• Ryan Reeves

Musings on Valuation

I've talked about valuation more in the last couple months than the past three years combined. And I think that's a good thing. Our natural inclination is to focus on valuation when stocks go down (as a reason to buy) and ignore valuation when things go up. I constantly fall for this cognitive trap.

The truth is that there is a price where, no matter how amazing a company is, it can be a bad investment. That's just math. The problem is that an overvalued stock can continue to go up. It's not like once a company hits a certain PE/PS ratio, it suddenly deflates. In fact, I would actually say that is the more likely scenario. A stock that goes from a 100 PE to a 130, increase by 30%, ignoring any growth in earnings over the period. What's really the difference between 100 and 130? They both seem so high that the perceived difference isn't really that large. But imagine another 30 turn increase, say from 10 to 40. Now that is a 4x and is INCREDIBLY rare. For something to go from half a market multiple to double it, there needs to be a drastic change of circumstances. For a stock to go from 100 to 130 on the other hand, maybe there is a strong job report? Maybe interest rates ticked down a quarter of a percent?

What I'm trying to say is that an overvalued stock is actually more likely to continue to get more overvalued. But there is a point where the last buyer won't continue to bid up the price. Now, if we only knew where that point was!

My method is trying to build a very simple earnings model to gauge what assumptions are embedded into the stock price. If you want a refresher, check out this post.

But even these models are drastically inaccurate. For me to think I know what's going to happen in five years is either, A) foolish or B) extremely overconfident. So what are we to do? Are these models a waste of time? Are they only valuable if you have a longer time-horizon?

In this post, we talked about the trade-offs of long-term investing and how it is generally a very good idea. But there is another side that is less talked about; and that's the benefit of turnover.

Internet bears will often point out that Cisco still hasn't returned to its all-time high in 2000. That's 21 years later. But I think their core assumption is misguided. Would I continue to hold that stock all 21 years?? Especially, when growth fell off a cliff after the dot-com bubble burst??

The answer is a big fat NO. That's one of the advantages we have as "retail" investors. We are free to change our minds on a dime; we aren't locked into a strategy or an arbitrary methodology.

The next question becomes, well, aren't we just speculating then? If we aren't holding companies for 20 years, aren't we just subject to the whims of the market? Some people might call it speculating! But I have a more endearing term -- paranoid buy and hold.

Our goal is to hold a company for as long as possible but we are constantly testing our hypothesis and comparing it to other opportunities. If growth is better for a better valuation and we have higher conviction, why not make the switch? We don't have to hold Cisco for 21 years, while "waiting for it to hit our buy price." We can sell and move on. Basically, we are changing our minds when the facts change. Has growth slowed and a company is no longer worthy of its valuation? Selling might be a good call. I think this piece of good high-growth investing is underrated. You either have to never sell and let the chips fall or you have to really stay on top of things. I think the middle ground is a tricky place to be in. Then again, there are times when the middle ground is warranted (DDOG and MDB come to mind).

A lot of investing is navigating the tension between two opposites. Valuation selling is yet another example. Sure, we have our models, but I try to give an extra-long leash when business results are good. I figure that I could probably get a higher price if I wait until the business results change rather than selling because I believe my assumptions about the future are going to be correct. That's not always true but I've seen it play out time and time again.

On the other hand, maybe I'm being too optimistic and I'm actually "resulting" based on the stock price. It's always hard to make predictions, as Mark Twain would say, especially about the future!

Here's to keeping an open mind and changing our minds when the facts change.


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