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My Business is Cheap - And No One Cares


Financial markets have changed a lot over the last several decades. It used to be that you could buy a stock at say 10-12x earnings, and figure out that the earnings growth over the next 2-3 years would be higher than investors realized, and when the improved earnings played out other investors would realize the company was better than they thought and the stock would rerate to 15x earnings and you would make 60-80% return over 3 years.


That doesn't work anymore. The problem is that other investors were active investors (just like you - analyzing companies and buying those whose prospects were better than the stock price indicated and selling those whose prospects were not as strong as the stock price indicated). There aren't many active investors around anymore. Most investors took money away from the active managers and allocated it to an index fund. Which led to this:


"By amassing so much AUM and ever-increasing inflows, it [the index] ceased to serve its original function of passive participation in markets. Indexation had begun, paradoxically, to directly change clearing prices and the very character of the markets it purported to free-ride upon. Its inflows had become the marginal bid—the trade that determined the last price—because each dollar of the inflows required an immediate pre-programmed, valuation-indifferent purchase by the ETF."(1)


So much of the money in stocks today is valuation indifferent. When the Federal Reserve buys bonds under its "QE" program, it doesn't care what the yield or return on the bonds will be - it only cares that it is influencing the cost of money. Similarly, when investors buy the index, they don't care what the return on the index components (individual stocks) is likely to be - they just want exposure to "the market" and assume that, in aggregate, stocks will go up over time.


The business that trades at 10x earnings experiences decent earnings growth but now gets re-rated down to 7x because no one is paying attention. No one cares because the company is not part of an index.


If no one cares, what's an active, valuation-aware investor to do?


"The problem now is if you buy that thing, even if it plays out the way it does, if it started at 11x, earnings in two years, it's very likely, instead of being at 15x earnings, feels like it's going to be at 7x earnings. We're basically at the same price with earnings up 40% over a couple of years. And you're not really going to make any money because there's nobody who is appreciating what is going on and analyzing it. It just gets lumped into a bucket.


So we need to have that story combined with, well, instead of paying 11x earnings, we're going to pay 4x earnings. And we're going to pay 4x earnings, and there's going to be a 20% buyback going on. And I think if we're able to do that. And we can do that because there's really nobody paying attention, so there are plenty of companies that are actually that cheap.


Like, you say, "Well, where do you find companies are that cheap?" There actually are companies that are that cheap in unpopular areas that don't even necessarily have bad businesses. And I think we're going to earn our returns off of buying things at much, much lower values and holding them until the capital has been fully returned."(2)


In other words David Einhorn is saying that if we can buy good (not great) business with (normalized) free cash flow yields at 15-20%, we either (a) if the company is private, earn back our investment in 5-6 years and create a very attractive IRR on a 10-15 year hold; or, (b) if the company is public – management can buy back a lot of stock (which provides an exit for those shareholders that don’t have a 10-15 year horizon) which shrinks share count and increases free cash flow per share, and which should – in time – drive up the price of the stock accordingly.


That means that if my company is public, I had better make sure that the management team understands the valuation of the company and understands that no one cares and is willing, therefore, to take matters into its own hands - by buying back a LOT of stock.


Problem is "VERY few [management teams] do the actual math…as to whether to buy back stock or not."(3)


My business is cheap and no one cares. Better find someone who understands valuation and capital allocation - now.

 

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