Former Morningstar Director & CFA: "We Are All Market Timers"
Tips and tricks from savvy investors are always appreciated here at Stockles. Today, we are going to learn from Brian Nelson, a former Morningstar director, a chartered financial analyst and president of Equity and ETF analysis at Valuentum. With that said, let's hear what Brian has to say about stock valuation, Berkshire Hathaway and so much more. Enjoy!
Independence and integrity are core elements for Valuentum. How do you incorporate those values in your service?
Independence and integrity are everything to me. There is no higher calling in the investment business than to put the needs of the individual investor, financial advisor/planner and institutional client -- all investors -- first. That’s what Valuentum stands for, but not all firms have the same mission.
Sometimes, a company’s business model can lend itself to questionable behavior. What finance learned during the dot-com bubble was that, even with substantial industry regulation, there can still be significant conflicts of interest that can hurt investors, in this case the conflict between investment banking revenues and authentic research and opinion. That investors during the dot-com bubble were receiving opinions that analysts themselves didn’t truly hold was one of the greatest failures of this discipline, but it also provided an opportunity to fuel the foundation for authentic, independent research.
This is where Valuentum comes in. At the end of the day, investors shouldn’t just want a smile and a handshake; they should want to know exactly what an analyst feels about a stock or strategy. I believe that only through independent research that one can get that opinion. While the conflicts of the dot-com bubble have been lassoed in, the incentives driving herd behavior in investment research because of career risk still put substantial limits on the degree of independence that analysts can truly pursue without fear of being wrong and losing their jobs.
I’ve been very blessed in my career. Having worked at Morningstar and Valuentum, I’ve been living and breathing independent research for a long time. But this is not learned behavior, per se. It is something that has been a part of me for as long as I can remember. While many may have been strangely inspired to get into this business by Oliver Stone's movie Wall Street in 1987 or the Wolf of Wall Street in 2013, it was Jack Bogle's book Character Counts that inspired me.
There is one small subchapter in Character Counts, two paragraphs in all, called "The Value of Candor." Jack Bogle wrote: "One of our most important values is candor--tell the whole truth and nothing but the truth, with no strings attached, and let the chips fall where they may." If there has been one line that has defined every step of the way at Valuentum, it has been this one. Our firm lives by candor, for better or worse.
This isn’t lip service. We put our values into practice. One example was in our team’s call on Kinder Morgan and the MLPs in mid-2015. Almost everybody said that we were wrong, for one reason or another. But we did not cave. We did not give ground. We stood by our opinion, spent months explaining it in depth, and eventually we ended up providing a variant opinion that may have saved investors billions. You just can’t put a price tag on good independent research. It’s priceless.
Today, I believe that finance has a tremendous opportunity to address conflicts of interest in other business models. For example, where the AUM business model may make a lot of sense for true active management, for those that are seeking to generate outsize returns, it may not lend itself to a best-interest standard for financial advice or planning. If there is a greater incentive to accumulate assets than there is to serve existing clients, we must find a better business model for advisors and planners, especially in the context of rules titled Regulation Best Interest or DOL Fiduciary Rule.
But our team goes far beyond providing independent stock and ETF opinion or open comments on what we think might best serve the financial community. Our efforts more recently have extended into quantitative finance, too. My book Value Trap talks about how I believe we can make quantitative finance better, not only in understanding why certain backtests and factors fail in walk-forward testing, but also why some may succeed, and how quantitative finance should seek to embrace forward-looking data within their processes to explain returns and create predictive models. I believe enterprise valuation, or the free cash flow to the firm process as in the price-to-fair value ratio should be the quintessential quantitative value metric.
To your question directly about how these values are incorporated into our service. At Valuentum, investors can count on our independent opinion, even if it may be the one that they don’t want to hear. That’s the most important thing to us: being an independent voice in an industry of noise and hidden biases. We focus entirely on striving to find the “right” answer and calling things how we see them. We measure success on the success of our research.
Your strategy is based upon selling overvalued stocks on the way down and buying undervalued stocks on the way up. For many investors, that might sound like trying to time the market which has proven to be extremely difficult. What do you say to such statements?
The concept of investing has been somewhat misconstrued today. For starters, we are all market timers. When it comes down to it, savers and retirees that are putting money to work today certainly don’t think that at a future time their investment will be worth less. They believe that at a certain time in the future, their investment will be worth more. If they believed that the market would not be higher in future years or decades, I don’t think they would be buyers today. They are timing the market. The same is true for those that consider buying stocks that they believe are undervalued. At a certain point in time, they think the stock price will be higher.
The investment thesis for both is the same and is based on the enterprise valuation process, or something I call universal valuation (the free cash flow to the firm process). For example, long-term investors that may want to park their assets into an index fund or dollar-cost-average into such vehicles, believe stock values and stock prices will continue to advance over time, and the enterprise valuation process, via the time value of money concept, reveals that this can be true. Similarly, that same process, the enterprise valuation process, shows that stock values and stock prices can become detached from each other at times, providing investment opportunities. One cannot be true without the other also being true.
However, the enterprise valuation process unveils one very important truism for both sets of investors. Just like enterprise valuation shows why stock values and stock prices can advance over long periods of time in favor of indexing, there are variables, including rising interest rates and reduced long-term growth expectations, that show stock values and stock prices could also theoretically decline for very long periods of time. This is why I believe investors should be calculating intrinsic values and paying attention to their investments: stock values and stock prices don’t always have to advance, even over long periods of time.
It is very difficult to estimate future correlations between asset classes, and during the worst of times, correlations tend to exhibit even more unusual behavior relative to historical relationships. For fiduciaries, I think the highest level of care is estimating the value of assets held in client portfolios. When it comes to valuing assets, cash is cash. To truly protect clients, understanding these cash-based sources of intrinsic value of assets is paramount, in my view. The end game for asset prices is not how the asset correlated with another asset, but rather what private equity or a strategic acquirer estimates is a fair price for the assets through enterprise valuation, the free cash flow to the firm process.
Enterprise valuation therefore is the core of what we do at Valuentum. We calculate fair value estimates for stocks, but we also embrace the concept of a fair value estimate range. True intrinsic value implies that investors know the future, which is an impossibility, and therefore precision is not the goal of enterprise valuation. Not only this, but in the future, stock values and stock prices will always be a function of future expectations at that time. True intrinsic value and the long term are two concepts that can never be achieved within the discipline of finance. We can never know the future, and at any point in time stock values and stock prices are based on the future.
Our goal with enterprise valuation is therefore to try to estimate what the market should be valuing a company at on the basis of reasonable future cash-based fundamental assumptions, not derive its true intrinsic value (which is impossible because nobody knows with certainty these future cash-based fundamentals). Often, we find that because of the application of other methods of valuation (e.g. the dividend discount model, valuation multiples), mispricings relative to enterprise valuation can occur. When these happen after incorporating a margin of safety, we would consider the company to be undervalued. But that is not all.
The market must eventually agree with us for our idea to be proven correct, or said another way, for this mispricing to be authentic and eliminated through price-to-fair value convergence. This is where momentum comes into play. For undervalued ideas that many value investors may be interested in regardless of their technical/momentum indicators, we’d first wait for the technical and momentum indicators to turn higher before we’d grow interested in adding any undervalued idea to the simulated Best Ideas Newsletter portfolio. We find this process also helps steer value investors away from value traps.
Quite simply, if the price never turns higher, it really doesn’t matter how far discounted shares appear to be. The information contained in prices is telling us this seemingly undervalued stock may not be undervalued. A good example of this recently was General Electric. Even though we thought shares looked cheap, its share price kept declining. While others were excited when GE was in the high $20s, and then in the teens, and then in the single-digits, we didn’t bite the whole way down. GE is good example of why we like stocks that not only we think are undervalued but also are going up in price. Frankly, we could get our valuation wrong, and the market is yet another check and balance. In GE’s case, the market was telling us something wasn’t quite lining up with its fundamentals.
For stocks that are overvalued and whose prices have been going down (i.e. poor technical/momentum indicators), however, we’d view these stocks as ones to consider selling. Both our assessment of the valuation and the market’s assessment of the valuation through technical and momentum indicators are pointing in a negative direction. Importantly, however, we won’t sour on a stock that we believe is overvalued until its technical and momentum indicators start to roll over, too. At that point in time, not only do we think the stock is overvalued, but the market is starting to come around to overvaluation, too. Having patience in letting winners run but being prudent in removing overvalued ideas when the market starts to sour on them is a core part of the Valuentum philosophy. We embrace the information contained in prices.
Our investment framework isn’t so much about timing the market, as it is one based on due-diligence in calculating the cash-based intrinsic value of the asset and adding additional checks and balances to the process such as technical/momentum indicators to capture that market backing to increase the probability of price-to-estimated fair value convergence. Time or timing matters little. Our process is driven by price-to-estimated convergence, which could happen rapidly in some cases, years in others, and sometimes not at all. But time is not the driver behind our decision-making process. Only when the enterprise valuation process and the market through technical and momentum indicators back an idea would we become interested in it.
In Value Trap, which is your book about your service, strategy and mental framework, you go hard on factor investing. You've said - “There’s never a backtest a researcher didn’t like”. Are there any reasons at all to invest in multifactor ETFs or funds?
Any investment philosophy can be considered an investment factor, or multi-factor process. Where I differ is that I believe the output of the enterprise valuation process (the free cash flow to the firm process), which is the fair value estimate, should be the central quantitative value metric in finance. It is the only one that actually measures price versus estimated value. I do not believe that valuation multiples, most of which are ambiguous, truly measure value, save for the price-to-estimated fair value metric. Investors can read more about why the P/E or the P/DCF multiples are driven by enterprise valuation in Value Trap, and why these types of multiples are hazardous short-cuts that can result in systematic issues.
In my opinion, finance cannot feasibly separate stocks into growth and value stocks, and a look at the biggest movers in the Russell 3000 Growth Index and the Russell 3000 Value Index show some of the same companies. Not only that, but some of the largest weightings in the Russell 3000 Growth Index are some of the most undervalued stocks on the market, in my view. Value Trap isn’t so much about an explanation of our service, as it is about creating a text in finance, where after reading it, the investor can have a very intelligent conversation about what matters in investing, and that’s the question of price versus estimated fair value.
Within Value Trap, I put together a theoretical proof that ties the expected returns of any multi-factor model that attempts to explain stock returns with the expected return function of enterprise valuation, and therefore show how all multi-factor models must eventually converge into the drivers of enterprise valuation (i.e. they must embrace forward-looking expectations, not realized ambiguous data). I believe this is a breakthrough in finance and explains why most empirical asset pricing models have failed and will continue to fail: realized ambiguous data simply cannot explain returns.
I think finance is finally starting to get some very good walk-forward data on a number of the most widely-known factors. Walk-forward data is performance or data following the development of a factor and excludes the backtest. The traditional quant value factor, for example, has been underperforming now for a very long time in walk-forward studies. The low vol factor is ironically among the most volatile factors. The bottom line, in my view, is that multi-factor models, if not embracing the forward-looking nature of enterprise valuation or a true estimate of price-to-fair value (or price versus value), may very well be spurious. We can ill-afford another 30 years of statistical studies to realize that is the very lack of an understanding of how to calculate intrinsic value, itself, that is leading to failures. Logic must come first in any investment process.
In Value Trap, one can read that there are now more than 70 times as many stock indexes as there are stocks, and many of these stock indexes have been created by somewhat suspect methods and backtests. Could you elaborate on what this means for investors? Did we see the effects of this in the micro crash in December 2018?
The proliferation of quantitative research during the past couple decades has been the driver behind index and ETF growth. Just about anybody, for example, can group just about any number of stocks together and call it an index. But how an index performs in the past, if its methodology is not backed by logic, may be nothing like it will perform in the future. This is a big deal for investors. Investors should understand that backtests are not the same as walk-forward tests and/or real performance. I believe walk-forward tests are the most authentic of tests, consistent with the scientific method of building a logical hypothesis prior to testing it, eliminating completely the possibility of data mining, in my view.
That said, I do not believe that indexes themselves were the cause of the micro crash in December 2018, nor do I believe index investors alone were the cause. I wouldn’t consider what happened last December to be significantly material either, even though the decline in December may have been among the worst December declines in history. My book Value Trap, however, serves as a warning to finance that if the trend of “nobody paying attention to price-versus-estimated values continues,” bad things can happen. Most indexing and quantitative trading today is not paying attention to the value of their assets, and the potentially misaligned behavior of indexed asset growth in AUM-based advisories may only exacerbate any negative outcome.
Valuation uncertainty is something you truly embark in your service, and you favor fair value price intervals over fair value point targets. Why is that and why aren’t all analysts presenting data like Valuentum?
Where Valuentum differs is that we embrace the fair value estimate range. Value will always be a function of future expectations, realized or not, and the future cannot be predicted with certainty. Therefore, value can only be expressed as a range of fair value outcomes. What is traditionally known as the sell-side tend to not use fair value estimates in their research, but price targets.
The difference is quite simple. A fair value estimate is an estimate of what a company is worth, while a price target is speculation about the future price at which a company will trade at. One is grounded on extensive discounted cash flow analysis, while the other is a function of what the analyst believes the share price will eventually trade to.
Because price targets are prevalent on Wall Street and the most common, academic tests with respect to fair value estimates are quite scarce. I believe Valuentum’s research is pushing finance forward in actually calculating whether analysts can predict price-to-fair value convergence more often than not, not necessarily whether they can speculate on price movements. The results thus far have been encouraging.
There’s a whole chapter devoted to dividends and dividend growth investment. For a novice investor trying to understand dividend (growth) investing, what’s the most important lesson you would you tell them?
I think there are probably five things I would want them to know:
1) The dividend, itself, is not a driver of intrinsic value. In fact, the payment of the dividend reduces intrinsic value. A cash dividend is paid from cash on the balance sheet, an asset. As a shareholder, you already own that cash that you are about to receive as the dividend.
2) The dividend therefore is not incremental to total return, but rather it represents capital appreciation that would otherwise have occurred had the dividend not been paid. The stock price is adjusted down by the amount of the dividend on the ex-dividend date.
3) Understand the concept of capital-market dependence. A company that generates strong free cash flows and has net cash on the books is a much stronger dividend-paying company than the opposite.
4) High yield dividend investing is very risky, and price declines on high yield stocks are fundamental, as many are capital-market dependent in order to support the payout. High yield often means high risk.
5) Don’t fall in love with the past. The strongest dividend is not always the one that was recently increased.
The dividend aristocrats and kings are very popular among dividend investors. You like them too but emphasize that one needs to focus on the outlook, not just historical data and prior dividend increase streaks. Should young people go for reliable stocks such as AT&T, Kimberly-Clark, and Southern Company which has overperformed in terms of dividend return but significantly underperforms in terms of total return?
Historical data is only useful in how it helps inform future expectations. If investors are only looking at historical data and not considering how it fits into the future picture, this is the classic definition of rear-view-mirror investing, which can be disastrous to any type of investor. Dividend growth investing can generate a lot of wealth over time, but investors should never ignore the enterprise valuation context, or the intrinsic value of a company. Even the strongest dividend payer, if purchased at the wrong price, can be a horrible investment. Capital preservation is paramount.
Further, beware of dividend growth studies that compare dividend growth and compounding with just price returns. That price return graph does not include either the dividend received by the investor or what an investor could have reinvested those dividends in. Theoretically, if those dividends received were reinvested into companies that performed better that the dividend growers, the total return of the price graph and dividends reinvested into other companies could be even better that than of dividend growth and compounding.
You've invented the Dividend Cushion ratio which is a forward-looking dividend safety ratio and you've used it to highlight risks of the dividends in Kinder Morgan and General Electric, to name a few. How can you be sure that the future expected free cash flows over a forward five-year period is correct? And if it is, why aren't all using this great ratio?
The Dividend Cushion ratio is a forward-looking measure that ranks dividend health. Generally speaking, the higher the Dividend Cushion ratio above 1, the stronger the dividend, though investors should still pay attention to management’s willingness to raise the dividend (its track record) and business-model specific risks (secular risks to its operations).
Specifically, the Dividend Cushion ratio considers the net cash on the books of the company and expectations regarding its future free cash flows over the next five years compared to its future expected cash dividend payments over the next five years. Thus far, the efficacy of the Dividend Cushion ratio is approximately 90%. I believe many investors are thinking about dividend health in this manner, but yet many others still rely on the dividend payout ratio.
When it comes to finance, precision should never be the goal. Direction and magnitude are always of greater importance, and the same is true with respect to the context of the Dividend Cushion ratio. For example, we would generally prefer dividend growth ideas with Dividend Cushion ratios far in excess of 1 (or parity), and we’d be very cautious of companies with Dividend Cushion ratios that fall deeply into negative territory. The outliers often represent the most interesting opportunities.
What do you think is the strongest argument for still buying such boring stocks when the S&P 500 or a global index is such a good alternative?
The best argument for owning a stock is that shares are undervalued on an enterprise valuation basis and that the company’s stock price is appreciating, on the path toward converging to estimated intrinsic value. If these companies are moaty and have strong dividends and dividend growth prospects, all the better.
Buying everything at any price, as in an S&P 500 Index fund, has worked well for a very long time, but I believe that prudence and care starts with an understanding of what assets are worth. I don’t think fiduciaries have an excuse that they were just indexing, or that prior correlations were such and such, if we encounter another crisis. If they do not have an informed estimate of the value of what they are buying for clients, they should be held responsible. But why do I feel this way?
For starters, there is growing theoretical evidence that the average active investor can outperform, net of fees, and that active fund underperformance does not support the idea that the market price is the best estimate of value. A simple weighted average in Value Trap, for example, shows that the average active investor can outperform, net of fees, and according to the Investment Company Institute, active funds and ETFs are just 16% of the corporate equity market, hardly sufficient support for indexing.
I believe conflicts of interest within advisories are fueling index ownership, perhaps more than anything else. The incentives for financial professionals to charge fees just to hold index funds could create misaligned behavior. Make sure that you are getting a customized plan that is personalized to your needs.
You’ve weighted Berkshire Hathaway 7% to 12% in your simulated Best Ideas Newsletter portfolio. What is it that you like so much about this firm and what will change once Warren Buffet’s successor takes over?
Berkshire Hathaway is a good anchor stock for the simulated Best Ideas Newsletter portfolio, in my view. I’m not a huge fans of the banking sector due to the opaqueness of their books, and insurance is often heavily tied to market movements given float, so I like Berkshire’s diversified slice of these sectors, but also that it has some of the strongest industrials, including one of my very favorites in Precision Castparts.
That said, I am very concerned about Warren Buffett’s successor, and we’d have to reevaluate the position in the case that Buffet is no longer at the helm. I haven’t been satisfied with a lot of his lieutenants’ picks in prior years, and many of them have left me scratching my head. We may no longer include Berkshire in the simulated Best Ideas Newsletter portfolio if the Oracle is no longer part of it.
Buffett is one of the very few market geniuses out there, particularly in his teachings about how stocks are neither value nor growth, but that growth is a component of intrinsic value, something I pound the table on every day. His teachings about moats are second to none and other investment firms’ methodologies have even been molded on them. His criticism of quantitative research also shows his passion to help investors.
I’m not seeing these types of things in his successors, and I don’t have a good feel whether his executive bench will adopt enterprise valuation as the primary consideration in the investment-decision making process (Buffett loves enterprise valuation, the DCF). If I don’t get a good sense that Berkshire’s investment principles without Mr. Buffett are consistent with the Oracle’s and ours today, we won’t hesitate to say goodbye to shares.
The picture below is Morningstar’s predictions of future returns from various regions. Do you agree with the low returns for U.S. stocks and the high returns from emerging market stocks? If so, what’s the best way to play this outlook?
These are the types of forecasts I would caution investors against making. I think it is reasonable to assume that a certain stock or certain stocks are undervalued but rolling such analysis into a market return forecast across regions of the world over the next 10 years significantly compounds the possibility for catastrophic error. The bottom line is that nobody can predict how returns will look in the coming 10 years. The support for this view is obvious (nobody can predict the future), but probably not in the way one may think.
The price 10 years from now, which will drive the market return, will be in part a function of future firm-specific fundamental expectations 10 years hence. Even if a forecaster can predict future fundamental reality 9 years hence with precision, year 10 prices (and therefore 10-year returns) will still be based future expectations of the future at that time (future enterprise free cash flows). The answer to the question about future returns is not based necessarily on a pure fundamental model, but one that must accurately predict the market’s expectations of the future 10 years hence, not even the actual future, itself. This is simply impossible.
I believe that investors that buy moaty, undervalued stocks that have highly-rated economic castles, strong technical/momentum support from the market, secular growth trends backing their products/services, and solid dividend growth prospects may be among the most attractive, regardless of their place of domicile. A couple stocks that fit this bill are Visa (V) and Apple (AAPL), for example. Another one that is more controversial but we also like is Facebook (FB). I expect these companies to do very well in the coming decades.
Which books, websites or resources would you recommend for those who want to strengthen their skills, both personally and business-wise?
It is equally important to stay away from certain types of books as it is to read certain types of books, in my opinion. Frankly, I have found more things that were not quite right in books than tremendous insights. I would stay away from books about day trading or get-rich-quick schemes, among others of these types. I mean this in the nicest way possible, but I’d also stay away from a lot of today’s quant stuff, too.
I think investors should start with Value Trap. It offers an excellent foundation of what I believe is a sound view on interpreting market prices, and it introduces a framework to readers on how to critically assess others’ views and strategies. Without reading Value Trap, investors might end up believing a lot of things out there that just aren’t true. Value Trap is rich in candor, and I hope readers love it. Don’t forget to scour its bibliography for books/content to read, too, but I have some highlights below.
After Value Trap, dig into the Berkshire Letters. Then pick up McKinsey’s Valuation. After that, you might want to take Why Moats Matter by Morningstar for a spin and then read anything about moats by Michael Mauboussin. I would view this as the heavy lifting. One might then consider taking a financial modeling course to start putting these lessons into practice. Reading Value Trap again after taking some instruction would further strengthen your valuation skill set.
Once you have a great handle on enterprise valuation and competitive-advantage theory, then pick up some light stuff with O’Neal’s How to Make Money in Stocks and maybe read some excepts from John Maynard Keynes. You should also read Competitive Strategy by Michael Porter and perhaps round out the skill set with Fundamentals of Corporate Credit Analysis by S&P. Then subscribe to www.valuentum.com, of course. You’ll see a lot of the thoughts in your readings come together in the work we do.
As for personal development, I found a lot of inspiration in reading Richard Thaler’s Misbehaving.
He had to overcome so much to push behavioral economics forward. I’ve found great inspiration in Jack Bogle’s Character Counts. Bogle was another figure in finance that had to overcome so much to achieve great success.
I would encourage those in finance to write every day. Being able to communicate your thoughts effectively and succinctly is one of the most important skills of any field. Having all the right answers is no good if you can’t explain them effectively.
With that said, I want to say thanks to Brian for sharing his knowledge and helping us all become better investors.