Conservatism with a small ‘c’
William Lough highlights the importance of exercising conservatism within one’s investment process.
“[T]he growth-stock approach may supply as dependable a margin of safety as is found in the ordinary investment provided the calculation of the future is conservatively made, and provided it shows a satisfactory margin in relation to the price paid.” - Benjamin Graham, 'The Intelligent Investor'.
In a previous note, I wrote about how we seek to find opportunities in the stock market where the true quality of a business is somehow hidden to the mainstream due to temporary factors. In this follow up, my goal is to highlight the importance of exercising conservatism within one’s investment process. It is this, above all else, which provides us with asymmetric payoffs. It protects us if we are wrong as well as tilting probabilities towards us of more favourable outcomes and therefore attractive returns.
It’s been said that ‘value investing’ is simply buying at a discount to what your calculation of intrinsic value is, based on the present value of forecast cash flows. This is true in principle, but also highly unsatisfactory from my perspective. There are two critical elements missing considering the application of conservatism.
First and foremost is the conservatism of any forecasts used. Discounted cash flow (DCF) valuation methodology is possibly at peak popularity today and is often slightly patronisingly pitched as the preferred methodology of the true connoisseur of fundamental investing. DCFs are a useful tool, but as with all models they are only as good as the inputs used … which can often be abused and reverse engineered to provide the answer the user wants! There are certainly plenty who deride DCFs for their ‘garbage in, garbage out’ nature. So, put simply, I believe that finding ‘value’ if your assumptions are based off high levels of growth being sustained – or even accelerating – far into the future and then using discount rates keyed off record low bond yields is hardly finding value, as the lack of conservatism creates multiple potential sources of disappointment. And secondly, if you buy at only a small discount to your estimate of intrinsic value then you put the odds further against you. Or, as Warren Buffett put it, “You don’t try to buy businesses worth $83 million for $80 million. You leave yourself an enormous margin. When you build a bridge, you insist it can carry 30,000 pounds, but you only drive 10,000 pound trucks across it.”
It’s instructive to use examples to show what good and bad practice looks like here.
Over the last 5 years, UK-listed companies Computacenter, Moneysupermarket.com and Hargreaves Lansdown all delivered a respectable 11-12% compound growth in EBIT (Earnings Before Interest and Tax). Presumably all showed similar share price performance, right? Wrong. Over the same period, Computacenter delivered a total return some 200%-plus (or 20-25% per annum) better than the other two.
The difference comes down to the starting point of expectations. Remembering that all 3 delivered the same attractive 11-12% EBIT 5-year CAGR (Compound Annual Growth Rate), consider the following:
- Moneysupermarket.com started the period on ~18x EV/EBIT (Enterprise Value/Earnings Before Interest and Tax), with a long-term EBIT forecast ~£130m or ~20% 5-year CAGR. In the previous 5-years EBIT CAGR was ~17%. They delivered ~£120m in 2019 (and are forecast ~£87m in 2020).
- Hargreaves Lansdown started the period on ~28x EV/EBIT, with a long-term EBIT forecast ~£360m or ~13% 5-year CAGR. In the previous 5-years EBIT CAGR was ~12%. They delivered ~£336m in 2019.
- Computacenter started the period on ~10x EV/EBIT, with a long-term EBIT forecast £100m or ~3% 5-year CAGR. In the previous 5-years EBIT CAGR was ~9%. They delivered ~£150m in 2019.
Hargreaves Lansdown and Moneysupermarket.com delivered attractive profit growth, but growth which disappointed elevated expectations within sell-side consensus forecasts – which implied a maintenance or pick up in profit growth over a 5-year period – or implied by the starting valuation multiple. Computacenter had a conservative expectation set and a relatively low hurdle for positive surprises provided by the valuation multiple.
Conservatism matters. Price matters.
Please note that the information within this article has been prepared and issued by River and Mercantile Asset Management LLP registered in England and Wales under Company No. OC317647, with its registered office at 30 Coleman Street, London EC2R 5AL.
River and Mercantile Asset Management LLP is authorised and regulated by the Financial Conduct Authority (Firm Reference Number 453087) and is registered with the U.S. Securities and Exchange Commission as an Investment Adviser under the Investment Advisers Act of 1940. The material within this article is directed at, and intended for, the consideration of Professional clients of River and Mercantile Asset Management LLP only. This article constitutes a financial promotion within the meaning of the FCA rules. Retail or other clients must not place any reliance upon the contents.
The information contained in this article is strictly confidential and must not be reproduced or further distributed. The value of investments and any income generated may go down as well as up and is not guaranteed. An investor may not get back the amount originally invested. Past performance is not a reliable guide to future results. Changes in exchange rates may have an adverse effect on the value, price or income of investments. The information and opinions contained in this article are subject to updating and verification and may be subject to amendment.
The information expressed has been provided in good faith and has been prepared using sources considered to be reliable and appropriate. While this information from third parties is believed to be reliable, no representations, guarantees or warranties are made as to the accuracy of information presented, and no responsibility or liability can be accepted for any error, omission or inaccuracy in respect of this. This article may also include our views and expectations, which cannot be taken as fact. The information and opinions do not purport to be full or complete. No representation, warranty, or undertaking, express or limited, is given as to the accuracy or completeness of the information or opinions contained in this article by River and Mercantile Asset Management LLP, its partners or employees. No liability is accepted by such persons for the accuracy or completeness of any such information or opinions. As such, no reliance may be placed for any purpose on the information and opinions contained in this article.
Please note that individual securities named in this article may be held by the Portfolio Manager or persons closely associated with them and/or other members of the Investment Team personally for their own accounts. The interests of clients are protected by operation of a conflicts of interest policy and associated systems and controls which prevent personal dealing in situations which would lead to any detriment to a client.
ES R&M UK Dynamic Equity Fund
This fund’s unconstrained approach enables investors to have targeted exposure to what we believe to be the strongest opportunities in the UK market.
Engaging with fund managers to deliver better ESG outcomes
Engaging with fund managers to ...
Ajeet Manjrekar explains how ﬁduciary managers can support trustees to meet their regulatory obligations by…3 min read