A Different Kind of Checklist

Trying to mechanically reduce the process of discovering undervalued equities to a few value ratios such as P/B, P/E or EV/EBITDA can hardly translate into sustained outperformance of the broader market. If this was was the case machines would have replaced every single money manager long ago. At the same time prices for stocks screening favourably would be bid up and the opportunity would cease to exist. Unfortunately this means that a straight-forward checklist, purely based on a bunch of financial ratios, does not help at all.

To define the checklist that can be of help to outperform the broader markets it is necessary to first outline the playing field  and from there answer the question of what has to be done to outperform the market.

I believe the playing-field looks like this:

1. Markets are (Almost Always) Efficient
It is no coincidence that since Eugene Fama came up with his famous efficient market hypothesis low cost index investments have been on the rise. Fama claims that market prices incorporate all public information and prices adjust rapidly for new information. Usually this is true and everyone should therefore question themselves if all the long hours put into research are worth the effort. I am asking myself this question at this very moment.
My answer is yes. But not because I do not believe in Fama´s findings, but because I think there are inefficient pockets in the markets where the conditions for efficient markets are not ideal. Often these pockets exists in places with equity or debt instruments that a) are either too small to be bought other than by private accounts and hence have no sell side research, b) see their entire sector falling out of favour (think of the famous baby that got thrown out with the bath water), c) cannot be bought by funds due to specific limitations or d) whose value is obscured by complicated structures. If this is not the case odds are that the security is efficiently priced.

2. The World is Uncertain
Valuing equities or other financial securities always involves making assumptions about the future and assumptions about the future always involve risk or uncertainty. We talk about risk when the specific outcome is unknown but the distribution of outcomes is observable. Think of tossing a coin. We cannot know for sure if the next toss will be heads or tails, but the probability for both to show up is a certain 50%.Unfortunately making assumptions in the world of finance can hardly be compared to a coin-toss. Throughout history whenever the attempt was made to forecast returns using textbook-distributions the results have been disastrous. Think about LTCM, which went under because real world probabilities and outcomes just didn’t care about LTCM`s model assumptions. The consequence was that several (according to LTCM´s models) once-in-a-lifetime-events blew away the funds tiny equity buffer.

Whether we like it or not the playing field has given us uncertainty to deal with, so we deal with it. But how? The most important thing I believe is to acknowledge the fact that uncertainty works both ways. Extreme events can materialise on up- as well as downside. Optimally we want a portfolio that will not be affected by unexpected and severe draw-downs, but gives us the opportunity to capitalise on what some call positive black swans. This translates inevitably into looking for opportunities with call option-like pay-offs.
The best we can do to achieve this is to assign no value to such call options by paying only for e.g. sticky streams of earnings or hard assets and thus being exposed to the upside at no cost. (I believe MEI Pharma was such an opportunitiy when it traded at net cash)

However, despite adhering to the principle just mentioned, we cannot completely eliminate being exposed to the unforeseeable to the downside. Even if we think of Grahams famous net net´s, which are stocks trading below net current asset value, i.e. current assets less all outstanding liabilities, assumptions about the future and dealing with uncertainty is still necessary. Just think of cash, the hardest of all assets. It is only worth its face value if we can rely on management not to squander it, the possibilities however to squander a cash-pile are endless and its probabilities uncertain. Hence even in the safest areas of value investing we are exposed to uncertainty. Therefore, beyond looking for call-option like payoffs, another important cornerstone to deal with uncertainty is real diversification. One specific shock alone should never be able to sink the portfolio.

3. Second-level Thinking is Required
“A good firm equals a good investment” – One might think that only unexperienced investors come up with their investing decisions like this. But back in the 1960 years investment professionals advised their costumers to buy at any price a list of 50 U.S. stocks that they believed were of superior quality. The argumentation was that since the quality of these stocks is so high that even at elevated prices they will eventually grow into the valuation and then above. In the following prices for these stocks were bid up to multiples of those of the S&P500. The end was a stellar underperformance of the Nifty Fifty despite their high quality.That a good company does not equal a good investment is nevertheless clear to most people. But second level thinking should continue way beyond that. Investing in financial securities is a social exercise. If a lot of market participants believe the a stock is undervalued it will cease to become so, since this becomes the consensus. Hence to generate outsized returns our view on the stock has to deviate from the consensus and in addition everyone else has to eventually agree that our view is the correct one. The consequence is that as an investor looking to beat the indices it is always David against Goliath, or me against everyone else. And that way it has to be. If not maybe there is no undervaluation after all.

What can be inferred of all this for the checklist? For me these two short paragraphs on second-level-thinking mean that a) we have to know about the consensus and b) our view has to be different from this consensus. Otherwise outperformance is not possible. A decent analysis should therefore not stop after having done a DCF, or any other valuation exercise, but it should go on with benchmarking the assumptions against the broader consensus that are e.g. analyst estimates. From here we should be able to explain exactly our differences from this consensus and be able to objectively argument why our estimates are more probable to occur. Arguably this is the toughest part.

The checklist resulting of all of this is probably shorter and very different from the usual “dividend-yield-above-2%, read-all-available-findings, only-buy-at-52-week-low, roe-above-20%-checklist” that I often read about. My checklist divided into the three important categories mentioned above goes like this:

  1. Market Efficiency
    • Can an undervaluation exist and why?
  2. Uncertainty
    • Is the payoff asymmetric or call-option-like?
    • Does the investment contribute to diversification
  3. Second-Level-Thinking
    • What is the consensus and how is my view different from it?
    • Why is this view more likely to occur?
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