Stop Thinking Chronologically and Start Thinking Psychologically
publication date: May 8, 2017
author/source: Brian Nelson, CFA
Image Source: Kenzie Saunders
Let’s cover three important investing prompts.
By Brian Nelson, CFA
The Psychology of the Markets
“The stock market is a discount mechanism of future expectations. Period. Sometimes prices are rational and based soundly on reasonable future fundamental expectations and sometimes they’re not.” – Brian Nelson, CFA
Stop thinking chronologically, and start thinking psychologically.
Many investors believe that they can just buy any old stock that pays a growing dividend and hold it for decades, and that’s long-term investing. Selection bias aside, this has worked in the past for many an investor. There are hundreds of examples of this. But I think it is incredibly important for you to understand how to think about the long term, regardless of your investment time horizon. The long term is generally taught and presented chronologically (i.e. hold a stock for years), but instead it is a far more psychological phenomenon.
First, any intellectual conversation of the long term must consider the discounting mechanism of stock prices in how they discount future information, whether it is risk through the discount rate or value through the magnitude of free cash flows. The long term, therefore, is a far more complex concept than many make it out to be. In the future, for example, stock prices will reflect the expectations of a "new" future at that point in time, not the fundamentals of the past or performance from the past to present. This is why in “The 16 Steps to Understand the Stock Market,” we say the "long term" can never be attained. It’s fallacious to think so. As time passes, there will always be a new “future,” and a new “long term,” and stock prices will always change to reflect the moving target of these changing long-term expectations.
Apple (AAPL), for example, is/was/has been a great performing stock because its future today has a larger free cash flow stream expected in it (and lower risk ascribed to it) than that of the future of its past. Its future value today is larger than what it was in the past. The present value of expectations of its long term, a "new" long term, have changed over time. This is very important to understand. It is not the passing of time (chronologically), per se, why stock prices advance/decline, but instead it is the change in the market’s future financial forecasts of them (free cash flow and the like) +\- net cash on the books at any point in the future that causes the stock price change (driven by buying and selling activity based on these changing expectations).
It's psychological, not chronological. Because expectations of the future are always changing, and the future is inherently unpredictable, there can theoretically never be a determinate or definitive “long term.” In fact, there is only a series of iterative expectations of the long term that drive the stock prices of today and stock prices as time passes. If you understand this, you’re moving closer to understanding what makes the markets tick.
Source: “The 16 Steps to Understand the Stock Market,” Brian Nelson, CFA
Dividends Are a Symptom, Not a Driver of Intrinsic Value
“The ‘dividend’ has done more to confuse investors about investing than anything else in modern-day society.” – Brian Nelson, CFA
Dividends are a symptom of value, not a driver of it.
The intrinsic value of a company is based on its net cash position on the balance sheet and what it generates in future free cash flows, discounted back to today. All other qualitative factors (management, strategy, new products, and the like) must translate into future income/cash flows to have any monetary value. Because a company pays a dividend out of free cash flows (or net cash on the books), the dividend is an output to the valuation of the company (it is a symptom), not a driver behind it. To hit this point home, for example -- there are many companies that could be considered fantastic investments that pay no dividends at all.
How dividends impact valuation: https://www.valuentum.com/articles/20140114_1
Let's use Teva Pharma (TEVA) as an example of how a company's dividend could be at risk but shares could still be considered cheap. The company is highly speculative (it is currently under DOJ investigation and is experiencing turnover in the executive suite) and one that we do believe has heightened risk to the sustainability of the dividend (its Dividend Cushion is far less than 1), even as we say we think shares are undervalued on our discounted cash flow process (the company has a tremendous free cash flow yield). We pay close attention to a large number of different variables in our work, but the price-to-fair value variable is one of the most important.
For example, if an investor can buy a stock for $0.70 (price) on the $1.00 (value), that's a good deal, and what we consider to be the cornerstone of investing. Estimating the company's value correctly is one of the most important things investors can do, and that's outside the context (independent) of the dividend.
More on this topic...
Q: Why does a stock have a good Valuentum Buying Index rating but a poor dividend growth profile?
A: The intrinsic value of a stock (company) is independent of the size or quality of its dividend payment or its dividend growth profile. Note: dividend payments are just a portion of a firm’s total free cash flow (earnings), and intrinsic value is driven by all of the future free cash flows (earnings) that belong to shareholders.
The discounted cash-flow valuation process for firms rests on assessing the discounted future free cash flows of an entity in arriving at a fair value estimate for that entity. We then use a margin of safety to better pinpoint an entry/exit point that captures the risks inherent to the company's business model. After doing this and conducting a relative value assessment, we then evaluate the technical and momentum indicators of the firm to further reinforce our entry/exit points. This process culminates in our Valuentum Buying Index (VBI), which uses a rigorous DCF evaluation, relative value assessment, and technical and momentum indicators to derive a score between 1 and 10 (10=top pick).
When evaluating a company’s dividend, we sum the future free flows of the firm and divide that sum by future dividend payments over a five-year period (and consider the firm's net balance sheet impact). If this relationship is below parity (1), we don't think the firm's dividend growth potential is strong. In other words, this analysis reveals the company doesn’t have a significant amount of capacity to raise the dividend. However, that doesn't mean the shares of the exact same company aren't undervalued and that investors aren't interested in other parameters that drive the company’s VBI rating -- which we think captures the major factors that drive a firm's future capital appreciation potential.
All things considered, it is perfectly consistent for a company to score high on our VBI scale and not have strong dividend growth prospects. Alternatively, it is perfectly consistent for a firm to score low on our VBI scale and have strong dividend growth prospects.
Don’t Revenue and Earnings Have to Advance for Stocks to Go Up?
“In short, no. If a stock is undervalued on the basis of its future free cash flow stream, price-to-fair value convergence can occur even if future fundamentals are less-than-desirable.” – Brian Nelson, CFA
The price-to-earnings (PE) ratio is a short cut and used incorrectly, almost all of the time.
The price of a stock almost never equals its true discounted cash-flow based intrinsic value, so regardless of where revenue or earnings go in future periods, a company can either be undervalued, fairly valued or overvalued today--meaning that its price will often differ from its true intrinsic worth. It becomes clear that even undervalued stocks with expectations for declining revenue and earnings can advance if price-to-fair value convergence occurs.
The discounted cash flow model, the method that we use to estimate intrinsic value, captures future expectations of revenue and earnings growth/declines today, and those future expectations are embedded in the current fair value estimate today, meaning future expectations are captured and discounted back to today (they are factored into the current estimate). Only deviations from those expectations (as expectations can and should change) will cause changes in the fair value. The future is all that matters when it comes to investing.
Importantly, thinking in terms of multiples may not be as rigorous of an approach as investors may like. Multiples at times can be meaningless in the case of negative ones, extremely small ones, astronomical ones, ones that exclude net cash, and others based on non-GAAP earnings. There are a great number of factors beyond just growth that can impact a company's multiple, which is driven by all of the drivers behind the discounted cash flow model. Please have a look at the following for some great reading: https://www.valuentum.com/articles/20120313_1.
Critically, the tendency for systematic overvaluation of industry and sector groups runs prevalent when only comparable multiple analyses are applied, too. This is what happened in the MLP space during mid-2015, as the price-to-distributable cash flow metric fallaciously took precedence over enterprise free cash flow estimation.