As markets continue to sit near all-time highs, you can almost hear the stretching sound as individual investors (and professional money managers) push outwards on all their valuation techniques that helps them define “value”. An article by Grahamites (“Charlie Munger on Berkshire’s Rationale for Investment in Salomon Brothers”, July 18 2018) cites Charlie Munger’s thoughts about their Salomon investment and that “compared to things available, we thought that it was a good thing to do at the time.” I refer to this problem as “criteria creep”
We all fall prey to it. As markets hit near continual highs, it isn’t that difficult to start thinking that maybe it really is different this time. Maybe that 15 - 20% cash position really is detriment to returns. So, we begin to make decisions that – under different circumstances – we might not even consider.
Criteria Creep: A Working Example
I thought I’d walk through a real-time example of this dilemma. I recently reviewed all my stock purchases since 2010 with a focus on the price-to-earnings (PE) ratio at the time of purchase. In 2015 I joined the team at Dorfman Value Investments (I left the firm as of September 28 2018) From 2015 – 2018 I spent an awful lot of time building portfolios while carefully looking to avoid criteria creep. Looking out over the past 10 years, the purchases I made at Nintai Partners and Dorfman Value show a distinct creep in pricing. The average price-to-earnings (P/E) ratio has increased from 19.6 to 22.7 (a gain of nearly 16%!).
P/E Ratio at 2010 - 2014 2015 - Present
Time of Purchase 19.6 22.7
Until joining Dorfman Value, I rarely placed much credence on the P/E ratio. But my former partner John Dorfman drilled into me the importance of this number and its potential impact on long term returns. That said, there was almost no movement in any other measure I used when assessing a potential investment. For instance, return on capital, equity, and assets remained within 2-3% of each other from 2010-2018. The same goes for cash positions, short and long-term debt and free cash flow conversion rates.
A second and larger difference has been the difference of projected growth in free cash flow growth from the period (2016-2021) – (2018-23). In 2014 – my last full-time year managing Nintai Partner’s fund – the estimated five-year free cash flow growth was 16.8%. in 2018 this number had dropped to just 13.3% in my portfolios. There is a chicken and egg issue here. As growth slows you would expect the PE ratio to rise as long as prices remain steady or growing. The quandary has left me the choice to pay more for future growth or to hold cash.
Projected Free. 2016-2021 2018-2023
Cash Flow Growth 16.8% 13.3
Buying In or Getting Out
This criteria creep – both in the PE ratio as well as projected free cash flow growth - has forced me to deeply consider whether to abide by my historical investment parameters or fudge a bit and overpay for any new investments. As usual, the answer isn’t cut and dry. While my overall strategy remains to purchase assets below my estimated intrinsic value, I’ve found myself in Charlie Munger’s position that compared to things available, some purchases might be a good thing to do at the time. As I made these decisions in real time, two questions have been at the core of my own personal criteria creep. First, is the underlying market conditions part of a new market reality? (the answer to this seems to be no as we’ve seen the Federal Reserve raise rates from near zero to over 2.0% over the past several years). Second, does the opportunity cost of holding cash and staying true to my traditional standards force my investors to seek greener pastures elsewhere? The latter of these two questions have been muted by the fact my collective performance has outperformed the general market since September 2016 while still holding roughly 15 - 20% of assets under management in cash.
I am currently in the process of rebuilding the Hayashi Foundation Trust’s investment portfolio[1] and find myself in the criteria creep dilemma once again. With markets reaching all-time highs as of late-September 2018, the ability to find 15 – 20 stocks at my traditional standards is nearly impossible. One stock I am looking at is Paychex. In the past year the stock has risen by 22%. It’s PE has risen from 19.8 in May 2012 to 29.3 currently. In addition, price/book has increased from 6.7 in May 2012 to 13.4 today. In nearly every valuation measurement tool, the stock is standing at all-time highs. Conversely, free cash flow has grown by 11.8% in the past 5 years and 30.4% in the past year. The stock currently yields a little over 3%.
Everything about this company’s stock meets my investment criteria – with the exception of those related to valuation. So the dilemma is whether the opportunity cost (and risk) is greater than simply holding cash. To help make a more educated decision, I find there are two questions/conditions that can drive your decision making.
Does Your Client Have Strong Feelings on Cash?
Some investors believe cash has no place in their investment portfolio. They see it as an inflation-based money loser whereby the lost opportunity costs far exceed any potential gains. If that’s the case, then you are pretty much locked out of holding cash and the consequences be damned. I have been fortunate that over my investing career every investment partner has seen cash as a placeholder or option to take advantage of undervalued opportunities. When I can’t find value in the marketplace, they support me in building up a significant cash position.
You Believe The Relationship Between P/E, P/S Has Fundamentally Changed
There really people out there who believe it truly is different this time, that the relationship between price and earnings really has changed. Some of these individuals believe that permanently low interest rates mean fundamental stock valuations have increased by 20-30% on a permanent basis (thereby making cash a loser’s game). Frankly, I don’t think the relationship between a dollar in earnings and the share price has permanently changed. With the Fed funds rate since at remarkably low rates (from a historical perspective) rates are slowly rising to more normalized rates every month.
Conclusions
So with all my pontificating, what I have chosen to do over the last few quarters? In some cases, I’ve taken Munger’s view that “compared to things available, we thought that it was a good thing to do at the time.” In these cases, I’ve made several smaller purchases to fill out the portfolio. But the vast majority of time, I have held firm against criteria creep and allowed cash to continue to build. In the Hayashi Charitable Trust – along with individual portfolio’s I personally manage – I may be over 30% cash in October 2018. There is a famous story that during negotiations between Tip O’Neill (the Democratic Speaker of the House) and Ronald Reagan (Republican President), O’Neill was pushing hard on a particular set of spending measures. Reagan blurted out, “You can make crap a watermelon, but you can’t get me to crap a pineapple”. The decision whether these lofty valuations represent a watermelon or pineapple is all yours.
As always, I look forward to your thoughts and comments.
[1] After serving on the Board of the organization, I took active management of the Trust’s investment portfolio as Chief Investment Officer on October 1 2018. The previous week, I resigned my position as Investment Manager at Dorfman Value investments.
We all fall prey to it. As markets hit near continual highs, it isn’t that difficult to start thinking that maybe it really is different this time. Maybe that 15 - 20% cash position really is detriment to returns. So, we begin to make decisions that – under different circumstances – we might not even consider.
Criteria Creep: A Working Example
I thought I’d walk through a real-time example of this dilemma. I recently reviewed all my stock purchases since 2010 with a focus on the price-to-earnings (PE) ratio at the time of purchase. In 2015 I joined the team at Dorfman Value Investments (I left the firm as of September 28 2018) From 2015 – 2018 I spent an awful lot of time building portfolios while carefully looking to avoid criteria creep. Looking out over the past 10 years, the purchases I made at Nintai Partners and Dorfman Value show a distinct creep in pricing. The average price-to-earnings (P/E) ratio has increased from 19.6 to 22.7 (a gain of nearly 16%!).
P/E Ratio at 2010 - 2014 2015 - Present
Time of Purchase 19.6 22.7
Until joining Dorfman Value, I rarely placed much credence on the P/E ratio. But my former partner John Dorfman drilled into me the importance of this number and its potential impact on long term returns. That said, there was almost no movement in any other measure I used when assessing a potential investment. For instance, return on capital, equity, and assets remained within 2-3% of each other from 2010-2018. The same goes for cash positions, short and long-term debt and free cash flow conversion rates.
A second and larger difference has been the difference of projected growth in free cash flow growth from the period (2016-2021) – (2018-23). In 2014 – my last full-time year managing Nintai Partner’s fund – the estimated five-year free cash flow growth was 16.8%. in 2018 this number had dropped to just 13.3% in my portfolios. There is a chicken and egg issue here. As growth slows you would expect the PE ratio to rise as long as prices remain steady or growing. The quandary has left me the choice to pay more for future growth or to hold cash.
Projected Free. 2016-2021 2018-2023
Cash Flow Growth 16.8% 13.3
Buying In or Getting Out
This criteria creep – both in the PE ratio as well as projected free cash flow growth - has forced me to deeply consider whether to abide by my historical investment parameters or fudge a bit and overpay for any new investments. As usual, the answer isn’t cut and dry. While my overall strategy remains to purchase assets below my estimated intrinsic value, I’ve found myself in Charlie Munger’s position that compared to things available, some purchases might be a good thing to do at the time. As I made these decisions in real time, two questions have been at the core of my own personal criteria creep. First, is the underlying market conditions part of a new market reality? (the answer to this seems to be no as we’ve seen the Federal Reserve raise rates from near zero to over 2.0% over the past several years). Second, does the opportunity cost of holding cash and staying true to my traditional standards force my investors to seek greener pastures elsewhere? The latter of these two questions have been muted by the fact my collective performance has outperformed the general market since September 2016 while still holding roughly 15 - 20% of assets under management in cash.
I am currently in the process of rebuilding the Hayashi Foundation Trust’s investment portfolio[1] and find myself in the criteria creep dilemma once again. With markets reaching all-time highs as of late-September 2018, the ability to find 15 – 20 stocks at my traditional standards is nearly impossible. One stock I am looking at is Paychex. In the past year the stock has risen by 22%. It’s PE has risen from 19.8 in May 2012 to 29.3 currently. In addition, price/book has increased from 6.7 in May 2012 to 13.4 today. In nearly every valuation measurement tool, the stock is standing at all-time highs. Conversely, free cash flow has grown by 11.8% in the past 5 years and 30.4% in the past year. The stock currently yields a little over 3%.
Everything about this company’s stock meets my investment criteria – with the exception of those related to valuation. So the dilemma is whether the opportunity cost (and risk) is greater than simply holding cash. To help make a more educated decision, I find there are two questions/conditions that can drive your decision making.
Does Your Client Have Strong Feelings on Cash?
Some investors believe cash has no place in their investment portfolio. They see it as an inflation-based money loser whereby the lost opportunity costs far exceed any potential gains. If that’s the case, then you are pretty much locked out of holding cash and the consequences be damned. I have been fortunate that over my investing career every investment partner has seen cash as a placeholder or option to take advantage of undervalued opportunities. When I can’t find value in the marketplace, they support me in building up a significant cash position.
You Believe The Relationship Between P/E, P/S Has Fundamentally Changed
There really people out there who believe it truly is different this time, that the relationship between price and earnings really has changed. Some of these individuals believe that permanently low interest rates mean fundamental stock valuations have increased by 20-30% on a permanent basis (thereby making cash a loser’s game). Frankly, I don’t think the relationship between a dollar in earnings and the share price has permanently changed. With the Fed funds rate since at remarkably low rates (from a historical perspective) rates are slowly rising to more normalized rates every month.
Conclusions
So with all my pontificating, what I have chosen to do over the last few quarters? In some cases, I’ve taken Munger’s view that “compared to things available, we thought that it was a good thing to do at the time.” In these cases, I’ve made several smaller purchases to fill out the portfolio. But the vast majority of time, I have held firm against criteria creep and allowed cash to continue to build. In the Hayashi Charitable Trust – along with individual portfolio’s I personally manage – I may be over 30% cash in October 2018. There is a famous story that during negotiations between Tip O’Neill (the Democratic Speaker of the House) and Ronald Reagan (Republican President), O’Neill was pushing hard on a particular set of spending measures. Reagan blurted out, “You can make crap a watermelon, but you can’t get me to crap a pineapple”. The decision whether these lofty valuations represent a watermelon or pineapple is all yours.
As always, I look forward to your thoughts and comments.
[1] After serving on the Board of the organization, I took active management of the Trust’s investment portfolio as Chief Investment Officer on October 1 2018. The previous week, I resigned my position as Investment Manager at Dorfman Value investments.
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