Monday, March 17, 2014

Asset Growth and Stock Returns, Part II

A follow up to this post that covered, among other things, what this 2008 paper calls "a substantial asset growth effect on firm returns."

Prior post: Asset Growth and Stock Returns

Paper: Asset Growth and the Cross-Section of Stock Returns

What do they mean by "asset growth effect"?

Well, the businesses with low asset growth saw their shares outperform those with the highest asset growth. At least slightly counterintuitive.

In fact, the gap was rather large. From the paper:

"...we find that raw value-weighted (VW) portfolio annualized returns for firms in the lowest growth decile are on average 18%, while VW returns for firms in the highest growth decile are on average much lower at 5%."

The paper also notes that "with standard risk adjustments the spread between low and high asset growth firms remains highly significant at 8% per year for VW portfolios and 20% per year for equal weighted (EW) portfolios."

So, no matter how you slice it, the effect is not exactly small.*

Here's an article with some nice charts that sum up the effect in both the U.S. and Europe. From the article:

"The European evidence is also compelling. Over the period 1985 to 2007, we find that low asset growth firms outperformed high asset growth firms by around 10%..."

That'd be a 10% gap each year.

In the prior post I mentioned the following:

...growth is too often treated as being always a good thing. Well, sometimes growth is of the low (or worse) return variety. Think airlines for many decades. That industry grew impressively for quite some time. In addition, sometimes too much is paid for the privilege of ownership due to the exciting growth prospects. The asset may end up performing well, but the owner doesn't get compensated sufficiently considering risks and alternatives.

Poor results can come from buying an asset with weak core business economics (airlines), simply paying too much in the first place for what might otherwise be a business with fine prospects, as well as the misjudgment of future prospects, among other things.

Occasionally, I'll hear (or read) a justification for the price paid of a particular asset with something along the lines of: "it may look expensive now but will grow into its valuation."**

Well, investment has to be viewed as a process and in the context of opportunity costs. The objective isn't for some investment to justify itself someday; the objective is (or should be) to get the best return at the least risk, within limits (i.e. buying only what's understandable...necessarily unique to each investor), and with alternatives in mind. The investment process can be controlled, at least somewhat, while outcomes, especially in the shorter run, may come down to other factors (luck more than skill). Improving intrinsic value estimation skills, developing the discipline to always buy with a substantial margin of safety, and sticking to what is understood well, are each examples of things within the control of an investor.

What the macro world might throw at an investor down the road generally is not.

This reality doesn't seem to discourage the professional prognosticators nor those who enthusiastically listen to their advice (and even pay for their services).

"We've long felt that the only value of stock forecasters is to make fortune tellers look good. Even now, Charlie and I continue to believe that short-term market forecasts are poison and should be kept locked up in a safe place, away from children and also from grown-ups who behave in the market like children." - Warren Buffett in the 1992 Berkshire Hathaway (BRKaShareholder Letter

Buffett: Forecasters & Fortune Tellers

From this interview with Charlie Munger:

"Warren and I have not made our way in life by making successful macroeconomic predictions and betting on our conclusions.

Our system is to swim as competently as we can and sometimes the tide will be with us and sometimes it will be against us. But by and large we don't much bother with trying to predict the tides because we plan to play the game for a long time.

I recommend to all of you exactly the same attitude.

It's kind of a snare and a delusion to outguess macroeconomic cycles...very few people do it successfully and some of them do it by accident. When the game is that tough, why not adopt the other system of swimming as competently as you can and figuring that over a long life you'll have your share of good tides and bad tides?"

Munger: Snare and a Delusion

So focus on the process instead of trying to predict the mostly unpredictable. As I've said, a sound investment process guarantees nothing but at least increases the chance of attractive long run outcomes.

Now, knowing whether you've paid too much comes down to being able to effectively estimate intrinsic value. Naturally, for partial ownership of a business, intrinsic value must be estimated on a per share basis. 
(For example, when buying shares of a publicly traded common stock though not limited to that. It could also apply to partial ownership of a private business. The point is that the decision to buy, with the long-term in mind, part of a business should always be thought of along the same lines as buying a business outright.)

On the surface, estimating intrinsic business value -- whether partial or outright ownership -- isn't necessarily difficult.


Just figure out what cash can be taken out of a business over the long haul then discount those cash flows, right?


Not so fast. It's the assumptions that have to be made that makes the calculation difficult and, inevitably, at best a range of possible values. Too often, the range of outcomes will be way too wide for comfort.


That's why, for most potential investments, it's better to just move on to something else.


The question is whether the investor can make the estimate into a usefully narrow enough range. That comes down to the capabilities and background of each individual investor, of course. 


When the estimated range of value is narrow enough, then a judgment call can be made as to how much of a discount -- margin of safety -- is appropriate. 

So the right margin of safety is inevitably very specific to each investment and will come down to the comfort level (hopefully one that is warranted) that an investor has with it.


Buffett pointed out in the 2011 Berkshire Hathaway (BRKa) shareholder letter:

"We have no way to pinpoint intrinsic value," but that book value happens to be a "significantly understated" but still useful proxy.***

He also explains it this way in the Berkshire owner's manual:

"Intrinsic value can be defined simply: It is the discounted value of the cash that can be taken out of a business during its remaining life. The calculation of intrinsic value, though, is not so simple. As our definition suggests, intrinsic value is an estimate rather than a precise figure, and it is additionally an estimate that must be changed if interest rates move or forecasts of future cash flows are revised. Two people looking at the same set of facts, moreover – and this would apply even to Charlie and me – will almost inevitably come up with at least slightly different intrinsic value figures. That is one reason we never give you our estimates of intrinsic value. What our annual reports do supply, though, are the facts that we ourselves use to calculate this value."

The calculation of Berkshire's intrinsic value has been explained in the Intrinsic Value - Today and Tomorrow section of the 2010 letter and toward the end of subsequent annual reports.

His explanation is a useful one because it shows that some of the judgment isn't a precise calculation at all. It's necessary to roughly estimate how well management will put future capital to work. 

That's an educated guess, at best, and has a huge impact of intrinsic value now and, more importantly, how it might change over time. When a company retains the bulk of its earnings that otherwise could be taken out of the business (and invested elsewhere) this hard to quantify element is terribly important.

Some relevant posts related to intrinsic value:


Intrinsic Value - March 2014
Berkshire Hathaway's Second Quarter 2013 Results - August 2013
Berkshire's Manufacturing, Service and Retail Operations - April 2013
Berkshire's Regulated, Capital Intensive Businesses - April 2013
Buffett on Buybacks, Book Value, and Intrinsic Value - December 2012
Berkshire's Book Value & Intrinsic Value - May 2012
Buffett: Intrinsic Value vs Book Value - Part II - May 2012
Buffett: Intrinsic Value vs Book Value - April 2012
Discount Rate - August 2009

So we're not likely to see Buffett nailing down intrinsic value anytime soon.

For many reasons, an investment decision shouldn't be made based upon someone else's estimate of value. One of the reasons? The conviction just likely won't be there when the near-term price action inevitably -- even if temporarily -- goes the wrong way.

Those who use conservative assumptions, and the patience to wait until market prices represent a significant gap to their well-judged estimate of value, increase their chance of favorable long-term outcomes.

Easier said than done though, with some discipline, hardly impossible.

False precision is dangerous in the investment business.

Price should mostly mitigate the possibility of permanent capital loss (i.e. not temporary paper loss due to price action); the discount should be rather obvious and, to get a good result, require nothing spectacular to happen.

If unexpectedly spectacular things do happen, there'll surely be no complaints.

Those who pay up for exciting prospects often end up just stretching to get inferior results at greater risk.

That may make for a more thrilling ride, but can be a costly way of doing business.

Adam

Long position in BRKb established at much lower than recent market prices

Other related posts:
Asset Growth and Stock Returns - Feb 2014
Buffett and Munger on See's Candies, Part II - Jun 2013
Buffett and Munger on See's Candies - Jun 2013
Aesop's Investment Axiom - Feb 2013
Grantham: Investing in a Low-Growth World - Feb 2013
Buffett: Stocks, Bonds, and Coupons - Jan 2013
Maximizing Per-Share Value - Oct 2012
Death of Equities Greatly Exaggerated - Aug 2012
Stock Returns & GDP Growth - Jul 2012
Why Growth May Matter Less Than Investors Think - Jul 2012
Ben Graham: Better Than Average Expected Growth - Mar 2012
Buffett: Why Growth Is Not Necessarily A Good Thing - Oct 2011
Grantham: High Growth Doesn't Equal High Returns - Nov 2010
Growth & Investor Returns - Jun 2010
Buffett on "The Prototype Of A Dream Business" - Sep 2009
High Growth Doesn't Equal High Investor Returns - Jul 2009
The Growth Myth Revisited - Jul 2009
The Growth Myth - Jun 2009

* The paper's conclusion adds: "We document a substantial asset growth effect on firm returns. Over our sample period firms with the low asset growth rates earn subsequent annualized risk-adjusted returns of 9.1% on average while firms with highest asset growth rates earn - 10.4%. The large 19.5% spread is highly significant. Weighting the firms by capitalization reduces the spread to a still large and significant 8.4% per year." The 13% gap noted above is value weighted but not adjusted for risk. Take your pick. These all represent rather significant gaps in performance.

** There are, no doubt, instances when the payment of a premium price makes sense. It's a matter of making sure that, due to the excitement over potential prospects, the margin of safety principle does not end up taking a back seat. That's just never a good idea. Considering what might go wrong -- and paying a price that reflects that possibility -- is of paramount importance in the investment process. There are instances where pushing for rapid growth to establish a tough to dislodge position in an industry makes a lot of sense. Powerful economics moats can be, and certainly have been, created this way. There's no shortage of examples over the past 10-15 years. That doesn't necessarily mean the investor should pay a premium price -- considering the execution/other risks of such a strategy -- for the privilege of ownership. Price shouldn't just reflect what might go right; it should also reflect what might go wrong. Well, sometimes the investor in a business with the most exciting prospects becomes too caught up in the "story". The result? Their bias becomes excessively toward what might go right. In the more dynamic industries -- whether an emerging one or an existing one experiencing some kind of a shift -- identifying who the winner is likely to be beforehand AND paying a reasonable price isn't often easy. It's the kind of investing neighborhood where costly mistakes get made. Becoming convinced, after the fact, that what is now a plain to see business success was obvious all along is just not a good investing habit. Some convince themselves that they're not susceptible to this behavior, when a more clear-eyed assessment would reveal otherwise. Mistakes are inevitably made but, to get good long-term results, investing well requires that they're minimized wherever possible. One big blunder can undo many other good judgments.
*** Book value is often not a very useful proxy for value but only happens to work for a variety of reasons unique to Berkshire. For most businesses, book value reveals not much about economic value. Most of the time, there's just no such thing as a formula or rule of thumb that's going to reveal intrinsic business value on a generalized basis. If it were only that easy. This post may or may not prove a useful starting point but, even if it is, it hardly deals with the more difficult and subjective judgments about value that are all important.
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