Investment advice often blurs the line between good companies, good management and good investments, using the argument that for a company to be a "good" company, it has to have good management, and if a company has good management, it should be a good investment. That is not true, but to see why, we have to be explicit about what makes for a good company, how we determine that it has good management and finally, the ingredients for a good investment.
There are various criteria that get used to determine whether a company is a good one, but every one of them comes with a catch. You could start with profitability, arguing that a company that generates more in profits is better than generates less, but that statement may not be true if the company is capital intensive (and the profits generated are small relative to the capital invested) and/or a risky business, where you need to make a higher return to just break even. You could look at growth, but growth, as I noted in this post, can be good, bad or neutral for value and a company can have high growth, while destroying value. The best measure of corporate quality, for me, is a high excess return, i.e., a return on capital that is vastly higher than its cost of capital, though I have noted my caveats about how return on capital is measured. Reproducing my cross sectional distribution of excess returns across all global companies in January 2017, here is what I get:
Blog Post on Excess Returns |
Now that we have working definitions of good companies and good managers, let’s think about good investments. For a company to be a good investment, you have to bring price into consideration. After all, the greatest company in the world with superb managers can be a bad investment, if it is priced too high. Conversely, the worst company in the world with inept management may be a good investment is the price is low enough. In investing therefore, the comparison is between the value that you attach to a company, given its fundamentals and the price at which it trades.
If you take the last section to heart, you can see why picking stocks to invest in by looking at only one side of the price/value divide can lead you astray. Thus, if your investment strategy is to buy low PE stocks, you may end up with stocks that look cheap but are not good investments, if these are companies that deserve to be cheap (because they have made awful investments, borrowed too much money or adopted cash return policies that destroy value). Conversely, if your investment strategy is focused on finding good companies (strong moats, low risk), you can easily end up with bad investments, if the price already more than reflects these good qualities. In effect, to be a successful investor, you have to find market mismatches, a very good company in terms of business and management that is being priced as a bad company will be your “buy”. With that mission in hand, let’s consider how you can use multiples in screening, using the PE ratio to illustrate the process. To start, here is what we will do. Starting with a very basic dividend discount model, you can back out the fundamentals drivers of the PE ratio:
Multiple | Cheap Company | Expensive Company |
---|---|---|
PE | Low PE, High growth, Low Equity Risk, High Payout | High PE, Low growth, High Equity Risk, Low Payout |
PEG | Low PEG, Low Growth, Low Equity Risk, High Payout | High PEG, High Growth, High Equity Risk, Low Payout |
PBV | Low PBV, High Growth, Low Equity Risk, High ROE | High PBV, Low Growth, High Equity Risk, Low ROE |
EV/Invested Capital | Low EV/IC, High Growth, Low Operating Risk, High ROIC | High EV/IC, Low Growth, High Operating Risk, Low ROIC |
EV/Sales | Low EV/Sales, High Growth, Low Operating Risk, High Operating Margin | High EV/Sales, Low Growth, High Operating Risk, High Operating Margin |
EV/EBITDA | Low EV/EBITDA, High Growth, Low Operating Risk, Low Tax Rate | High EV/EBITDA, Low Growth, High Operating Risk, High Tax Rate |
Thus, you can have good companies become bad investments, if they trade at too high a price, and bad companies become good investments, at a low enough price. Given a choice, I would like to buy great companies with great managers at a great price, but greatness on all fronts is hard to find. So. I’ll settle for a more pragmatic end game. At the right price, I will buy a company in a bad business, run by indifferent managers. At the wrong price, I will avoid even superstar companies. At the risk of over simplifying, here is my buy/sell template:
Company's Business | Company's Managers | Company Pricing | Investment Decision |
---|---|---|---|
Good (Strong competitive advantages, Growing market) | Good (Optimize investment, financing, dividend decisions) | Good (Price < Value) | Emphatic Buy |
Good (Strong competitive advantages, Growing market) | Bad (Sub-optimal investment, financing, dividend decisions) | Good (Price < Value) | Buy & hope for management change |
Bad (No competitive advantages, Stagnant or shrinking market) | Good (Optimize investment, financing, dividend decisions) | Good (Price < Value) | Buy & hope that management does not change |
Bad (No competitive advantages, Stagnant or shrinking market) | Bad (Sub-optimal investment, financing, dividend decisions) | Good (Price < Value) | Buy, hope for management change & pray company survives |
Good (Strong competitive advantages, Growing market) | Good (Optimize investment, financing, dividend decisions) | Bad (Price > Value) | Admire, but don't buy |
Good (Strong competitive advantages, Growing market) | Bad (Sub-optimal investment, financing, dividend decisions) | Bad (Price > Value) | Wait for management change |
Bad (No competitive advantages, Stagnant or shrinking market) | Good (Optimize investment, financing, dividend decisions) | Bad (Price > Value) | Sell |
Bad (No competitive advantages, Stagnant or shrinking market) | Bad (Sub-optimal investment, financing, dividend decisions) | Bad (Price > Value) | Emphatic Sell |
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newbie18
Can explain on IW City and Redtone as example? I am newbie so want to know.
2017-03-10 11:20