Competitive Advantages, Growth, Economic Resilience, and Strong Balance Sheets
We have written in the past about how we consider the relationship between price paid for and expected returns from an investment to be a “law” of investing: the higher the price one pays for a stock, the lower long-term future returns will be, and vice versa. This inverse relationship between recent experience and future expectations is in direct contradiction to evolutionary biology. Evolution has programmed all of us to rely on past experiences to predict the future. If a person walked down a certain path and safely gathered nuts and berries yesterday, the same path is probably a good place to look again today. Conversely, if a different path is full of thorns and is infested with snakes today, it is probably a better idea to avoid it tomorrow. This default conditioning remains useful. For example, if a restaurant serves a great meal, returning to that same spot will probably yield good food again. This mental shortcut does not work in all aspects of the modern world, however, with investing as a notable counterexample.
Since what a company is worth, its intrinsic value, is the sum of its discounted future cash flows, over time a company’s market value will converge with the value of its owner earnings stream. Of course, an increase in the price of a stock does not change our long-term expectations for that company’s underlying earnings. Instead, a rising stock price simply brings returns forward to today and reduces the future returns that an investor can expect. Logically, the reverse outcome makes it clear why we root for what most people would consider an unwelcome and uncomfortable outcome: we want stock prices to go down in the short-term. Most investors’ DNA is unconditioned for this desire, but a stock price decline gives the patient investor an opportunity to own more of a company’s future cash flows at a lower price and, therefore, at a higher expected return.
The most important factor in accurately determining the intrinsic value of a business is to correctly assess the magnitude and longevity of its cash flows. This process is multi-faceted and unique to each business, but we are looking for a few common characteristics in all cases:
- Sustainable Competitive Advantage – A defendable, predictable earnings stream arises from a durable competitive advantage. This “moat” is often reflected in superior returns on tangible capital and higher profitability.
- Earnings Growth – A growing stream of earnings is more valuable.
- Macroeconomic Resilience – A sustainable cash flow stream should be resistant to economic downturns, which are inevitable (really, they are!). A non-cyclical earnings stream can be valued with greater certainty because an investor can have increased confidence that current results reflect profitability throughout the economic cycle. Additionally, this resilience is a sign that a company’s product or service is differentiated, highly valued, and commands pricing power when its customer’s wallet is under pressure. In effect, it is further proof that a competitive advantage exists.
- Strong Balance Sheet – A stream of cash flows is easier to predict if a company has a conservatively-built balance sheet. Higher levels of leverage increase the likelihood that financial difficulties will lead to distress that significantly impacts or even eliminates future cash flows (i.e. bankruptcy). This condition increases an investor’s risk of permanent capital loss.
An earnings stream that lasts longer, grows faster, and costs less is compelling. Consistent with the aforementioned law of investing, we believe the Fund’s prospects for a satisfactory return are superior to the S&P at current prices. While interesting, this relative valuation gap is an insufficient condition to achieve strong, long-term absolute returns. More importantly, we believe that the Fund’s portfolio is trading at a more attractive discount to its intrinsic value than it has in some time. At the core of our investment approach is the idea that investing where this margin of safety exists offers an asymmetric risk vs. reward – this discipline allows for outsized returns when we are correct and protects against permanent capital losses when we make mistakes. In other words, buying at an attractive price both increases potential return and decreases risk.
 Owner earnings are the cash flows produced by a company that are available to be paid to its equity owners. We generally define it as net income plus depreciation, amortization, and other non-cash charges and minus maintenance levels of capital expenditures, working capital investments, equity compensation, and other relevant expenses that are not necessarily captured by generally accepted accounting principles.