Years ago, I was reading an investor letter of a fund manager, and came across a formula that made everything clear:
Change in Price = Price going to Value + Change in Value + Noise
Recently I had a chance to reflect on this formula and deepen my understanding. The result was a new perspective which is helpful in categorizing investments and getting more insight into the portfolio.
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Before we dive in, yes, I am of course familiar with the Discounted Cash Flow model (DCF). Through that lens, there is no “change in value” – the intrinsic value of the business is just the net present value of all future cash flows. In a DCF, change can only occur via the passage of time or by changing the assumptions about future cash flows.
However, the framework I am going to present here is more analytically useful, as it separates the value of what the company has already accomplished from what is yet to be built. In that context, “value” is going to refer to the value of what is already in place whereas “change in value” will refer to cash flow generating capabilities that the company still needs to take actions to achieve.
So let’s dive in. As I started my recent reflections, I asked myself: OK, so what are the factors underlying price going to value? And how do I deconstruct the components of change in value to make this actually useful?
Let’s start with the price going to value part of the formula. It has two components: magnitude and timing. Value investors traditionally don’t focus much on timing, but it’s hard to argue that it’s not a major determinant of the rate of return that any investment will produce.
You might ask: But isn’t it a fool’s errand to try to opine on when the price/value gap will close? Aren’t we just at the mercy of the market’s whims?
In some cases yes, but in some cases no. What are some factors which can accelerate the timing of the gap between price and value closing? Here is a list to illustrate the point:
- Maturity of the security (e.g. bond or preferred stock)
- External events (e.g. acquisition of the company by an outside entity)
- Internal events (e.g. sale of an asset/division, cost restructuring, strategy change)
- Capital allocation (e.g. large share buybacks or dividends)
Of course, none of these might be present. Or there might be more than one of the above acting to speed up the likely timing of the price/value gap closing. The important point is to think of value as exerting a very slow pull on price on its own. The presence of one or more of the above factors has the potential to accelerate this process.
So when we think about the price going to value term, one way to think of it is as follows:
- Magnitude: negative (meaning price > value), small, medium or large
- Timing: unknown, accelerated or imminent
What about the change in value component of the formula? It’s important to realize that it has both a magnitude and a probability. After all – the future is uncertain, and different paths have different likelihoods of occurring.
Let’s use a hypothetical example of a retailer that has 100 current stores already opened and successfully operating. The value of the business at its current scale can be thought of as the value referred to in the first term of the formula. Where does the change in value come from? It comes from opening up more successful stores.
How likely is it that this retailer can open up another 100 successful stores? Let’s say we know a number of retailers serving similar demographics that have 500 to 1,000 units each. So the answer would be: likely.
How about another 500? Reasonably likely but far from certain. Another 1,000? Possible, but not likely based on what we know so far.
What about the probability that this retailer can open a second concept and successfully grow it as well? A distant chance at this point.
So we can think about the change in value term as follows:
- Magnitude: negative, small, medium or large
- Probability, small, medium or large
In a moment, I will show you how this framework can be used to understand and categorize frequently occurring investing patterns. First, it’s important to think through the dynamics of this framework.
Realize that the value investing formula refers to an investment’s attributes at a point in time. Let’s go back to our hypothetical retailer. Let’s say that at a point in time when it only has 100 successful stores its value is X and the stock market is valuing it at 60% of X. With nothing else in the picture, its investing attributes might look like this:
- Medium price/value gap with unknown timing of closure
- Large change in value potential with medium probability
Now, imagine that the market price changes, and now values the company at 150% of X:
- Negative price/value gap with unknown timing of closure
- Large change in value potential with medium probability
Again, imagine that time passes. The company successfully goes from 100 stores to 500. The stock goes from 100% of X (where X is the value of 100 stores) to 400% of X:
- Small price/value gap with unknown timing of closure
- Small change in value potential with medium probability
A larger competitor now announces their intent to buy the retailer for 500% of X, stock goes to 450% of X:
- Small price/value gap with imminent timing of closure
- Low change in value potential with low probability (e.g. a higher bid)
Hopefully the point comes across clearly. The value investing formula can and does change as a function of fundamental developments, external events and changes in the price of the security.
Finally, let’s apply this framework to common investing situations. The last situation describes a typical merger arbitrage situation, so I won’t repeat that one. Let’s look at another common pattern:
- Medium price/value gap with unknown timing of closure
- Low change in value potential with low probability
The above describes the typical “deep value” holding of many value investors. It’s too cheap for what’s there, they don’t know when the gap will close but trust that eventually the markets will do their job, and there isn’t any material potential for growth in value.
How about this one:
- Negative price/value gap with unknown timing of closure
- High change in value potential with low probability
If you guessed that this is the typical early stage growth story-stock pattern, you would be right! Not a lot of value there yet, lots of promise, but the odds of achieving it are low (unless you listen to the CEO, of course).
- Medium price/value gap with accelerated timing of closure
- Low change in value potential with low probability
I will argue that the above can describe an undervalued cyclical. The timing of the cycle turning, assuming that you correctly classified the problems as cyclical, act as a catalyst. Cyclical downturns don’t usually last more than a year or two, which is far less time that some “deep value” stocks with not catalysts can remain deeply undervalued.
- Negative price/value gap with unknown timing of closure
- Medium change in value potential with low probability
Surprisingly, the above describes many turnaround situations before there is evidence of a turn! Market participants frequently ignore that the majority of turnarounds don’t turn and confuse management’s aspirational targets which might happen with the most likely scenario, which is that the business doesn’t turn around.
- No price/value gap
- Large change in value potential with high probability
Finally, this could describe Warren Buffett’s famous “great business at a fair price.” Of course, the price isn’t really “fair,” otherwise Buffett wouldn’t be that interested in buying it. However, it is fairly reflecting the value of what is already there, with large, high-probability growth in value thrown into the bargain for free. This could perhaps be the most attractive pattern of all, despite no current price/value gap. Unfortunately, it is exceedingly rare in the market environment of recent years.
The value investing formula mental model is useful in two ways. First, we can use it to assess the attractiveness of individual investments. Second, we can look at our portfolio and monitor the diversity of different combinations to make sure that we have some balance between situations possibly requiring many years of patience and those where the unlocking of value is likely to happen sooner. The goal isn’t to strive for some specific mix, but rather to be aware of our holdings through a different lens.
If you are interested in learning more about the investment process at Silver Ring Value Partners, you can request an Owner’s Manual here.
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Article by Gary Mishuris, Behavioral Value Investor
