Value Trap, Second Edition, Is Here and More!
publication date: Aug 6, 2020
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author/source: Valuentum Analysts
Value Trap, Second Edition, Is Here and More!
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Hi everyone,
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I wanted to thank you for making the launch of the second edition of Value Trap: Theory of Universal Valuation a huge success. It just hit the "digital shelves" on Amazon yesterday. For those that have yet to order their copy, it is available for the introductory price of $14.99 here. I sincerely hope you enjoy the added commentary to the first edition, from a new 40+ page Prologue to a new Appendix and even a few "clever" multiple choice questions that hit home the arbitrary nature of multiple analysis.
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There is truly no short cut to the process of enterprise valuation, in my humble opinion. Now at 426 pages, the second edition of Value Trap: Theory of Universal Valuation makes the case for future expectations, something practitioners lose sight of today, amid the proliferation of big data and the quant factor revolution. The book Value Trap was so crucial to write because it is not just that future expectations are important, it may very well be that future expectations are all that matter.
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Here is a brief excerpt from the late Peter L. Bernstein's wonderful book Capital Ideas Evolving, page 94:
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Sharpe is concerned that too many practitioners--and a large number of the business school professors from whom they learned their trade--tend to forget that all asset pricing models are about expectations. And how in the world can you measure expectations, which are a look forward, not backward? You cannot just look at history and deduce much about what expectations have been--or will be. The whole matter revolves around the future. Therefore, the historical data on which we all depend so heavily may be useless for asset pricing. As we never know with certainty what the future holds, all we have to rely on is a sense of the probabilities of future events.
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"You are just reduced to a religious statement," Sharpe concludes. "I have been around long enough to see empirical results that seem to be really solid until you try a different country or different statistical method or different time period. Maybe that's why Fischer Black said you should put your trust only in logic and theory and forget about statistical empirical results."
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For those that missed the Exclusive 2020 video conference, it can be accessed here. I think the 40-minute video is definitely worth watching, if you haven't already, as I walk through the pitfalls of believing that certain widely-known factors actually "drive" returns. It may be as simple as investors confusing the statistical term "explain" with "drive." In the eyes of this author, the construct of enterprise valuation--the free cash flow to the firm method or more commonly known as the discounted cash-flow process--is the causal driver behind stock prices and returns. I hope you will sit down with me over a cup of coffee on the video. Thank you.
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To no surprise to our team (and hopefully you, too!), the NASDAQ crossed the 11,000 mark today! We continue to be bullish on large cap growth, big cap tech and the NASDAQ, "Stay Optimistic. Stay Bullish. I Am." On that note, we wrote up the quarterly performance from Apple (AAPL), Facebook (FB), and Alphabet (GOOG), and our research work can be accessed here, here, and here, respectively. Based on the high end of our fair value estimate ranges in parenthesis, we still see considerable valuation upside for Facebook ($335) and Alphabet ($1,795) on an enterprise valuation basis, though we are growing a bit more cautious on Apple's valuation ($413), even as we let this big winner run. The market could know more than us on Apple, so we're being patient with this one.
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Please be sure to read Value Trap as we explain how we think about the fair value range and the information contained in prices. As you know, value is not a point estimate (it is always a range of probable outcomes based on future expectations), so we use the fair value ranges as a way to inform our process as to what may be a fair price to pay for shares. Though we generally would prefer entities that are trading below a fair value estimate range, we're also okay with "paying" a fair price for a great net-cash-rich, future free-cash-flow generating secular growth powerhouse. Remember Warren Buffett's famous quote: "It's far better to buy a wonderful company at a fair price than a fair company at a wonderful price." Investing was never meant to be a mechanical process, and many that were heavily exposed to the small value factor learned that the hard way during the first quarter of 2020.
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In the newly-added Prologue of Value Trap, I explain how we think about fair value estimate ranges with respect to companies with strong cash-based sources of intrinsic value versus those without. There is a big difference. For example, we'd be comfortable "participating" at the higher end of the fair value estimate range for companies with strong net cash and solid expected future free cash flows backed by secular growth prospects and strong competitive advantages--e.g. Apple, Microsoft (MSFT), Alphabet, Facebook--but we wouldn't go near an overleveraged cyclical like an airline, for example, even if it started to trade below our estimate of fair value. There are so many things that can go wrong when future expected free cash flows are not based on a solid, recurring and largely-predictable foundation (e.g. airlines' future free cash flows are very sensitive to energy resource prices, fare transparency, and exogenous shocks--all out of their control).
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Stick to the cash-based sources of intrinsic value (e.g. net cash, future expected free cash flows) as you're mulling through new idea generation, particularly in this environment. Use the fair value estimate range to get a feel for what is a fair price for shares, and then assess whether the market is backing the entity with strong pricing support. This criteria should help you steer clear of many value traps, but there is so much more (see Figure J below, excerpted from Value Trap). As for portfolio construction, we continue to be "fully invested" in equities as we ride this bull market ever higher. Reduced discount rates coupled with increased pricing/inflationary expectations are providing substantial valuation support to net-cash-rich, strong free cash flow generating secular-growth powerhouses of which the newsletter portfolios are concentrated. We continue to be focused on the long haul.
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All told, we have a lot of exciting things in the works. I'm working diligently to be in a position to meet the needs of members that are interested in outsourced/managed portfolios, and we are considering rolling out even more ideas with respect to our options commentary. The options ideas have performed remarkably well thus far, and I couldn't be more pleased. Just a reminder that Valuentum is a publisher, so we can't ever tell you what to do, even if it may be what you want. I'm still working through my inbox, so if you have sent me a question recently, I'll do my best to get back to you as soon as possible. Don't forget to order the second edition of Value Trap here, and tune into the video conference here. The August edition of the Exclusive will be released Saturday, August 8.
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Always my very best,
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Brian Nelson, CFA
President, Investment Research
Valuentum Securities, Inc.
brian@valuentum.com
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Brian Nelson owns shares in SPY and SCHG. Some of the other securities written about in this article may be included in Valuentum's simulated newsletter portfolios. Contact Valuentum for more information about its editorial policies.