This article is the fourth in an introductory series on value investing that was first published in 2006 and went on to become the core of our book Value: The Intelligent Investor's Guide to finding hidden gems on the sharemarket.
See also: 1. The essence of value investing; 2. What price a margin of safety?; 3. How to value stocks; 5. The beauty of book value; 6. Putting a price to earnings; 7. The delights of dividends.
Earlier this week we discussed how, in theory, shares are worth the value, in terms of today’s dollars, of the cash they’ll generate in future.
In practice we really can’t know exactly how much future cash they’ll produce, and that puts a spanner in the works. In fact, it can destroy the works completely; if we can’t make a decent stab at a valuation then we have no choice but to move on. But if we can, we must first consider one crucial, overlooked, factor: what do we mean by best estimate?
Don’t underestimate the Don
There are two main ways to look at this: think of the middle point of a range of possible outcomes (the ‘median’), or the average of the possible outcomes (the ‘mean’ or ‘expected value’).
In many situations the median is close to the average because the range of possible outcomes is evenly spread about the median: if you line up a group of people by height, for example, the person in the middle – with the median height – is likely to be very close to the average height. But thinking like this as an investor can get you into trouble.
Take Don Bradman’s test batting record as an example. His median score (between dismissals so that not outs are accounted for) was 67. But opponents would have been wrong to bank on him making only 67 before being out — because when the Don scored big, he very often scored BIG, which raised his average to 99.9.
So the expected value of a Bradman knock would be 99.9, even though that’s some way above the most likely outcome (the median) of 67. You get the same thing with companies.
Margin of safety
Even though you might expect 99.9 runs from the Don, you probably wouldn’t put your house on it. An unplayable delivery from Harold Larwood, aimed at his head, might render you homeless if you did. So we want a decent margin of safety and the bigger, the better: you’d feel pretty good about backing Bradman to make 50 and even better backing him to make 20.
This is our thinking behind our current Buy recommendation on News Corp. Based on our latest estimate, our base case values News Corp at around $22. At current prices the company is trading around 22% below this estimate.
If things go well, News Corp could be worth up to $30. You’d be more confident backing the Don to score big on a flat pitch with Harold Larwood injured but it’s more likely that Harwood would be fit and the pitch more bowler-friendly. Similarly, our base case is more likely than our bull case or high estimated value.
So we always use our base case and then, adhering to the margin of safety principle, require a discount to it. This is why we recommend you buy News Corp up to $20 rather than up to the base case value of $22.
Despite having a fat margin of safety you shouldn’t make too big a bet on a single opportunity. That’s why we have maximum recommended portfolio weightings for each recommendation. In News Corp’s case, it’s 5 per cent. This stipulation will help minimise losses should our low estimated value of around $13 instead prove correct.
Even the great Don Bradman made seven test match ducks. So you need to spread your bets over a number of different opportunities. It’s called diversification and will be the subject of a future article.
Increasing expected return
Importantly, as we’ve noted previously, the bigger your margin of safety, the bigger your expected return, because your expected value is that much higher than the price you’re paying for the shares.
So although shares are difficult to value accurately, we can deal with that situation by sticking to companies which we understand, making a conservative estimate of their value, requiring a margin of safety and hedging our bets through diversification.
Over the next few articles we’ll look at some of the tools we can use to help us estimate value.