Expectations, Price, and Fundamentals (Or Congressional Questions Gone Awry)

I was watching a congressional hearing last week on climate change, and a congressman asked one of the scientists testifying, "but you have to admit if you took the 10 hottest days out of your analysis your thesis falls apart". The scientist replied, "Well, Congressman, I suppose if pigs could fly we could call them airplanes ... but they don't. As scientists we don't have the luxury of taking the 10 hottest days in recorded history off budget. They happened. They are real. And we simply can't deny they happened."

However one feels about climate change the idea of removing data from a model made me think of how we assess companies at Nintai. Do we – out a desire to find the next 10-bagger – alter or remove data about expectations and price that give us inconvenient results? In an age where you can see an ad for Gorilla Trades asking, "Don't you wish your stock picks are HOT like mine?" or a headline from the Street.com that asked "Do Earnings Still Matter in this Volatile Market?" it's easy to see how investors might feel required to fudge things a little bit.

Michael Moubassin wrote, "Perhaps the single greatest error in the investment business is a failure to distinguish between the knowledge of a company’s fundamentals and the expectations implied by the market price.”

It's this gap between expected value and market price where the danger of stunted thinking and intellectual short cuts can be very dangerous. And we mean that from both an upside and downside. That space is what separates value investors from all other Wall Street operators. If we approach it as the consensus does then we will – in the words of Lord Wellington – "be beaten back in the same old way."

The ability to play in that grey area between fundamentals and expectations – objectively and uniquely – gives us an enormous competitive edge against Wall Street. One way of seeing this is taking a look at how analysts have done in estimating EPS growth over the years. In their 1994 study, Michelle Clayman and Robin Schwatrz found analysts on average estimated first month earnings 57% higher than actual earnings. (“Falling in Love Again” – Analysts' Estimates and Reality, 1994). In a 2013 study by Factset Research, analysts’ predictions for the S&P 500's earnings were matched against actual earnings. Similar to Clayman and Schwartz, Factset found that over the past 15 years analysts overestimated by an average 10.1% for 10 of the 15 years. (Factset Research, "How Accurate are Analyst Annual EPS Projections One Year in Advance," January 2013). But it isn't just overestimates on years where earnings growth occurred. The real estimate failures happened during downturns such as 2000-2002, 2008-2009 and 2011. In 2000 analysts were on average overestimating by 36%, in 2008 by 53% and 2009 by 27%. High expectations indeed. These EPS estimates gave Wall Street entirely false assumptions for making a decision to invest or not. In Moubassin's words, analysts had entirely "false expectations implied by the market price." If we invert this, we see that analysts got the market price wrong by implying false expectations. Growth estimates too high meant implied price estimates were too high which meant overpaying for non-existent growth. This ripple effect creates a situation that is highly unlikely to produce long term gains for the investor.

Why this matters

I point all of this out because as valuations stretch in ever increasing market, it is very easy to substitute a better number or remove a worse one for the model and price to meet your expectations. As we've seen Wall Street falls prey to this to the detriment of their investor returns. Our gift as value investors is the ability to ignore such pressures that an analyst faces and not make relevant data "off budget" as our scientist so eloquently summed up.

But it isn’t easy. Research shows repeatedly that, as a situation becomes more widespread (such as a five year bull market), there is greater need to distort facts to be part of the wider environmental success. In an article of the CFA Institute’s blog “Enterprising Investor” one of the top reasons for financial analysts to not tell the truth was to “make a positive impression on others or to protect themselves from embarrassment or disapproval” (Enterprising Investor, July 19, 2012). Another report of the Journal of Basic and Applied Psychology (August, 2013) found a direct correlation between the amount of time the analyst had been wrong and the amount of size/scope of misrepresentative data.

Reality bites … but it’s the best friend we have in the markets

I can remember when I was starting in investing and I found a company that met all our criteria – financials, management, great business, growth, etc. There was one kink in the works. I couldn't get the projected cash flows to get me to a 25% discount to fair value – a mandate for investment. I had adjusted everything I could. So I added 1.5% growth on for three years and voilà – 25% below fair value. When my superior – the managing partner at the firm – saw my analysis he said to me “what’s the past 3, 5, and 10 year FCF growth rates?”. I told him. His reaction was “then what hell makes you assume it’s going to increase these three years?”. I knew I couldn't tell him it was because I fudged it to hit the financial model. But he was very pleasant and said, ‘Tommy….when you start in this business you had better understand right away that sometimes reality bites, but it’s the best friend you will ever have in the market. The real problems begin when people start to believe the lie.” It was a great learning for me. The best investors use reality to take a hard calculated look at the space between expectations, price and fundamentals, and then make the appropriate – and often difficult - decision.

To beat the markets you must think differently

To outperform you have to create mental models that do not reflect the consensus of the crowd. If you don't you are unlikely to outperform a market since a market - by its very definition – reflects the consensus. Thinking differently means the ability to a.) create models which analyze issues from multiple angles seeing relationships where most see none and b.) build in numbers that reflect both the highest and lowest expectations accounting for all kinds of variables. Taking a unique look at expectations can give very different conclusions than the majority of investors. But one view must be consistent – the fundamentals of a company are rarely subject to your own interpretation. For these a spreadsheet provides all the thinking you need in most cases. Seth Klarman (Trades, Portfolio) once said "Successful investing is the marriage of a calculator (fundamentals) and a contrarian streak (expectations)”. ** Please note words in parentheses are my additions.

Just being different fails, being cognitively different makes money

Thinking differently doesn’t always mean you’re on the right path. I’m sure the first person to ever say, “What’s the worst thing that could happen here?” learned the harsh reality between thinking differently and acting intelligently. Thinking differently must be paired with using wisdom. Such an idea as credit default swaps may have been thinking differently, but didn’t really use the most worldly wisdom. The genius of Ben Graham and all the disciples who have come after is the ability to think differently about expectations and fundamentals, divine an estimated value, and then seek a margin of safety for their investment. That’s thinking differently and acting intelligently.

Conclusions

For all the talk here about expectations versus price, there really isn’t any easy or best way to tackle the problem. Much as Ben Graham said his three most important words might be “margin of safety,” I might suggest in this debate four words – “be truthful with yourself.” Time after time investors have taken a severe loss when their expectations were far in excess of price and fundamentals. Much like the congressman, when we fudge expectations to make the fundamentals work we almost always get the solution to the question – just not the correct one.

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UPDATE ON MANHATTAN RESEARCH (MANH, Financial)

On an entirely different note, today we made the decision to sell half of our position in Manhattan Associates (MANH). We first bought this stock in May, 2008 and have held it until this week. Our total return (including splits) is roughly 900% since purchase.

As we’ve stated previously we will hold on to a company like a tiger if it continues to meet our expectations. This the company certainly has done. Over the past 10 years the company has grown revenue at nearly 11% annually and free cash flow and even better 17.4% annually. It has increased ROC from 43.6% in 2008 to roughly 52% in 2014 and raised ROE from 12.4% in 2008 to 39.2% in 2014. The company has never had any short or long-term debt and currently holds $111M in cash and securities on the balance sheet. A true compounding machine. And this is why we will retain 50% of our holdings. We believe there is an even better story to come.

The reasons why we are selling the other half of the holdings are based on two issues. First, the company has gone from 4% of Nintai holdings in 2008 to nearly 12% in 2014. While having a holding take up a significant percent of the portfolio doesn’t concern me personally, it does our investors. So we shall act accordingly. Second, the price to valuation ratio is clearly stretched. When we first bought MANH in 2008 we believed the company was roughly 35% below fair value. Today we estimate the company is roughly 20% above fair value. Again, not a real concern of ours but not the type of stock you want to have hold such a large percentage of the portfolio.

Accordingly we will make the transaction to sell the shares as of end of business Monday, January 26, 2015.

Revised Nintai Holdings Table, as January 26, 2015