My thoughts on Prof. Sanjay Bakshi’s talk on “What happens when you don’t buy quality”

In 2013, Prof. Sanjay Bakshi gave a seminal talk[1] tilted, “What happens when you don’t buy quality”. The crux of the talk was that market participants are unable to delay gratification and thus, heavily discount cash flows occurring far into the future. According to Prof. Bakshi, such behaviour makes investors not invest in high quality businesses which look “expensive” based on traditional investing metrics (like PE, PB, etc.), but which, in fact, are cheap.

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This talk is much talked about in  Indian value investing circles and has become part of investing folklore. However, some people have wrongly understood it to mean that markets are short term oriented and usually discount future cash flows at a high rate. Based on this assumption, they end up buying businesses regardless of the expectations already being built into the price of the stock.

If the problem with markets is that they are always unable to delay gratification then, I’d like you to think about investors in companies like Tesla, Snap and Amazon, who are paying up for cash flows that lie far in the future.

As I will argue in the following sections, not being able to delay gratification could be one of several reasons because of which investors end up under/ over-valuing businesses.

My own time machine valuation

To prove his point, Prof. Bakshi used examples of excellent businesses which have done exceedingly well for investors. Borrowing from Charlie Munger, let’s invert this situation and analyse a company which is a quality business but which hasn’t delivered for investors over the past 10 years – Infosys. We know it is a high quality business because even today Infosys earns over 30% returns on equity.

Just like Prof. Bakshi did with Asian Paints, let’s go back in time (April 2007) when Infosys was trading at a PE multiple of 30x and see how the investment panned out.

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So what does the time machine valuation reveal?

Based on how reality unfolded between then and now, Infosys was overvalued in April 2007. Using a discount rate of 12% and a terminal growth of 4%, its fair PE multiple was close to 17x compared to the then prevailing PE of 30x.

Using Prof. Bakshi’s methodology and holding everything else constant, we would have to discount at a rate of just 8.78% to equate the present values of actual cash flows to the market capitalisation as on 30 April 2007. This is interesting, since the 10-year Indian Government Bond rate at the time was hovering around 8.2%. Is it that Infosys’ investors are demanding only 8.8% when the going government bond rate is 8.2% – a spread of only 0.6% for the risk of investing in the residual claims of a company?

It is possible, although unlikely.

The one thing that we can safely assume is that investors were being irrational in 2007 and were overvaluing Infosys at 30x earnings. However, what we need to figure out is whether their irrationality lies in their estimation of the discount rate (delayed gratification) or something else. In my view, it is more likely that investors were overestimating growth in cash flows rather than underestimating the discount rate.

Back to basics

First principles are my crutch when analysing any proposition and, I’ll use them here to justify my claims in the previous paragraphs. In a nutshell, the value of a business is the present value of all its future cash flows and can be encapsulated in the following equation:

Screen Shot 2017-10-28 at 12.25.07 pm

As you can see, to estimate the future course of a business, we need to estimate the following four inputs:

  • Cash flows from existing assets: These are based on the current sales, margins, reinvestments, etc. of the firm in the most recent year;
  • Growth in those cash flows: This is based on expectations of price/ volume increases, margin improvements, reinvestment needs going forward, etc.;
  • Risk in cash flows, represented by the discount rate: The discount rate is the culmination of the current risk free rate, the riskiness of the businesses that the company operates in and the level of risk averseness of equity market participants at a given point in time; and
  • Competitive advantage period, i.e. the period until which the company becomes a stable growth firm and earns a return on capital greater than its cost of capital.

Given these fundamentals, investors can go wrong not just in their estimate of the discount rate, but on any or a combination of the above four inputs when valuing a company. In my view, we need to assess investor expectations on a case by case basis and not attribute it all to the discount rate. I say this because, when we assume that investors are unable to delay their gratification, we are implicitly assuming that investors have correctly estimated future cash flows and that the undervaluation is simply on account of them not being able to wait for these cash flows. My contention is that their estimate of cash flows itself may be incorrect in the first place.

On this subject, Michael Mauboussin[2] has this insightful explanation about whether markets are short term oriented in one of his books[3]:

“… commentators frequently point to short (and shortening) investor holding periods to support their belief that the market is short-term… How can investors who hold stock for months, or days, care about a company’s long term outlook?   

This conundrum has a simple solution: Investor holding periods differ from the market’s investment time horizon. To understand the horizon, you must look at stock prices, not investor holding periods. Studies confirm that you must extend expected cash flows over many years to justify stock prices. Investors make short-term bets on long-term outcomes.    

How do we know that the market takes a long view? The most direct evidence comes from stock prices themselves: We can estimate the expected level and duration of cash flows that today’s price implies. As it turns out, most companies need over ten years of value-creating cash flows to justify their stock price.” (Emphasis mine)

Conclusion

Does this mean that a stock trading at 20 – 30x (or for that matter any multiple) is expensive? Not at all! The answer, as with most things in finance, is IT DEPENDS. It depends on the fundamental determinants of a PE ratio – growth, risk and returns on equity – but that is a post for another day.

All I am saying is this – Prof. Bakshi is right that markets may undervalue great businesses because they don’t want to wait long for cash flows to come to fruition but, that may not be the only reason. Maybe the investors in Asian Paints sitting in September 2005 never imagined the kind of growth in cash flows that actually transpired.

[1] At the October Quest conference on value investing in India.

[2] Former head of Global Strategies at Credit Suisse and adjunct lecturer at Columbia Business School.

[3] Expectations Investing: Reading Stock Prices for Better Returns

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