When I was recently reviewing Empire Investing, I luckily stopped at the "value" step of their investment strategy, as this gave me time to reflect on a couple of things.
The first is the concept of intrinsic value, which most value investors will know well, as the traditional texts of Benjamin Graham and Warren Buffett refer to it often. I, however, don't subscribe to it. I simply don't believe that anything has an "intrinsic value" - the only "value" that can be placed upon something is someone's desire to have it.
A long term investor will value certain properties of a company very differently than a short term investor would value those properties.
Consider the example of a house. I could describe a house as "2 bedrooms, 1 bathroom, modern and in a nice suburb" to a room full of people, and ask each of them to create a baseline valuation of this house. It doesn't matter what valuation they come up with. I could then ask "and what is the change in value if I add a double-car lock-up garage on". To some people, this might de-value the house, (if for example they didn't have a car, didn't want one, and didn't need the storage space) and to others, like myself, it would add value to the house. So, what is the "intrinsic value" of the garage? It doesn't make sense.
So, what Buffett et al are referring to when they refer to intrinsic-value is actually value-to-them, as long term investors.
When I have analysed a company, and have determined it's conservative long term growth rate, I can then create a target buy-price for that company. Not only that, but I can look at today's price, and determine a long term (10 year) annual compound rate of return expectation.
Of course, the two are directly related. If I determine that the rate of return at today's price is 13%, then I it logically follows that if my target rate of return was 26% then I would need to wait until the company was available at half of today's price before I could expect that return.
So, one's target buy-price is fully determined by one's desired rate of return, which begs the next question, what's an appropriate target rate of return? Surely, 15% is better than 12%, and 20% is better that 15%, and so on, and so on. So, why not wait for the 1,000,000% opportunities? I'm sure you've guessed - that they never happen.
In fact, the higher the desired rate of return, the less often those opportunities will occur. But what does that distribution "desired rate of return verses frequency of opportunity" look like, and where is the optimum point between return and likelihood?
Unfortunately, at this stage, I only have anecdotal evidence, and not statistical evidence. One day, I hope to calculate the optimum values. Until then, I'm simply waiting for similar rates of return that became available in the crisis of 2007-2008.
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Bingo Dave.
ReplyDeleteThere is actually no such as intrinsic value - when it comes to purchasing shares of company using a secondary exchange (e.g ASX). This is considered heresy by traditional value investors, but its true.
Part of our extensive research realised this and funnily enough, brought us back to Ben Graham and early Warren Buffett (i.e partnership not BH days).
Modern value investors confuse what Buffett has done at BH (mainly purchase entire companies on a primary market - i.e direct negotiation with the owners) with how the market actually works. i.e Empirically....Empire...
Now put this concept together with the concept of a "marketplace" of differing assumptions and timeframes of what people consider value and you are getting a picture of why value is what you receive, but the price is set now, and in the future, by what people are prepared to pay.