Thread by @eboroian, (1/n) Value investing is about buying something for less than it’s worth. [...]

(1/n) Value investing is about buying something for less than it’s worth. 2 problems with the implementation of this:

1/ People don’t have the same definitions/frameworks for thinking about what something is worth

2/ The worth of things changes over time, esp in dynamic markets

Relating to point 1, many investors equate ‘what it’s worth’ with a low multiple. This approach is decreasingly useful for various reasons

Investing has always been about a company generating more long term FCF than the market thinks (or with less risk than the market thinks)

Most of the companies that do this are of high quality.

Historically, investors weren't that good at identifying quality, initially due to inability to screen for it, but also because there were far fewer resources on how to think about it

Therefore, within 'low multiple' stocks, there were various quality companies that delivered far more FCF than the market had assumed (or w/ less risk) & thus outperformed, giving a good name to this approach.

The low multiple was an occasional correlation but not causal

Today, there are multiple resources (books, papers, websites, podcasts etc) on how to identify quality. Most investors have a component of this in their process

There is much more competition looking for quality at a reasonable price, including a plethora of quant funds etc.

In addition, the way companies reinvest has changed, including much more via the P&L, which impacts margins short term despite creating significant long term value, giving false signals

As a result, the correlation between low multiples and good future performance has dropped, and is much more reliant on the environment. Why?

Because most low multiple stocks today are generally companies that are low quality, cyclical, levered etc.

They often don't really control their own destiny, and rely on an improving macro environment to do well. This helps explain why 'value as a factor' has done so poorly over the recent past given the tougher macro backdrop

Although it will have occasional recoveries (and one might be starting now), it's structurally impaired as an approach because the companies within this universe don't structurally create more value over time (or often any value at all)

Thus their IVs decline or at best stagnate & their stocks do the same...often oscillating with the economy

If your framework involves focusing on multiples, my view is that you will continually struggle over time, & the reasons you outperform won't be for the reasons you thought

Take Apple as an example, which has performed very well. An investor that bought 5-6 years ago at 10x earnings might think...see, investing in high quality at low multiples works...

The truth is that Apple has likely outperformed for 3 reasons:

1/ they delivered higher FCF than initially assumed, driven by products that weren't in analysts models 5 years ago (air pods, apple watch, apple music etc)

2/ services and apps represent a larger portion of sales. Users that store photos and data within icloud, that have created playlists in apple music, that can get decent exchange value for their iphone etc. are more stick.

Switching costs have increased, ie moat is stronger

This has the double effect of increasing duration of cash flows and lowering the riskiness of those cash flows (ie the risk free rate)

3/ Apple is a long duration asset, which are more sensitive to rates, and US rates have declined significantly

If you combine higher FCFs, lower risk premium and lower risk free rate, you get a meaningful increase in Apple's intrinsic value.

Notice the difference in framework for thinking about this. It's hard to predict multiples. It's less hard to think about FCFs and risk

And ofcourse I realize that terminal value based on the delta between discount rate and the residual growth rate is essentially a multiple when inverted.

But it's not a shortcut/derivation, it's based on FCF, and it's not short term, which is the flaw in most multiples...

Also, I realize that if you make small adjustments in some of these variables, it can have a meaningful impact on intrinsic value.

But that's only a problem if you think of IV as an exact amount that doesn't evolve. If you think about how it changes, it's less of a problem...

Relating to the second point, most of the outstanding long term returns come not from situations where something was purchased below what it was worth, but where the worth increased meaningfully over time.

I realize this is counterintuitive

If a stock goes up by a factor of 20 over a period of 10 years, is it more likely that investors at the onset bought at a 95% discount to initial intrinsic value, that the intrinsic value changed over time, or that it's a bubble?

Has anyone ever seen someone attempt or claim to purchase something at a 95% discount? I’ve never attempted or seen this. Do any investors try or admit to holding 'bubble' stocks? I haven't seen this either.

But I’ve seen quite a few investors hold positions for 20x or more

So the most important question investors should be asking, in my view, is what causes intrinsic value to increase (or decrease) over time?

And then focus mainly on those things and their inputs (ie the drivers behind them)

I see lots of explanations on twitter for why a business has an existing moat. I see some discussions on mispricing

I see less discussion on why future value creation & FCF will be significantly higher than the market thinks (or less risky), and thus IV is likely to increase...

That's the bottom line of an investor's job:

find situations where the cash flows the company is likely to generate in the future will be significantly more than the market thinks (and/or less risky than the market thinks)

Although it might not be explicit, traditional value investing leads investors to think about intrinsic value as something static, and also something precise. It also leads to anchording. This is not the right framework imo

Thinking about IV requires thinking qualitatively about the future using various scenarios. It requires creative thinking and imagination. It requires understanding to what extent your view is likely, and also how it compares to what other investors think in aggregate...

Here's another way to think about it.

I am a shareholder in a private company. I invested at a certain valuation. In the interim, we have talked about new ways to create value: new products to launch, regional expansion, new distribution channels etc.

Some of these weren't included in the initial discussions. If some of them are successful, the business will likely generate more cash than we had initially planned for, and the valuation will change vs what we initially set out

If this continually happens, the value might evolve meaningfully over time

I think that investing in public markets should be thought of similarly...

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