Wednesday, May 13, 2015

Multiple Expansion, Buybacks, & The P/E Illusion

...if you expect...[total] rationality either in humans or human institutions, you're expecting what's not going to happen. - Charlie Munger at the 2014 Daily Journal (DJCO) Annual Meeting*

Multiple expansion -- that enough market participants will someday be willing to pay more for a given amount of recent, future, or maybe normalized earnings -- is brought up from time to time and it's often in the context of how it has contributed to returns or, alternatively, might contribute to forward returns.

Well, consider the following...

Let's say a stock with no earnings growth is bought at a P/E of 10 times earnings and sold for 15 times earnings twenty years later. In this case the benefits of multiple expansion appear to be working for the investor.

For simplicity, we'll assume all profits are used for buybacks and the price increases immediately such that the earnings multiple becomes 15 not long after purchase. That multiple of earnings per share then persists over the next twenty years. The shares are sold at the higher multiple at the end of year twenty.

This "multiple expansion" scenario would turn a $ 10,000 investment into ~ $ 60,000 over twenty years.

Not a bad outcome at all.

Now, let's say the same stock with no earnings growth is bought at 10 times earnings and sold for 6 times earnings twenty years later. Once again, assume all profits are used for buybacks but the price drops immediately such that the earnings multiple becomes 6 shortly after purchase. That multiple of earnings per share then persists over the twenty years. The shares are sold at the reduced multiple at the end of year twenty.

On the surface this "multiple contraction" scenario feels like the relatively unlucky outcome and in the short or medium run, of course, it is.**

Yet when the time horizon increases enough, and the compounded effect of buybacks becomes the dominant factor, it's actually the second scenario -- even though it was sold at the reduced multiple -- that produces the better result.

The second scenario actually would turn a $ 10,000 investment into more than $ 200,000 over twenty years.

Basically, that's less than a 10% annualized return with expansion compared to a more than 16% annualized return with contraction.

At first the math may seem off but run the numbers in a spreadsheet and the reason why this works out so well should become more obvious. The fact that it's not intuitive is what makes it useful to those who look for assets that are mispriced.

In the multiple expansion scenario, the purchaser of the stock experienced an immediate 50% gain while, in the multiple contraction scenario, the purchaser of the stock experienced an immediate 40% decline. So naturally the short-term trader -- or even someone who's holding period is several years -- would clearly prefer the former outcome and view the latter outcome as a disaster.***

That multiple expansion isn't always a good for the long-term investor seems to too rarely get consideration. Yet, with a simple spreadsheet, it's easy to show contraction can lead to a better long-term outcome for the business with a durable competitive position, selling at a discount to intrinsic value, with solid, even if unspectacular, core economics, and a sensible buyback plan. It's worth highlighting that these investment results are being produced without exciting business growth. The earnings are flat (though, importantly, there's very significant per share earnings growth due to the buybacks). This is just one example where purchasing, at a fair or better price, part of a business with modest growth but durable and sound economics can trump those with more exciting growth prospects.

The specific circumstances where multiple expansion is not necessarily such a wonderful thing are worthy of more attention than they get.

So why isn't multiple contraction viewed more favorably by those who have a long enough time horizon? A contributing factor might be a market dominated by participants who are mostly speculating on what'll happen in the near-term or intermediate-term -- time frames where multiple contraction is not at all a benefit. It might also be in part due to what I've in the past described as "The P/E illusion". The end result being the long-term benefits of multiple contraction is underappreciated.

Intuitively, that multiple expansion would be less than beneficial to a long-term owner doesn't seem right. Yet it is. This is a case where mathematical intuition leads to an incorrect conclusion.

Understanding the math here isn't difficult, but understanding how framing effects cause this to initially be a bit less than intuitive is, to me, the more important thing.

The reason for the higher return in the multiple contraction scenario essentially comes down to how the earnings yield (inverse P/E) is working for the investor. When you start at a P/E of 10, the 40% drop to a P/E of 6 creates a significant incremental earnings yield tailwind that makes the buybacks extremely beneficial for continuing owners. In this case, the earnings yield increases from 10% to 16.7%. That tailwind combined with buying back stock over twenty years becomes, increasingly, the dominant factor.

This effect becomes much more important than multiple expansion over the longer haul. The implications are significant when it comes to managing the risk of permanent capital loss relative to the potential rewards.

Framing effects can influence decision-making in a way that's easy to underestimate.

The math may not feel intuitively right, but the important thing is that it is right.

Multiple expansion is overrated when it comes to long-term investment.

Essentially, part of what's occurring is an intrinsic value transfer from impatient owners to continuing long-term owners. This only works out well if the buybacks occur when the shares sell for less than per share intrinsic value.

Those who own part of any good business for the long haul should prefer that stock prices lag and multiples contract.

The challenge isn't just buying shares at a discount; it's getting comfortable with the idea that it's better if they remain at a discount -- even if that means the price remains below the initial price paid -- for an extended period of time.

That's understandably a tough sell for traders.

It shouldn't be a tough sell for investors.

For the long-term investor, multiple expansion is a good thing on the day of the sale but that's about it. The key being that the expansion isn't required to get a very nice result. The above multiple contraction scenario is a case in point.

Selling at a high multiple of earnings shouldn't be a necessity to achieve the desired investing outcome. It's best to assume market prices won't be spectacular when the time to sell arrives (many years down the road) then simply consider it a bonus if they turn out to be.

If the total return would be attractive assuming merely a decent selling price, there'll be no complaints if the multiple of future earnings per share the stock can be sold at ends up being somewhat (or quite a bit) higher.

Margin of safety is, in part, about how the price that's paid upfront compares to an estimate of intrinsic value; it's also about making conservative assumptions including, but definitely not limited to, the eventual selling price.

Since an investor can't control near-term market price fluctuations no sensible approach should depend on selling at a great price.

As I've noted in prior posts -- when they were much cheaper than now -- the shares of many consumer packaged goods makers have not only been solid defensive investments, they've also, in the longer run, done rather relatively well in terms of total return. Much of this comes down to the quality of the businesses; the current problem is they're mostly no longer cheap. Too many are selling for a high multiple of their earnings these days. This necessarily means, if these higher multiples persist over time, they'll likely return less for owners in the long run all else being equal. So the tailwind noted above generally doesn't currently exist with these stocks right now. Long-term returns will be adversely effected if this persists.
(In this case -- unlike the examples above where it was assumed all profits were used for buybacks -- it's also dividend reinvestments, not just the buybacks, that won't be as effective or could even destroy value if/when shares sell for a premium to value.)

The combination of a strong competitive position, business economics that are durable and the high return variety, along with shares frequently selling at a discount to intrinsic value accounts for a good chunk of what's been an attractive risk-reward profile for consumer staples companies. Going forward, what needs to be carefully considered is how a changing competitive landscape might alter what have been attractive core economics for a very long time. Are any key advantages being diminished over time? Are viable alternative brands with sufficient distribution being created? Does the internet make it easier/cheaper to create competing brands? Are some of the largest retailers becoming an increasing threat?

The list goes on.

Just because they've produced great results for many decades guarantees nothing.

That doesn't mean these have become horrible businesses.

In fact some are, and seem likely to remain, fine businesses.

It just means the investment risk-reward -- partly due to market price and partly due to prospects -- has become less favorable in some cases.
(Naturally not all are created equal. Some continue to have substantial advantages and possess extremely wide moats.)

Naturally what matters is future performance. Well, if the valuations remain persistently on the high side, these stocks will not do nearly as well even if the businesses perform.

Those that own shares of these small-ticket branded goods makers for the long haul should be hoping for a steep decline in market prices sooner rather than later.

Adam

No position in DJCO

Related posts:
Buffett and Munger on IBM
The P/E Illusion
The Benefits of a Declining Stock
Buffett's Purchase of IBM Revisited
Buffett on Buybacks, Book Value, and Intrinsic Value
Buffett on Teledyne's Henry Singleton
Why Buffett Wants IBM's Shares "To Languish"
Buffett: When it's Advisable for a Company to Repurchase Shares
The Best Use of Corporate Cash
Buffett on Stock Buybacks - Part II
Buffett on Stock Buybacks
Buy a Stock...Hope the Price Drops?

* From some excellent notes that were taken at the meeting. These notes, presented in four parts, are well worth reading. Not a transcript.
** Working through a simple spreadsheet makes what might at first be mathematically counterintuitive less so. Simply put, the persistent and extremely high earnings yield combined with consistent buybacks creates a tailwind over twenty years that trumps the initially negative effects of multiple contraction. Naturally, a price drop of 40% usually coincides with something happening that at least appears material and not good. Whether temporary but fixable or indicative of something more serious is what has to be understood. Multiple contraction is a good thing (or, at least, can be when the circumstances are right) but sustained and meaningful earnings contraction is not. Are the near-term difficulties indicative of a permanent and material reduction in earnings power? Have the core business economics changed for the worse? Has something like a fundamental change in competitive position occurred? Near-term setbacks that temporarily reduce earnings power don't matter nearly as much. In the moment, it's not always easy to differentiate temporary challenges from those that are more permanent. Sometimes, recent results get incorrectly extrapolated. Mispricings can occur when there's confusion about what recent events will end up meaning in the longer run. Judging this well, and acting accordingly when the opportunity presents itself, is often the toughest part. When the price paid upfront is reasonable, and market prices remain persistently below intrinsic value, even a permanent (though not catastrophic) reduction in earnings power can still potentially produce a more than satisfactory investment outcome. The price paid must represent a discount to per share intrinsic value, estimated conservatively. Any decline in earnings needs to be at least roughly accounted for in the present value calculation. None of this should distract from the fact that, when years away from selling  -- all else equal -- multiple expansion is not such a wonderful thing if a stock was bought well (i.e. at a discount to value) in the first place. For the speculative trader, multiple expansion is generally a good thing because they're likely selling soon enough. In addition, multiple expansion is helpful if a premium was paid and the speculator hopes to sell at an even greater premium before enough other participants have figured out the folly. Of course, after all the buybacks and dividend reinvestments have been completed (at a discount) over the twenty year period, the long-term investor certainly isn't going to mind if the multiple suddenly were to become rather high when it's time to sellOtherwise, an expanded multiple actually reduces long-term returns in a scenario similar to the one described in the above post (as well as many other variations including both situations where earnings are growing or in decline). Somewhat different assumptions can alter the specific returns but don't negate the effect. This works best when the earnings yield is on the high side. Stocks that are speculatively priced for lots of growth but prove unable to deliver on the promise generally have insufficient earnings yield for multiple contraction to make a real difference. In other words, a 100 P/E stock that drops to a 60 P/E goes from a 1% earnings yield to a 1.67% earnings yield. That's just not enough of a tailwind. In the real world, unfortunately, businesses with sustainable advantages don't usually sell for a multiple of six times earnings over many years. In fact, a business with that kind of multiple often -- though not always -- is mediocre or even low quality. That doesn't change the reality that multiple contraction, even if to a lesser extent, of a sound business (selling at a discount to value) can be preferable for long-term investors when combined with sensible buybacks and dividend reinvestments.
*** It'd be tough for anyone to complain about a quick 50% gain, of course, but in the real world most of us can't reliably produce quick gains without also risking big losses. Investing is about the net long-term result with all risks considered -- especially the risk of permanent capital loss.
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