Steve Jobs & Business Folk Lore

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In “Steve Jobs: The Lost Interview” (which can be seen on Netflix), the interviewer asks Mr. Jobs an interesting question: How did you learn to run a company in your early twenties without any particular training? His response is worth thinking about:

Throughout the years in business, I found something: I always asked why you do things. And the answers you would invariably get are “Oh, that’s just the way it’s done.” Nobody knows why they do what they do. Nobody thinks about things very deeply in business – that’s what I found… In business, a lot of things are – I call it folk lore: they’re done because they were done yesterday and the day before. So what that means is if you’re willing to ask a lot of questions and think about things and work really hard, you can learn business pretty fast – it’s not the hardest thing in the world.

I’d argue that this applies in a big way to investing as well: most market participants don’t seem to think very deeply about what they’re doing (for example, a stop-loss strategy); it seems to me they purposefully avoid asking themselves tough questions about why they take a particularly approach to investing – probably because it’s easy to poke holes in most approaches if you start asking serious questions. (I’ll be the first to admit that I find flaws and inconsistencies in my approach to investing all the time – and while I try to force myself to address those issues head on, it’s much easier to sweep it under the rug and pretend that it’s really not that important.)

Here’s an example of a questionable approach that’s often used by analysts: I frequently see the argument that businesses should trade at a slight premium or discount to the market multiple or a group of their peers (I'll also extend this discussion to the company's own historic valuation - relative to itself). The good companies should trade at a small premium and the bad companies at a small discount – usually as justified by their historic relative valuations. Here’s an example from Barron’s in late 2013 (link), quoting analysts from Janney Capital Markets:

At just north of 9x CY14E EV/EBITDA, ConAgra (CAG) trades at a 20% discount to the group, well below its historical 10% discount despite slightly worse visibility and volume trends.

So here's the question I’d like to consider: what’s the rationale for accepting historic discounts / premiums to the market or industry peers as representative of fair value? There are numerous reasons why I think this approach is flawed – or at least has questions that need to be answered.

The first problem is that companies and their peers are not static – they change. To use the above example, ConAgra purchased Ralcorp for ~$5 billion in 2012, shifting their business mix pretty significantly; as a result, Treehouse Foods (THS) seems to me like just as likely to be an appropriate peer as Kraft (KRFT) for ConAgra. Similar changes in business mix have occured for some of the other members of the peer group mentioned in the article as well. This alone is enough to make one question the validity of using historical relative valuations – particularly when used to justify small variations (like a 20% discount versus a historic discount of 10%); the fact that we don’t know the measurement period used for the historic multiple is also an issue worth further consideration: it’s likely that the relative valuations have been substantially different over the past one, three, five, and ten year measurement periods.

Another problem is that Mr. Market’s credibility is questionable in the short term, particularly when reviewed over long periods of time; consider this chart of Markel’s (MKL) stock, which shows the trailing price-to-book valuation for MKL shares over the past decade or so:

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We can see that Mr. Market suddenly decided that Markel was only worth ~1.2x book in the past few years (to the end of 2013) – after believing that it was worth 2x or more for most of the five year period to the end of 2007. What could justify the sudden change to a 40% lower average P/B multiple? To give you an idea on the fundamentals, book value increased at a rate of 18% per annum in the five years to 2007 – a single point higher than the five years to 2013. That certainly seems like a drastic reaction: would MKL be worth less than book at a 15% CAGR? The more reasonable explanation is that Mr. Market can stay in moods – optimistic and pessimistic alike – for long periods of time.

The final issue with this approach was covered in an article I wrote a few months back (The Real Definition of Intrinsic Value): the longer your time frame, the wider the justified discount or premium to the average becomes (assuming the fundamentals are unchanged). In the defense of our analysts, this issue applies to the market as a whole: the short term perspective of the average market participant results in tighter spreads than what is justified by the financials (this point is a bit more contentious, and some may disagree with that conclusion; personally, I’m convinced that this is an accurate statement, on average, for high quality businesses).

Assuming the fundamentals are expected to stay unchanged, great businesses should trade at a substantial premium to the average – not the slight premium (a few turns on the P/E) that I think is more commonly argued for in practice. Analysts have a good excuse for ignoring this: it’s their job, and impacts their compensation and career advancement. They are in a big guessing game that’s focused on finding out what Mr. Market will be willing to pay for a dollar of earnings for a given business in 6-12 months – not the intrinsic value of the underlying business based on its expected cash flows over the next 10+ years. I’d argue that there’s a big difference between the two, which has a substanial impact on how you think about a business and its appropriate valuation – and it all comes down to differing time frames.

For those who can take a long-term perspective, the math is clear: businesses with superior underlying fundamentals and the ability to reinvest back in their core business are worth a substantial premium to their peers.

Conclusion

As Steve Jobs noted, you can get ahead in business and investing if you’re willing to ask questions and spend time thinking about things. As it relates to valuation, I think there’s a strong argument to be made that the use of historic relative valuations has serious limitations; upon analysis, it seems closer to folk lore than an intelligently reasoned approach to equity valuation.