One of the most important concepts for any investor to accept is the following: price is different than value.
Price is what you pay for shares of a company. Price is driven by buying and selling and the collective monetary-driven outcome of all investors’ opinions. Price can be influenced by dividend payments, news, rumors and other dynamics that influence the buying and selling of stock.
Value, on the other, is based purely on future expectations of a company’s entire future free cash flow stream (and the firm’s non-operating, excess net cash on the balance sheet). Value considers a company’s competitive advantages (patents, intellectual property, network effect and the like) and compresses these complex qualitative variables into a future free cash flow stream and what we call a fair value estimate.
The dividend payment is an outcome of the value generated by a company, not a source of its value (a dividend payment can drive buying and selling in shares, which is why it is a determinant of price, but not value). A fair value estimate reflects a company’s intrinsic worth; a price target represents an opinion of where an analyst thinks a company’s shares will eventually change hands.
We like shares of companies whose prices are lower than our estimate of their intrinsic values, and we generally prefer to own these companies when the price is moving higher. We think this process allows us to find the best bargains on the market, and ones in which the company’s share price is being supported by buying strength. Such buying (or technical and momentum strength) offers additional evidence that a firm is fundamentally undervalued on the basis of its future free cash flow stream (other investors are also buying because shares are underpriced).
We call underpriced stocks that are going up Valuentum stocks. Without technical and momentum support of a holding, it becomes more likely that an underpriced stock may actually be fairly priced (or worse)—and that the value assessment may be incorrect (other investors are not buying because shares may not be underpriced—they may know more about something that has yet to hit the newswires and cannot yet be factored into the valuation).
High conviction ideas are the ones that have been added to the Best Ideas portfolio. For ideas to be included in the Dividend Growth portfolio, we overlay the Dividend Cushion ratio and seek out high-yielding equities that are poised to grow their dividends long into the future. The Best Ideas portfolio and Dividend Growth portfolio serve two different types of investors.
Perhaps to speak the value gospel, we don’t like shares that are not significantly underpriced. For one, many stocks can attract new investors by hitting new highs or being in the headlines frequently, but ‘playing the momentum game’ often leads to striking out (momentum stocks do not have valuation support in all cases). Having continued valuation support on a strong performing stock—a Valuentum stock—is critical to ongoing capital outperformance (capital appreciation). We put this in practice every day and in full transparency.
In the cases of Sprint (S) and T-Mobile (TMUS), and Fox Entertainment (FOXA) and Time Warner (TWX), the respective management teams of the suitors became too enamored with wheeling and dealing and used market strength as a sign that a deal should get done—the management teams became momentum investors. The executive suites lost sight of the intrinsic value of the take-out (and the economic value that could be generated following a combination). When markets soured, the deals were taken off the table because they were not supported in the valuation context. Sprint’s CEO lost his job as a result.
Think of their behavior as that of a new investor to the stock market. The new investor gains conviction in his or her ideas because the market is moving higher—maybe even buys more of the company. But as soon as shares drop, the new investor wants to run to the exit.
The informed investor, however, gains conviction in his or her ideas through both the valuation and technical/momentum process—only buys more of a company when both criteria are supported. The informed investor is better able to assess whether a decline in the stock warrants selling or not—if momentum and value characteristics are both poor, there may be no reason to own shares (absent the income discussion). But if the informed investor has conviction in the valuation of an entity, he or she can withstand a market sell-off that is promulgated by investors of the uninformed variety.
Valuentum’s Take
We’ll be updating our reports on Sprint, T-Mobile, and Time Warner shortly (we don’t cover Fox yet). The important takeaway is that Valuentum stayed far away from all of this nonsense. We can’t help it if other investors want to fall into behavioral traps, but we do our best to make sure members don’t. Neither one of these entities was included in either the Best Ideas portfolio or Dividend Growth portfolio – the two portfolios that include our best ideas for investors. The value of a service not only rests in the ideas it steers members to, but also in the companies it steers readers away from.
At the time of this writing, Sprint is down ~20%, T-Mobile is down ~6.5%, and Time Warner is off ~12%.