The Eternal Caravan of Value Reincarnation

What to make of the sharemarket? It was Armageddon time in August and September. Come October and the bulls are charging with their ears pinned back and like there is no tomorrow. If the market was a race horse or an athlete there would be calls for drug testing. If, as an investor, you are trying to make your investment decisions based on where the market is heading you are probably suffering a severe case of whiplash. So what is the alternative?

In previous blogs we have discussed aspects of the value approach to share investing this being the successful approach developed by Warren Buffet (to in investment terms drop a rock star name) and others including in Australia MyClime, Roger Montgomery and Lifestyle Financial Services. The focus is first and foremost on individual companies as businesses. If an individual business is able to sustainably grow its profits and dividends it will increase in value over time and sooner or later this increased value will be reflected in the share price regardless of whether the sharemarket has been going up, down, sideways, perpendicular or doing the foxtrot. See previous blogs (www.lifestylefstas.com.au/blog) that demonstrate it’s the performance of the individual business and not the market that is important over the longer term.

To repeat the mantra it means that to be successful long term investors we want to invest in companies that as businesses are high quality, have favourable longer term prospects and can be bought at a rational (not overvalued) price. Which begs the question what is a rational price? What we need to do is to make estimates of the value of a company as a business both now and in the future. After all if a business is growing profits and dividends it is reasonable to expect that its value is also going to increase. And it is on this estimated future (in particular) value that we need to base our investment decisions.

Ok theory time for a moment. Estimates of current and future values for a business are based upon forecast profits and dividends, forecast Return on Equity (ROE) or profitability and a required rate of return to allow for risk. If you want more information on this please contact me. It’s one of my favourite subjects in life and I can happily talk about it until the cows come home. However for now let’s look at Telstra (TLS) as an example. The following table sets out forecast profits and dividends, ROE and estimated current and future values for TLS.

TLS are currently trading at $5.55. So what we can do is calculate an expected return based on the share price for TLS equalling the estimated value of TLS in 2018. This results in an expected return of 19% per annum (11% capital growth and 8% grossed dividend). For a company as stable as TLS this is an attractive potential return. If we invest in TLS at $5.55 it certainly appears that we are paying a rational price.

So to recap we do our analysis on the basis that there is no sharemarket. It is only when we have done our analysis that we then look at the sharemarket to see what the current price is. Benjamin Graham who is regarded as the founder of share analysis and the mentor of Warren Buffet called the sharemarket Mr Market and commented in essence as follows. If you have shares where the market price is higher than the estimated future value Mr Market will buy them from you. Now get this. If the price is well below the estimated future value Mr Market will sell the shares to you. He really is an obliging fellow. As Benjamin Graham noted in the shorter term the sharemarket is a voting machine but in the longer term it is a weighing machine. In other words all kinds of short term factors (investor optimism, pessimism, greed, fear, short selling, computer driven trading, fads, fashions, sectors that are hot baby, sectors that are on the nose and so on can push the share price for a company below and above estimated fair value. And sometimes well above or below and sometimes for extended periods. However the underlying value for a company will sooner or later be reflected in the share price. What we need to do as investors is have a firm view of what is a fair future value for our shares. It is empowering.

Of course nothing to do with the future is guaranteed. However if we consistently invest in businesses that are high quality, have favourable prospects, are available at a rational price and thus have an attractive potential return probabilities means that we are going to achieve those returns more often than not. Over time we will experience investment karma. As we will surely experience if we consistently invest in low quality businesses that do not have favourable prospects or are bought at an irrational price. When we consistently invest along the lines of probabilities there becomes a certain air of inevitability about the whole process and eventual outcomes.

Day, evening, night, morning, day. Summer, autumn, winter, spring, summer. Life, death, rebirth, life. Quality shares fairly valued, overvalued, undervalued, fairly valued. The eternal caravan of reincarnation.

Regards,

Curtis