The Heart of Value Investing
At the heart of value investing is buying an asset at a discount to its intrinsic value and – here’s the more challenging part – then selling it at a premium to its intrinsic value.
But whether your strategy includes investing in poorly-run businesses or great businesses, value investors must return to this first principle. It should hold that if you’re using discounted cash flow analysis to determine a buy price, it should also inform your sell price.
We can debate how much a premium is warranted, but you should be ready to sell at some premium. Maybe you don’t sell a wonderful business at a 1% premium, but if you’re not considering a sale at a 30% premium, what you’re doing is not value investing.
Let’s consider the math. If you had an asset worth $100 today and somehow knew its value would grow 10% per year for the next 10 years, it would be worth $259 in year 10. If someone offered you $130 today for the asset, their expected return would be 7% per year. And you should take that offer, assuming you can reinvest the proceeds in a higher-return asset of comparable quality.
To be sure, as business-focused investors, we like nothing more than investing in a great business at a discount and holding it for many years while it compounds its intrinsic value at high rates. In fact, eight of our current holdings (38% of the holdings in a typical Ensemble client account) have been held for over seven years. Yet at a high enough price, even those companies are for sale every day in our portfolio.
It’s true that great businesses often produce unpredictable value, making original valuations look quaint in hindsight. But as investors, all we can do is forecast what we consider to be a likely outcome based on what we think at the time. As we learn more or gain new insights, we adjust our forecasts accordingly.
To illustrate, we had strong conviction in Tiffany, as we communicated in a recent conference call. However, after LVMH announced an offer for Tiffany, we sold our position. Tiffany’s share price surged on the takeover news. Based on our fair value estimate, we decided the market price no longer offered attractive return potential. We reinvested the Tiffany proceeds into other holdings with higher expected returns.
As fellow investor John Huber noted in this excellent blog post on portfolio turnover, your portfolio returns are a function of the return of each investment and how quickly you turn over those investments. We’re not day traders, of course, but we’re also not “buy and forget” investors with single-digit turnover.
At Ensemble, our goal is to put capital into the highest-expected return outcomes, adjusted for conviction. Even the greatest business with continued fundamental growth can be a bad investment at the wrong price.
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