Super-investor Warren Buffett and the search for hidden value
“Valuation”. The word derives from the 500-year-old French word “valeur,” which means “worth” or “value.” To most of us, and certainly those of us involved in real estate and/or financial markets, the word is usually expressed as a number with a currency symbol preceding. Your house is valued at $1 million, for example, or XYZ’s shares have a valuation of $5.00 per share etc.
Valuation in financial services is a subjective word and the process of valuation is part art and part science. Don’t let anyone tell you otherwise. All those different valuations (you, me and everyone else including the computers) make up what we call a “market” or staying with the French theme – a bourse (a purse or wallet) – a place of price discovery.
As investing has evolved, so too has the way we attempt to value things. A Price to Earnings (P/E) multiple and Net Asset Value (NAV) was home base, Free Cash Flow came around (thanks to the private equity firms needing to fund debt), and then the world got all excited about DCFs (Discounted Cash Flows), and then EV/EBIT ratios and variations of it – Enterprise Values (Market Cap + Debt) / EBIT (Earnings Before Interest and Tax). Since then, more letters keep getting added to the denominator supposedly adjusting for everything from Amortisation (A), Depreciation (D), Leases (L) and lots of other letters. In more recent times we have lived and had the opportunity to invest in a world of hyper-growth companies that don’t actually make any money. Enter the newer world of valuation metrics, Revenue Multiples, Cash Burn Rates, TAMs (Total Addressable Markets) and seemingly any other investment bank sorcery. My personal favourite is the PEG ratio or the P/E multiple divided through by some measure of the company’s earnings growth. The logic being a low-growth company would attract a lower P/E and a higher growth company might attract a higher P/E – but their PEG ratios might both be the same. All things equal, PEGs lower than one were quite good…
In the headlights recently and very relevant to this topic is a company I’ve talked about before, Nvidia, and more importantly how it beat earnings guidance and expectations and how “expensive” it is because its share price has gone up so much. Some perspective: adjusting for the new earnings upgrades Nvidia shares are now actually “cheaper” than they were (forecast earnings revisions are higher than the increase in the share price and market capitalisation). We just saw literally dozens of well-paid analysts and hundreds of fund managers completely miss the explosiveness of the upgrade that Jensen Huang (Nvidia CEO) delivered, and this isn’t an under-researched small-cap. It is easily argued that every stock in the top 10 in the US S&P 500 today has been “expensive”. Equally, many that were in the top 10 of the US S&P 500 are now amongst the cheapest (Ford, General Electric, General Motors, etc. to name a few).
Valuation is important but defining it is the moving target. Some investors like bargains, some growth, others defensive etc., we call these ‘factors’ and these in turn are one of the many building blocks of selecting securities for portfolio construction. Said another way – you might own several different shares but in fact the factors may be similar and make it just the same big bet (as is the case for example with interest-rate sensitive shares today).
Many financial markets followers and commentators say Warren Buffett is the greatest investor of all time (that’s another debate). What’s most interesting for me is that Buffett started in a world (the 1950s…) of valuation arbitrage. He’d read annual reports looking for hidden “intrinsic value” where (if you did the hard work) companies often had more assets than liabilities or assets that weren’t on the balance sheet at the correct price / value. In turn, he could buy those companies at an effective discount, operate them better, take them private rather than stay listed or hope others would at some stage pay a higher price. Generally speaking though this valuation arbitrage does not work as well any more. Rapid information dissemination has “closed that arb.”
Warren Buffett subsequently said, “It’s far better to buy a wonderful company at a fair price than a fair company at a wonderful price”. This was, in essence, to change the narrative from the hitherto approach of Berkshire Hathaway seeking valuation arbs and not paying premia for investments to doing just that if the circumstances are right.
Buffet’s last great value trades were arguably during the GFC when he and his investment company Berkshire Hathaway held Goldman Sachs and Bank of America to near extortion when they desperately needed capital. In a damned-if-they-do damned-if-they-don’t moment their respective Boards accepted Berkshire Hathaway’s terms in exchange for a capital injection. Buffett made a fortune here, a position afforded to him by having so much cash and taking advantage of a situation.
Berkshire acquired around approximately US$31 billion of Apple shares over several years starting in 2016 – which some might argue was somewhat late to the game. Today though, the stake is worth US$180 billion and is Berkshire’s largest holding and 22% of the company’s value. Lots can be said about this investment, but surely the most interesting is that Charlie Munger, Buffett’s long term partner at Berkshire Hathaway, was aged 92 at the time the initial investment was made. 92!?
I’ll leave you with this thought from Canadian ice hockey legend, Wayne Gretzky: “Skate to where the puck is going to be, not where it has been”.