially pay a price for a stock that fully captures these aspects, you will cease to benefit from them.
While we view business quality as important, it is a wholly insufficient condition alone for investment success. These high quality businesses must be bought for less than the discounted value of their cash flows, otherwise the only way to earn above the cost of capital used to discount those cash flows is if someone is willing to buy the stock off you for greater than what that stock is worth (i.e., the greater fool theory).
Assuming that one pays for less than what the business is worth (i.e., a sensible price), then time is the friend of the investor who puts their capital into the stock of a high-quality business. As the intrinsic value grows over time, then over longer investment holding periods the performance of the business will depend less on any changes to the earnings multiple, and more so on the growth in that company’s earnings power. Again, all this is predicated on not paying a price that bakes in the entirety of that business’s growth.
An overarching tenet of our investment philosophy is to identify these great businesses that are likely to grow in value over time, and to buy them at cheap prices. Over a longer investment horizon, these businesses provide a safeguard of growing their intrinsic value, as opposed to low quality businesses that may trudge along, or even see their intrinsic value dwindle over time. Finding these fabled businesses, pressure testing the sustainability of these company’s competitive moats, and then figuring out a sensible price to pay for these businesses is the crux of what we do.