In a recent interview with Aaron Edelheit on the mindsetvalue.substack, value manager and Founder of Hayden Capital Fred Liu discussed his value investing strategy and valuation process. He recommends not trying to forecast future cashflows but instead focusing on what the business is worth today and whether it can maintain its dominance into the future. If this is the case, then future cashflows are ‘free options’ in the future. Here’s an excerpt from the interview:
Q3 2020 hedge fund letters, conferences and more
Aaron: In your most recent letter, you make this point that discounted cash flows are great for companies that are optimizing, but not great for knowledge-based companies. And, you know, as a value investor, you know, one of our kind of tool sets is to learn from studying Buffett or any of the traditionally great value investors was like, hey, take a look at the cash flows that matter.
And you have to, like, estimate and do this, just, you know, build this model. I really would love for you to expand on this point. And if you could use a specific example to kind of explain how you’re thinking about how you analyze these knowledge-based companies; it would be enlightening for me.
Fred: Yeah, number one, it’s a case-by-case basis. So, each company is different. But I will also say, you know, and I mean, one of the core tenets of value investing is the idea of a margin of safety. And that you don’t want to basically pay for growth or future growth because you’re unsure if that will happen. It’s the similar way that I think about these companies as well, because as long as you are confident that this business is dominant or is going to be dominant and they already have a very viable and sustainable business, you don’t try to underwrite the future growth necessarily.
We basically invert that DCF and say, what is this business worth today as it is, as long as it just maintains its market share and grows along with the industry and can kind of defend its position today, what is that worth? And then we know that there are these options on the horizon, say one, two or three options on the horizon. But we don’t know the timing of that or necessarily the exact magnitude of it. Like how large the option will be if it works. But we have a rough idea of it.
And so basically, we want to buy these companies without paying for these options at all. And you get moments like that when it’s an earlier stage company where the market is skeptical whether this business will be self-sustainable or whether they will reach that critical mass. You usually get a lower valuation, a lower multiple that doesn’t price in some of these options at the same time.
You can read the entire interview here:
Fred Liu, Hayden Capital Interview (Mindsetcapital.com)
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