Thursday, April 9, 2009

Intrinsic Value: The Six Stock Portfolio

Below, I've noted how I think current market prices compare to likely per share intrinsic value of some very good businesses.

These are shares I like for my own portfolio over a very long time frame.* In other words, I never have a view what others should own. In fact, for many reasons, I think it unwise for any investor to buy or sell a common stock based upon the views of someone else. To me, the only good way to develop real (and warranted) conviction about a particular investment is through one's own work.

This is less about stock picking (and not about trying to gauge near-term price action), more about finding shares of great business franchises to own long-term that are available at discount to value, conservatively calculated.

On prior occasions, Warren Buffett has explained that investing can be simple but it's not necessarily easy.

Well, the approach below attempts to respect this dictum (as well as many of Mr. Buffett's other investing principles).

So the idea is to buy several great durable businesses with high returns on capital at a fair or better than fair price and own them long-term. I've posted what I believe the shares of the six businesses below will be worth in three years not what the stock prices will be (though in the long run those stock prices will approximate value). An estimate of intrinsic value is, of course, never a precise number.

I think about it this way. Within three years or so, there's a good chance the stock prices will begin to close the gap and more closely reflect the intrinsic value of these businesses. Some, inevitably, more quickly than others.

In addition, purchased at or near current prices, I believe shares of these businesses can return (including dividends) in the range of 10% to 14% per year, on average, over the longer haul.** I could easily be very wrong, of course. The returns, if they materialize, will come primarily from long-term increases to intrinsic value, not some clever attempt to own the stocks at just the right time. It starts with owning durable business franchises with attractive returns on capital. That, in addition to paying a price that represents a nice margin of safety, is what matters when it comes to generating investment results over the long run. It comes down to owning what inherently has a sustainable competitive advantages and, ideally, is run by talented managers that will build on that advantage over time.
(The business must also be comfortably financed. That means being financed in a way that is conservative in nature but appropriate for the specific business and industry characteristics. So this assessment includes judging balance sheet strength but isn't limited to that and can't be viewed in a vacuum. What's sufficiently comfortable under one scenario would be hardly at all in another.)

So, if I can't figure out the range of what a business is likely to be approximately worth in one or, ideally, more like two decades using conservative assumptions, I'd rather not own it now. I do not spend much time and energy concerned about stock price action in the short run or even longer. In fact, if the price continues to stay meaningfully below intrinsic value, it just provides an opportunity to buy more shares over time. It also allows the company to buyback shares cheap to the benefit of continuing shareholders. Otherwise, it's better to use available time and energy evaluating whether the core franchise is being strengthened or weakened. Even the best business franchises can run into A) short-term troubles (AXP) or can even be B) permanently damaged (newspapers).

A) = opportunity, B) = threat

The portfolio*** is made up of the following stocks: Diageo (DEO), American Express (AXP), Pepsi (PEP), Philip Morris International (PM), Wells Fargo (WFC), and Lowe's (LOW).

Stock | 3-Yr Intrinsic Value | Recent Price
DEO   |          $70-80/share    |$ 45/share
AXP   |         $55-65/share      | $ 15/share
PEP    |         $75-80/share     | $ 52/share
PM     |         $60-70/share     |$ 36/share
WFC  |         $45-55/share      |$ 14/share
LOW  |         $35-40/share     |$ 18/share

The financials I've listed have, at this time, difficult to gauge regulatory risks. The prices I've posted assume reasonableness in the policy area will prevail in the coming months. Any of these could pull back in the near term and I do not believe this portfolio will necessarily outperform in the next 2-3 years. Having said that, over the next decade or so, I'd expect these to perform well at less risk than the market as a whole.

As always, I attempt to buy shares at a price that provides a nice margin of safety. What makes sense at one price is dumb at another. That's true for even the best business. Generally speaking, my preference is to buy shares of the financials listed here when selling for at least a 50% discount to my necessarily rough estimate of current per-share intrinsic value and the others at a 30% discount.

Sometimes slightly more or less based upon factors that are unique to each business.

Adam

Long position in DEO, AXP, PEP, PM, WFC, and LOW

This site does not provide investing recommendations as that comes down to individual circumstances. Instead, it is for generalized informational, educational, and entertainment purposes. Visitors should always do their own research and consult, as needed, with a financial adviser that's familiar with the individual circumstances before making any investment decisions. Bottom line: The opinions found here are never a recommendation to buy or sell anything and should never be considered specific individualized investment advice. In general, intend to be long the positions noted unless they sell significantly above intrinsic value, core business economics become materially impaired, prospects turn out to have been misjudged, or opportunity costs become high.
** The average annual return will, of course, almost certainly be vastly different than what happens in any particular year. These are common stocks, after all, so wide year-to-year fluctuations driven by market mood swings and other factors more or less specific to the individual business should be considered the norm. The focus here is on intrinsic per share business performance over the long haul, not near-term price action. The key is to buy shares at a discount to value in the first place.
*** This portfolio is concentrated by design. Some might consider such a concentrated portfolio to be extremely risky. My view is that concentration can be a good thing in the long run even if it sometimes increases volatility and near-term underperformance. Concentration forces the investor to own what they understand and prefer the most. It works if the investor feels rightly confident that what they've decided to own has sound long-term economics, durable advantages, and reasonably capable management (those who are smart capital allocators among other things). It works if the business has sufficient financial strength (and, where appropriate, is improving that strength) to weather inevitable, hard to foresee, future economic storms and specific business difficulties. More diversification makes sense if the investor is less comfortable with judging the long-term prospects of individual businesses. I say this knowing that, over the long haul, each one of these six businesses is almost certain to get into difficulties, maybe even serious, from time to time. I think of risk in terms of the possibility of permanent loss of capital, not temporary paper losses, and certainly not worse-than-useless measurements like beta or anything similar. Importantly, this approach requires minimal trading activity and, for that matter, trading acuity. Fewer moves means fewer potential mistakes and reduced frictional costs. It all comes back to whether business prospects and value can be judged well then paying the right price. Now, if the economic moat of one of these became materially damaged in some way then, of course, a change might be in order. Otherwise, my preference is to minimize moves and get results primarily via what these businesses will produce over time.
 
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