If an investor is to passively own a business (that is, not participate in the management or ongoing financing of that business), there is essentially no long term difference to the owner if the entire business is owned versus only a portion. If what is owned is a portion, also known as a “share,” then the investor is subject to one considerable difference that may be for that investor either an asset or a liability: the price of the share of the business, if publicly traded the way stocks are, is usually more volatile than the changes in value of the underlying business. During times of euphoria or great upheaval, stock price volatility can be so dramatic as to be completely unmoored from the underlying company’s actual value. By contrast, such underlying value plods along much more quietly and to much less fanfare.
Intrinsic value, says Warren Buffett, is “an all-important concept that offers the only logical approach to evaluating the relative attractiveness of investments and businesses. Intrinsic value can be defined simply: it is the discounted value of the cash that can be taken out of the 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 [Buffett’s business partner] Charlie [Munger] and me – will almost inevitably come up with at least slightly different intrinsic value figures.”
Now imagine that the two people setting the market prices are not as rational as Warren and Charlie. Instead, market prices are being set at the time by millions of market participants who are transacting under the duress of their own emotionalism. At times like we have seen since the outbreak of Covid-19, countless professional investors are buying or selling filled with the fear that they will be perceived as wrong over the coming quarter, month, week or even day. There are numerous other impulses driving investor behavior that are not strictly focused on rational, businesslike investing and a clear-minded calculation of the intrinsic value of the stock’s underlying business. The result is market prices that are often quite different than the intrinsic value of the underlying company.
If determining the underlying intrinsic value of a business and comparing it to the market price of a stock was not challenging enough during normal times, it is certainly more complicated during social and economic crises. In the case of Covid-19, market participants sold shares overwhelmingly in an effort to preserve their capital ahead of what they feared would be lower future stock prices. During the first quarter, this caused stock prices in the U.S. to be lower by nearly 20% (after falling 34% from their peak). Some industries have seen their average share prices decline by more than 75% in just several weeks.
But, for U.S. businesses as a whole, or – more importantly to us at Cheviot – for the type of high-quality companies that we seek to own, have their long-term intrinsic values declined by a similar amount? If we start with the assumption that very high-quality businesses will survive the spread – and eventual containment – of Covid-19, then we must consider those future cash flows that Warren talks about when evaluating a company’s true worth.
In the next five paragraphs we take a deeper dive into valuation scenarios. Please forgive us if you are not in the mood for a little extra math, and feel free to skip the next five paragraphs (we will not take it personally).
To understand the importance of a business’s future cash flows, let us look at how different short-term earnings scenarios affect longer-term annualized returns to shareholders. Take the case of a company whose earnings were expected to be $2 per share this year. Before the Covid-19 outbreak, each share was trading for $40 apiece. This equates to a Price-to-Earnings ratio (P/E) of 20. ($40 ÷ $2 = 20.) Assuming annualized earnings growth of 6%, in 10 years’ time this company’s stock would sell at roughly $72 if it had the same P/E of 20. [($2 x (1.06)10) x 20 = $71.63]
Now let’s consider two scenarios in this post-Covid-19 world that we expect will prove overly cautious: one a very conservative outlook and another a worst-case projection.
In the conservative case, we assume the company has no earnings for two full years (2020 and 2021), and it is not until year three (2022) that the company resumes being profitable, but only at the level it was expected to be in 2020. (It is worth noting that, through the Great Depression, World War I and II, the Spanish Flu epidemic, and the Great Financial Crisis, the aggregate of large, publicly-traded U.S. companies has reported profits in each of the past 150 years.) To assume that our already-financially stable company would remain unprofitable for more than one year is a very conservative assumption.
In the worst-case projection, the company remains unprofitable for a period of three full years (2020, 2021, and 2022) and resumes profitability in year four (2023) at its 2020 level.
Under the conservative assumption, due to the change to our earnings schedule, after ten years instead of trading at nearly $72 per share, our company trades for $63.75 per share. In that case, the ten-year annualized return for our company drops from 6% per year to 4.77% per year. In the worst-case scenario our ten-year return drops to 3.32% year. Neither return is stellar, but even the worst-case is still far better than what can be earned in interest on a 10-year bond (less than 1% annually), CD, savings account or money market account. Importantly, neither scenario accounts for annual receipt of dividends, something that may boost returns per year by at least 2% to 3%. As such, total returns to post-Covid-19 buyers (of the right businesses) could be closer to a minimum of 7% to 9%.
The 20% share price decline occurring in the market in the wake of the Covid-19 bear market more than offsets the much smaller decline in the company’s long-term intrinsic value. Moreover, the buyer of shares at that lower price stands to earn a satisfactory return by holding such a high-quality company for the longer term.
Temporary events can exact significant and even permanent damage on companies, particularly lower-quality ones. Investing in companies in the right industries with dominant market positions and strong balance sheets might be less glamorous than speculating in younger companies or loss-making enterprises that one hopes will someday act like a winning lottery ticket. But when times get tough, strong balance sheets matter a great deal. A corporation’s ability to survive and eventually thrive through a downturn becomes paramount. In our portfolios, we try to hold businesses that can withstand severe economic difficulties and, in fact, emerge even stronger from such challenges. High quality companies accomplish this by, among other things, gaining market share lost by weaker competitors or by acquiring those competitors outright.
“Throughout Cheviot’s history, we have strived to own durable businesses that can withstand economic turmoil the type we are now experiencing.”
Throughout Cheviot’s history, we have strived to own durable businesses that can withstand economic turmoil the type we are now experiencing. We also have used major market downturns to increase our holdings of such businesses by acquiring shares when, to us, they represent a bargain price.
Buying shares of discounted companies is difficult now when the near-term future is so unknown as a result of a pandemic that is not merely a business event but a global shock that may threaten the health of our friends, our loved ones, and ourselves. As always, we rely on long-term projections of a company’s intrinsic value. Despite the need for an analytical framework for how to view stock ownership, having the stomach to support the brain’s attempt to act rationally is as important as ever.