One of the biggest questions lingering in my mind over the last few weeks has been one that I'm sure all value investors regularly struggle with. It relates to those companies that just keep going down. As value investing is inherently contrarian, these businesses often pose painful questions for us - as they present us with a firm that often looks incredibly cheap on a number of bases but simply keeps falling. Since I don't believe in any sort of market timing at all - thinking it more to be a backward-looking, data mining exercise, the thought of 'jumping on the bandwagon' - shorting the stock simply because it's going down - is ludicrous to me. That said, it sometimes feels like that's the way they're destined to go; like HMV, Game, or Thomas Cook Group, the three which sit in my mind most currently - see chart below.
Shorting the stock isn't always bad, of course; just foolish for me to do unless unless I find fundamental reasons to short the stock. My portfolio doesn't currently have any short positions - and nor do I plan to add any soon - but from a theoretical perspective, I have absolutely no objection to shorting a stock that you think is overpriced by the market. The trouble is, it seems to me, the set of tools I use to value stocks loses some of its predictive power when a stock heads into the death spiral Game, HMV and Thomas Cook look to have entered. Am I simply being lazy and looking for reasons to avoid valuing these stocks? Perhaps I am, but bear with me!
My valuation techniques, largely, focus on earnings. All of my companies were profitable last year (Barratt are a fine-line, but were profitable pre-exceptionals). The majority of my companies are conservatively financed, in my opinion. None of them have experienced particularly spectacular growth in the last few years - they are predominantly in industries likely to be defined by the market as receding, not growing. In some sense, then, they're on the 'easier' scale of companies to value. I don't think that's a bad thing, and nor do I make the jump to thinking that I'll be accurate because of it - but there is a reason I don't try and ascribe a value to tech or growth companies - I think it requires a completely different skill set entirely; one which I don't have, and I'm not sure many do.
Think of this post as an open letter, then, as I'd love to hear you opinions as I conjure up one possible explanation. Is it the case, in exactly the same way it's foolish to use simply P/E and PBV ratios to value tech and growth companies, that these metrics lose any sort of relevance when companies go past the 'tipping' point in the mind of the market? Is the concept of a 'tipping' point an oversimplification? It seems to me that there is almost a cyclicality of reasoning in companies who are on the way down; equity investors won't invest on the basis of uncertainty in their lending, and I wonder whether lenders are put off by a company which has shed 70% of its value in the last 6 months. Both sides like confirmation from the other that the business is solid.
That said, though, if earnings and assets lose their relevance - as I have basically said above - what do we actually have left with which to value a business? The business is worth the discounted present value of future cash flows, the easiest proxy for which we have is earnings. How can earnings, then, lose their relevance? Maybe, as I posted in the second paragraph, I am simply looking for reasons not to invest in companies I have no idea how to value. I'm not sure that's such a bad thing, but there is always the possibility that I am missing a great deal of value here. It almost feels as if am buying into exactly the premise I so strongly reject - that herd mindset that scares us away from stocks on the way down and sees private investors so often load up on stocks just as a long bull market peaks.
Maybe the answer is staring me in the face - the fact that all three of these companies have huge obvious catalysts for the share price - refinancing arrangements. The capital structure of all three companies, if they survive, is likely to change dramatically, and that's not something I have any experience in. Market thinkers commenting on the scale of equity raises or debt refinancing deals elicit no opinion from me - simply because I acknowledge how little I know about how these things work historically. Is this most obvious explanation the best one? Simply that these stocks have passed through 'the value zone' and into the realm of investors who are able to accurately perceive the outcome of capital rearrangements? I'm sure many of my peers have that skill, but it's certainly one I don't possess, and may explain my ambivalence!
Filed Under: Value Investing,