The math of investing is not difficult and can be done with a little division and some basic algebra, but the math is essential. Buying and selling securities without a fluent understanding of how intrinsic value is calculated is mere speculation.
where i = periods; CF = Cash Flow (e.g., CF1 means the cash flow in year 1); r = discount rate
In the third quarter of 2013, we wrote about predicting the cash flows that make up one of the three variables in this formula. This quarter we want to highlight a different way to look at this equation in order to explain a broader point. Instead of solving for Intrinsic Value, one can input the current price of a security and solve for the discount rate: r. When one does this, r becomes the internal rate of return for the security if purchased at the current market price. Note that an expected rate of return is inversely (and geometrically) related to the price of a security. That is, the more one pays for a security the lower your future return will be. The chart at the top reflects the internal rates of returns for a one hundred year stream of annual $1 coupons bought at different prices.
One’s success as an investor boils down to two things. The first is the ability to predict the cash flows of a business. This takes diligent research, an evaluation of the competitive position of the business, an assessment of management, an understanding of microeconomics, etc. This process is not an easy task in any circumstances and can only be done consistently well when an investor remains within his circle of competence. Second, an investor’s success depends on his patience and discipline to buy securities only when they are cheap enough to offer adequate returns and to do nothing when such a price is not offered.
By example, we purchased Arca at a price to earnings ratio of 7 with both a history of and an expectation of double-digit earnings growth. Our value investing discipline argues that low prices like this simultaneously offer the prospect of high returns and low risk. Conversely, higher priced securities offer lower return prospects AND higher risk. Whether the returns currently offered warrant taking the risks associated with them is a pressing question for market participants. We are increasingly finding our answer to be “no” as we maintain our discipline of investing only when we expect to realize our minimum annual hurdle rate of return. Accordingly, we expect to underperform the market indices as long they continue to rise like they did in 2013. Price appreciation has far outpaced growth in the real earnings of business. We cannot guarantee it, but we do believe, and history suggests, that our patience in the face of the current opportunity set will be rewarded in the future. Our goal remains the same – to earn the highest returns possible over 30-year periods of time.