Thursday, October 09, 2008

Valuation and how capitalism should work

I think the last year or so has proven that valuation of financial securities is at best a crapshoot.  You can develop equations for theoretical values of stocks, options, bonds, and derivatives; but without strong inputs they are absolutely worthless.  In finance, valuation is based on the timing of mean expected cash flows.  The spread of outcomes can become very large at times, increasing the variance of expected CFs.  This therefore should increase the beta of the security, decrease its value, and increase its required rate of return.  At this point, investors should be watching the % under value and more importantly, the Compound Annual Growth Rate that is currently priced into the stock.  This is how capitalism works.  When risks can be accounted for and reasonably priced in, investors will jump in and take risks with capital.  There will always be someone willing to step in and buy an asset as long as the rate of return compensates for the risks of holding a security.  If the rate is not high enough, then the price is too low.  Does this mean that some companies will get screwed over?  Yes.  But that is a lesson learned.  Do not overpay for investments.

At yesterday's close, given public expectations of growth the following CAGRs have been priced in to several stocks.

>10% CAGR: 23 stocks
>15% CAGR: 7 stocks

With that being said, there are a few good things about having systematically driven investment ideas.  For a pure value investor, you should have a trigger point for investment.  Buffet talks about having a 10% required rate of return for the future, however his required rate for most private companies has been in the 15-20% range, or 4-6 times cash flows.  If you have access to a comprehensive spreadsheet like I recently built, you can monitor changes in valuations and CAGRs.  I personally would require at least a 15% return to own large cap equities in this environment, so once a company on my spread nears this area, I start looking at the fundamentals of the company; management strength, debt position, competitive position, etc.  If the company is well managed, and under this environment, lightly or unleveraged, I buy.  If the CAGR is higher I take a slightly larger position.  It is difficult to fill an equally weighted portfolio of 10 large cap stocks, even now, due to the high required rate of return.

I have experimented with value investing for a long time, unfortunately with poor results because I did not know how I should handle the variance in future cash flows.  To me, given my resources, forecasting future earnings is a fruitless venture.  Therefore, using public information is a much less stressful and probably more accurate method than me pulling a random number out of the air.  Systematic trading/investment is the best way, I've found, to keep the discipline necessary to make optimal investment decisions.  Without rules, investors can get caught in the madness that is the financial markets.

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