Professional Investors do not like to compare investing and the casino, yet they are constantly making forecasts and evaluating their odds when making buy and sell decisions. Whether you are a sports bettor placing a wager on a football game or an investor searching for alpha, it is imperative to identify times when the underlying expectations to justify the betting line (or stock price) are too optimistic or pessimistic to exploit the House (or Market).
While we are not known in Las Vegas or Macau for our sports betting prowess, we have built a live, out-of-sample database of 20 million valuation estimates dating back to 1998. This provides insight not only into individual company valuation levels but also the expectations for sales growth embedded in the stock’s price. This allows us to identify opportunities when a company’s hurdle rate is extremely low or unrealistic, and on an aggregate basis, identify when sector or index expectations move outside of “normal” range.
If you have been reading our material, by now you know we are not talking price multiples here, we are focusing on the true economic profitability and underlying intrinsic value or valuation of a company. Avoiding simplistic price multiples, correcting for the perpetuity issues inherent in most traditional DCF models, and focusing on economics rather than accounting data, allows us to be….
“Fearful when others are greedy”
Based on our analysis of the expectations at the height of the Tech Bubble, we issued reports that showed Technology stocks and CSCO expectations were extremely lofty. Even though the expectations for future growth were nearly impossible to meet, most investors could not wait to pile their money into the next great “dot com” name. The market environment seemed very friendly to investors at the time, but we understood that the unachievable underlying expectations would eventually come to a head.
“Greedy when others are fearful” – Warren Buffett
During previous times of extreme market volatility and investor suffering, we have proven an ability to be the calm in the storm and help investors identify some golden opportunities to build wealth and avoid panic selling. Two examples of us beating the drum that expectations were abnormally low and that it was a great time to invest during periods of extreme emotional unease were just after the Financial Crisis of 2008 when the average S&P industrial firm was priced to shrink sales in half over the following 5 years. Again, shortly after the most recent market crash in Feb/Mar 2020, we issued a report that market valuations represented a “generational investment opportunity” as the average S&P industrial was priced to grow sales at 0% over the next 5 years. In both circumstances, investors had been beaten up pretty badly, but the expectations signaled that an extraordinary investment opportunity was at hand. The market subsequently rewarded investors with an understanding of expectations in both instances.
After an intense run-up to end 2020, what type of growth is the market pricing-in to stocks now?
The chart below highlights the implied forecasted sales growth the average S&P500 Industrial firm (ex. Financials/Utilities) needs to deliver in order to justify its trading price (Dark Black Line), the green and red lines represent the +/-1.5 StdDev “zone of reasonableness” to help identify when expectations become irrational, the black dotted line represents the median sales growth actually achieved by the same group over the prior 5 years, and the green/red circles signify the times (mentioned above) when we have gone on record to say that expectations were not in-line with reality. Based on our most recent analysis of the current S&P 500 expectations, the median company in the S&P500 is priced to grow revenue by over 15% over the next 5 years, while these companies have delivered just 5% revenue growth on average.
Granted, much of the high expectations can be attributed to mega-cap growth stocks, many of which are in the tech sector. It will be extremely important for managers to have the ability to find those companies that still have reasonable expectations and are priced at a discount to their intrinsic value. In times of high expectations in the past, many managers tend to chase momentum and disregard valuation.
We will place our bet on valuation, as it has proven to weather storms in market cycles of all stripes.
By solving for the implied sales growth a company needs to deliver to justify its current trading price (using historical median EBITDA & Asset Turns), we begin our search for undervalued securities with valuable insights into what level of sales growth the market is currently pricing in. This allows us to leverage our time and focus efforts on analyzing a smaller number of stocks with expectations significantly lower than their own historical performance, their peers, or your own insights. Once you have identified a shortlist of stocks with low expectations, you can spend the time making precise model calibrations to calculate an intrinsic value based on your forecast.
In aggregate, this analysis helps us to identify times when expectations for industries, sectors, or indices become too optimistic/pessimistic or out of touch with reality. Listening to these market signals allows us to take advantage of mispricings, more carefully analyze segments of the market where expectations become abnormally high/low, and serves as a sanity check during times of extreme market tumult and investor unease.