Does valuation not matter for high quality businesses?

31012020_Value investing

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.

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George joined MGIM in September 2015 as a Research Analyst. Prior to joining MGIM, George was an investment analyst at Private Portfolio Managers where he covered global equities across various industries, using a value investing framework. George’s prior experiences include equities research and investment banking roles at both Citi and Greenhill & Co.

This post was contributed by a representative of Montgomery Investment Management Pty Limited (AFSL No. 354564). The principal purpose of this post is to provide factual information and not provide financial product advice. Additionally, the information provided is not intended to provide any recommendation or opinion about any financial product. Any commentary and statements of opinion however may contain general advice only that is prepared without taking into account your personal objectives, financial circumstances or needs. Because of this, before acting on any of the information provided, you should always consider its appropriateness in light of your personal objectives, financial circumstances and needs and should consider seeking independent advice from a financial advisor if necessary before making any decisions. This post specifically excludes personal advice.

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2 Comments

  1. This is a subject close to my heart and a question I’ve always asked myself. From my observation of the share market over the past 30 years, I believe overpaying for a share and have it grow into its valuation is very real, e.g. an independent source valuing CSL back in 2008, even after the crash had it way overvalued at around $40, and in essence many sources throughout later years have had it overvalued. Without a shadow of a doubt CSL has been one of the greatest success stories in our share market. Waiting for an undervaluation opportunity probably wouldn’t have served you very well!

    Unfortunately, this is a real dilemma with shares and what makes investing so difficult. There’s also the possibility that even if you identify an undervalued share, it will stay undervalued because the company goes off the rails and doesn’t capitalise on its position. So, nothing in the share market is ever a given.

    Obviously, after a crash is potentially the greatest time to sift through the “ruins” and find the best opportunities. But anyone knows it’s still not easy at those times. I think you still have to take a bit of a punt at times, but limit your risk by not going overboard thinking any investment is the key to your riches. If you believe in a share, try to buy a number of allotments strategically over the years. Time and the value of dividends can also help your investment to realise a reasonable return. An example I’ve had is with MQG. Back before the GFC I had bought various allotments. These investments were looking pretty sick after the crash, but with the passage of time and MQG recovering, my MQG investments have provided reasonable returns to this point.

    I think waiting to purchase undervalued shares has merit, but there are times when we need to take a bit more risk if we believe a share is worth buying.

    • Hi Wesley, Do you agree that “overpaying for a share and have it grow into its valuation” works in a bull market better than in a bear one? We have had one of the longest running bull markets ever and any kind of startegy that requires momentum to win, will look good. We had apple as a buy waaaay back and we bought CSL waaaay back on valuation grounds. As you rightly point out, diversification is required too. I hope you purchased more Macquarie when it looked like it was going out of business without a rescue.

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