Monday, March 17, 2014

If it is a strategic growth investment in China, the numbers don't matter! Or do they?

If I were asked to characterize my investment philosophy, I would describe myself an investor who believes in value, but I would be lying if I told you that it has always come easily or naturally. My faith in value is tested constantly, not only by the recognition that there is far more that I don't know about value than I do, but also by the market, which seems to have an uncanny ability to sense my doubts and find ways to probe them.

The Market Test
To see if we share some of the same weaknesses, let's try an experiment. Assume that you value a stock at $20 and it is trading at $30. What would you do? If you are a value-based investor, the answer is easy, right? Don't buy the stock, or perhaps, sell it short! Now let's say it is three months later. You value the same stock again at $20 but it is now trading at $50. What would you do now? Rationally, the choice is simple, but psychologically, your decision just got more difficult for two reasons. The first stems from second guessing. Even if you believe that markets are not always rational, you worry that the market knows something that you don't. The second is envy. Watching other people make money, even if their methods are haphazard and their reasoning suspect, is difficult. You are being tested as an investor, and there are three paths that you can take. 
  1. Keep the faith that your estimate of value is correct, that the market is wrong and that the market will correct its mistakes within your time horizon. That may be what every value investing bible suggests, but your righteousness comes with no guarantees of profits.
  2. Abandon your belief in value and play the pricing game openly, either because your faith was never strong in the first place or because you are being judged (by your bosses, clients and peers) on your success as a trader, not an investor. 
  3. Preserve the value illusion and look for "intrinsic" ways to justify the price, using one of at least three methods. The first is to tweak your value metrics, until you get the answer you want. Thus, if the stock looks expensive, based on PE ratios, you try EV/EBITDA multiples and if it still looks expensive, you move on to revenue multiples. As I argued in my post on the pricing of social media companies, you will eventually find a metric that will make your stock look cheap. The second is to claim to do a discounted cash flow valuation, paying no heed to internal consistency or valuation first principles, making it a DCF more in name than in spirit. The third is to use buzzwords, with sufficient power to explain away the difference between the price and the value.
If you choose the first path, I respect you for your principles. If you pick the second one, I understand your pragmatism. If you pick the third path, I think that you are on dangerous ground, as you wander the netherworld between trading and investing. Unfortunately, though, it seems to be the path most often taken and in this post, I would like to shine a spotlight on the buzzwords that are most frequently used by investors to distract and delude themselves and others.

The deadliest buzzwords
As someone who teaches at a business school, I am aware of both the ubiquity of buzzwords and their power in decision making. The most powerful buzzwords can still discussion, stifle dissent and overwhelm common sense and they share three characteristics. The first is that at their core, they are built around undeniable truths, even though those truths might get stretched in practice. The second is that they come with highbrow backing from academics and/or well-known practitioners, skilled at packaging and presenting these concepts to broad audiences. (An academic paper is nice, a book is better and an appearance on national TV show cements the deal). The third is that they tie into the world views of many investors and thus provide an intellectual rationale for anecdotal evidence and story telling. So, with no further ado, here are my five deadliest buzzwords, ranked from least to most potent (based upon my subjective judgment). I would hasten to add that I have been guilty of using some of these buzzwords myself and promise to be more careful in the future in both when and how I use them.

5. Optionality
What it really means: Success in a particular product or market may give a company the option to enter a different market (product-wise or geographically). Thus, Apple's success with the iPod allowed it to enter the music retailing market (with iTunes) and led eventually to the iPhone and the iPad.  From a valuation perspective, these possibilities could not have been foreseen (explicitly) in 1999, but the optionality could have been incorporated into the value.
In Buzzword form: You use the existence of a large market as a rationale for giving a company an option premium, often subjectively determined to be whatever you need it to be to justify buying the stock. In the late 1990s, some analysts used the potential of a large e-commerce market as justification for attaching option premiums to dot-com company valuations, just as many analysts are using the online advertising market as a reason for attaching option premiums to social media companies. 
The key test: Exclusivity. In its generic form, a call (put) option gives its holder the right to buy (sell) an asset. In the same vein, any optionality argument has to be built around exclusivity, where the company in question has the exclusive or close-to-exclusive right to expand into new markets. This exclusivity can come from owning a proprietary technology or possessing an exclusive license to operate in a market. The e-commerce companies of the late 1990s had no such exclusivity, and while the social media companies of today use their large user bases to stake out exclusivity, it is on shaky ground, since these users are fickle and quick to move to the "next big thing". With Apple, the exclusivity derived from the company's control of the operating system, making it very difficult for competitors to enter their very profitable ecosystem.
If you really mean it: If you are going to use an optionality argument, you have to be comfortable with both option pricing fundamentals and models. However, option valuation is not an alternative to traditional valuation, but an addendum. Thus, to value the optionality in a company, you have to do a discounted cash flow valuation first, make judgments on the size and uncertainty in potential markets next and then value the option. 
Links (perhaps helpful, perhaps not): (1) My paper on real options (2) A spreadsheet to value the option to expand.

4. Growth potential
What is really means: There is a large potential market for the firm's goods and services, which will allow the company to to scale up revenues and profits over time, without running into market capacity constraints. This argument has resonance when valuing small companies that operate in large markets, since high growth can be accommodated with ease. In my valuation of Tesla in September 2013, it was the magnitude of the automobile market that allowed me to make generous assumptions about revenue growth in the future.
In Buzzword form: You argue that a company has high value because it has growth potential, but you refuse  to be specific about the market that your company is operating in, how big the market is today and how much of that market your company will capture over time. (This is my bone of contention with analysts who use the online advertising market to justify high growth in social media companies, without clarifying their assumptions about the overall market.)
The key test: Excess returns. I may be beating a dead horse here, but growth, by itself, has no value. To create value, you need to earn excess returns while growing, and to earn those excess returns, you need barriers to entry and competition. Thus, if you are going to make an argument for growth potential, you have to twin that argument with one that explains what the company's competitive advantages will be that will allow it to create value from that growth.
If you really mean it: To value growth potential, you have to do the grunt work of defining the market, determining your company's competive advantages and forecasting how much you will have to reinvest to deliver that growth.
Links (perhaps helpful, perhaps not): (1) A spreadsheet to value growth

3. Strategic considerations
What it really means: Taking the action (investment, acquisition) is critical to the company's long term growth and profitability, though the short term effects may be negative.
In Buzzword form: You use strategic as prefix for any action where the numbers don't add up but you want to take anyway. Thus, a strategic acquisition is one where you pay too much for a sought-after target company, a strategic investment is one where you know you will never make money but is indispensable (at least to you) and in its most cringe-inducing form, you are a strategic buyer, i.e., one who will pay any price to buy something. 
The key test: Show me the money. You cannot pay dividends with strategic victories or nice sounding stories. All decisions, no matter how strategic and long term they might be, are ultimately financial decisions. Consequently, if you make the strategic argument, the onus is on you to then convert the qualitative benefits into earnings and cash flows. If you cannot show me the money, I am afraid that there is nothing strategic about this decision, other that the prefix.
If you really mean it: Start converting stories to numbers, dreams into plans and deal makers into managers. No matter how much uncertainty you face or how far in the future the benefits may lie, you need to put your best estimates down on paper, before you take action. Not only will that put some discipline into the process but it will also become the basis for organizing and planning to deliver those benefits and holding someone (perhaps you, since you pushed for it so hard) accountable.
Links (perhaps helpful, perhaps not): (1) My paper on valuing synergy (2) A spreadsheet to value synergy.

2. Disruptive
What it really means: A new entrant in an existing business uses a new or unorthodox business model to lower the costs of production (Southwest) or the delivery/distribution system (Amazon) or even the product/service (Apple). In the process of doing so, the disruptor finds way to be profitable at the expense of the status quo.
In buzzword form: You view any new entrant in a business as a disruptor, even if that entrant brings little of value to the process, no cost savings innovations or no game changing products, and is unlikely to change the way the business is run.
The key test: Status Quo. While disruption takes many forms and has happened in different markets, the common feature that allows it to succeed is dissatisfaction with the status quo, either on the consumer side (because consumers are not getting the products and services they want or are getting them at prices that they believe are too high) or on the producer side (because producers are unable to generate the economic profits they need to make to stay in business).
If you really mean it: You have to complete the story of disruption by fleshing out the details. In particular, you have to map out a pathway for the disruptor to grow in the disrupted business, with realistic estimates of the challenges and costs that will be faced along the way. It is worth noting that most disruptors fail to change the status quo, and that the few that succeed often have setbacks along the way. It is easy to point to Amazon and Apple as successful disruptors, but these companies are the exceptions, not the rule.

1. China
What it really means:  A billion plus people, with rising incomes, is a very large market and any company that succeeds in this market should be able to generate large revenues and perhaps large profits.
In buzzword form: For many people, especially those not from Asia, the notion of a billion plus people in a market addles the brain. Thus, investors are quick to give a company that is China-based, one that has entered China or one that is even thinking about China a boost in market value. Companies, recognizing this impulse, are quick to play the China card, slipping it into investment announcements and earnings reports.
The key test: Preferred Competitor The Chinese economy is neither free nor open. The game is tilted towards one competitor over others, and that tilt does not necessarily reflect product quality. If you are the competitor preferred by the Chinese government, you will be a big winner. If not, you are just an also-ran, destined to invest large amounts of money in the Chinese market, with little benefit to show for it. For instance, in the contest between Google and Baidu to be the search engine for the Chinese market, Baidu starts off with a decided advantage as the preferred competitor and that translates into significant market share and large profits.
If you really mean it: Quantify the preferred competitor status, which will require you to understand political reality on the ground. You can start off with few presumptions. A Chinese company will be preferred over a non-Chinese one, and a Chinese company with good political connections will beat one without those connections. Analyzing the value of expanding into China requires you to be as much political analyst as valuation assessor.

Closing Thoughts
There are sensible uses for all of the terms that I have listed above, but unfortunately, the buzzword versions are the ones that I see more often in practice. In fact, I find that the people who are quickest to bring up a buzzword or use it to justify a premium often are the ones who have the shakiest understanding of it, leading me to put forth two propositions about buzzwords:
  1. The Buzzword Count Proposition: My exposure to both equity research and buzzwords leads me to conclude that there is a negative correlation between buzzword usage and valuation quality. In other words, the more an analyst uses words like real options, disruption and China in talking about a company, the less substance there seems to be the actual research.
  2. The Buzzword Swarm Proposition: The most dangerous challenge that you will face as investor will be when multiple buzzwords come together in the same news story. We have two IPOs coming up in the near future, Alibaba and Weibo, which will qualify under multiple buzzwords (strategic, growth potential and China at the minimum) and will undoubtedly be priced to deliver multiple premiums.
My resolutions for the near future are that I will use buzzwords sparingly, that I will not them use as a substitute for analysis, and that when I do use them, I will go the extra distance and try to work through the consequences.


Eduardo Moreira said...

Interesting article, Professor. I am wondering here that it can actually be feasible to get your "Buzzword Count Proposition" actually tested through text mining tools!

It would be interesting to check the relationship between the relative frequency of your "deadliest buzzwords" in the valuation literature (not only in Equity Research reports, but also buy-side letters to investors and investment pundits' social media account content) and the market-derived multiples of tech stocks and the like.

I'm sure Prof. Foster Provost would be glad to find an IOMS doctorate student to carry a study like this, that could bring many insights on behavioral finance. Once again thanks for the great post!

newsmartinvesting said...

When I look at a dollar bill, I can't for the life of me figure out it's source.
(yes, the banal answer is the bank/the mint etc).

In other words, I don't really care how it was generated (provided it was generated lawfully of course).

If I value a company @ $10 and it trades at $20 and then later at $50, I don't really care because and mostly because:
1) I know there are many, many fish in the ocean of stocks that might follow a truer path (ie: market follows valuation)

2) I know the manic nature of Mr.Market and I only want him to serve me not be my master.

So my choices of envy fade away, because I know that unless one has supernatural powers, one can't always be right about a bet that isn't fundamentally sound. Yes, it may go up and you may make a lot of money, but if you don't quit (for GOOD) after making that pile, your fundamentally unsound technique will cause a permanent loss of capital at some point. If lucky, the loss won't be devastating.
The power of compounding coupld to a fundamentally sound technique of valuation shines brightly and steadily.

Jason said...

Another great post, I always learn when I come to your blog professor. Thanks for sharing!

Patrick Garcia said...

Prof. Damodaran this was one of my favorite posts. It's both interesting and amusing. I've worked in a global mining company and I know the power of these words, as shallow as the undelying meaning may be and regardless of the decision. Even a pen color choice may be strategic! I also feel exactly the same trying to hold on to my value investing beliefs, especially in the latest years in Brazil. Thank you for sharing this post!

Anonymous said...

Professor, going back to the basic precepts of investing, on your comments re the stock you feel should be $20 but goes from $30 to $50, why do you believe that the price will ever converge to your value, even if this is the 'true' accurate value of the stock? If you believe the price will converge to value, how do you judge how long to wait sitting around for it to happen? An investment has a cost, not to mention potential losses along the way assuming you don't cut the position at a 'puke point'.

The reason I ask this is not to be facetious but as I am having a real crisis of faith in the current stock market environment. If you are a value investor who shorts stocks you would have got carted out head first, even if you were long only, companies which offer value have lagged by a mile a lot of hare-brained businesses in bio tech/social media/small cap pie in the sky etc. companies. I am beginning to think stock prices hardly ever represent true value, they always are just a reflection of perception .. until its glaringly obvious the business is DONE, investors will just make up their own ideas about it.

Anand Raj

PS .. to add insult to injury, I was in a shop yesterday with a finance book and a Lithuanian store assistant told me that he'd made a lot of money in stocks over his investment lifetime (6 months), he added he thought it was 'EASY' ... I asked what methodology he used, he replied common sense and technicals (not sure what he meant exactly by technicals here) .. this was the moment I started to question not only the whole basis of investing, but also if there is a God ... & if so why he wants to punish me like this.

John said...


There has been talks about the optionality of holding cash. People will point to how Buffett was able to mobilize his cash position in the depth of GFC to do very profitable deals that others couldn't. I suppose it satisfies your definition that cash was scarce at that time and, thus, had some exclusivity. But then there is also a time element here. People like Buffett preserved their cash at the time when cheap cash was abundant. It's only when shit hit the fence cash became scarce.

So, what's your view? Is there optionality in holding cash?

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Stock Exchange said...

In this stock market update you will see even though the market hasn’t made large gains since the beginning of the year we definitely are not in a down trend.

Aswath Damodaran said...

I wish I could give you an easy answer but I think that the analogy to religion applies. You have to have faith, you will have your faith tested but if you hold on to your core beliefs, you can come out with it stronger. Most people don't make it. That is why there are so many value investors on paper and so few in practice.

Unknown said...
This comment has been removed by the author.
Unknown said...

Thanks Prof, Great post once again.
Honestly I am in habit of using these words myself. Your post will be in my mind before I use any of these words next time.

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Anonymous said...

Any person who wants to turn on a financial news network show should read these five points again.
Any person that invests in a value fund and is disappointed about the quarterly performance should read these five points again. Don't judge value investing by trader results.
If you want to cut through all the media noise, read this post again in the future. Great post!

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Chinese Electronics said...

I think there has been discusses the optionality of holding money. Individuals will indicate how Buffett was equipped to assemble his trade position in for spendable dough the profundity of GFC to do exceptionally beneficial arrangements that others proved unable. I assume it fulfills your definition that money was rare around then and, in this way, had some selectiveness. In any case then there is likewise a period component here. Individuals like Buffett safeguarded their money when modest money was rich. It's just when poo hit the wall money got rare.

Aswath Damodaran said...

I think that the optionality argument with cash has to be used sparingly. If you are a company with easy access to capital in a well developed capital market, cash has no optionality. Period. If you are a company that has trouble accessing capital or operate in a market that has liquidity/capital raising constraints, cash can have optionality, but only if you face great investment opportunities (that earn more than the cost of capital). Thus, the argument can be made that Buffet used the optionality of his cash holdings in the last quarter of 2008 to find bargain investments, partly because of the crisis environment and partly because of his reputation. I don't believe that there is any optionality in his cash holdings now, just as I don't believe that there is any optionality in Apple's cash holdings now.

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China looks like its in a real slowdown fir sure.

Scotto said...

Dear Professor,

Great post. I think when talking about China, and other foreign markets, you have to take the valuation one step further. As a consultant working in China, I always ask my clients the simple question, "What exactly are you buying?" The first answer is always something like 25% of company X. But this doesn't really answer the question. What rights do you have as a shareholder? What are you entitled to? What rights do you have? Will your rights be respected?

In developed markets, we take for granted that boards have a fiduciary duty to shareholders, that companies are run to maximize shareholder value, and that there are courts to resolve matters.

Many Chinese companies have only a small % of share float, boards that are not independent, and may be run to maximize employment and tax receipts within a province rather than shareholder value. In reality, shareholders only have a claim to receiving dividends. Layer a VIE structure and currency controls on top of all this and I'm not sure what the "value investor" is left with.

Companies like Facebook and Google, as benevolent dictators, have made many US investors complacent to corporate governance issues. China is growing at an incredible pace, and the world is much better for it. However, the implicit assumptions of western models don't hold when valuing the foreign listed shares of Chinese companies.

watchwait said...

Thanks for the insight. Love the China comments. After struggling to understand the impossible valuations of Qihoo and now Weibo using SEC filings I am coming to understand how powerful this buzzword is. Your writing is great. Clear and enlightening. Not bad for a finance professor. I look forward to reading more.

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Anonymous said...

Yes, I think there is a strategic growth investment in China, and Forex Signals can also play an important role to maintain it.

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