- By John Kinsellagh
Seth Klarman (Trades, Portfolio), chairman of the Baupost Group and one of the most successful value investors on Wall Street, has long been an unwavering disciple of Benjamin Graham and David Dodd, whose insights he calls "timeless."
The intrinsic value of PG
Klarman, who applies the principles of value investing, regardless of ever-evolving market environments, offers us a glimpse of his views on the inherent limitations of valuing the future growth of a company in the preface to the sixth edition of "Security Analysis."
Graham and Dodd repeatedly stressed the importance of humility and prudence when attempting to predict the future earnings of a company, regardless of the valuation methodology employed or the trend of earnings -- a measure that far too many analysts today obsess over, particularly with regards to the FAANG group of tech stocks. In the preface to the first edition, Graham and Dodd, while acknowledging the "vital significance" of determining future growth, nonetheless, explicitly stated their book would not dwell on nor discuss in any detail the determination of the future prospects of a company "because little of definite value can be said on the subject."
Klarman's view on the difficulty or sheer folly of trying to ascertain with precision the earnings growth of a company, to a large degree, mirrors the admonition contained in the pages of "Security Analysis." The guru did not dismiss the importance of growth when he wrote, "Clearly, a company that will earn (or have free cash flow of) $1 per share today and $2 per share in five years is worth considerably more than a company with identical current per share earnings and no growth." He noted, however, the difficulties of trying to ascribe a meaningful value to a stream of a company's future earnings because growth can come in different forms, reflecting the difference in business models of diverse companies.
Klarman reiterated that an observation the authors of "Security Analysis" offer about valuing future earnings is as valid today as it was back in the 1920s and 1930s. As Graham and Dodd wrote, "But while a trend shown in the past is a fact, a 'future trend' is only an assumption." The authors reinforced this point by noting the limitations trend analysis must have on the valuation methodology.
"It may be objected that as far as the future is concerned, it is just as logical to expect a past trend to be maintained as to expect a past average to be repeated. This is probably true, but it does not follow that the trend is more useful to analysis that the individual or average figures of the past. For security analysis does not assume that a past average will be repeated, but only that it supplies a rough index to what may be expected of the future. A trend, however, cannot be used as a rough index; it represents a definite prediction of with better or poorer results, and it must be either right or wrong."
Given the inherent limitations stated by the authors, they consider trend analysis, even though it may be stated as a quantitative factor, a qualitative factor.
Klarman agrees with this essential premise adopted by Graham and Dodd on the pitfalls and traps that await those who rely predominantly on earnings trends as a basis for valuation. As a student of the two legends, Klarman warned of the "significant downside" of paying up for growth or obsessing over it.
Klarman believes that focusing exclusively on growth can be detrimental and distinguished, as Graham and Dodd took pains to note, the investor from the speculator. The guru reinforced his point by quoting Graham and Dodd, when they wrote, "Analysis is concerned primarily with values which are supported by the facts and not with those which depend largely upon expectations."
As the authors of "Security Analysis" observed, for those who develop a myopia with valuing growth and the trend of earnings, paying for growth or for one's projection for future earnings, theoretically implies that no price could possibly be too high for a good stock and that such an issue was equally "safe" after it had advanced to $200 as it had been at $25. Klarman noted that precisely this mistake was made when stock prices surged skyward during the Nifty Fifty years of the early 1970s and the dot-com bubble of 1999 to 2000.
Perhaps one of the most astute value-investing observations Klarman made is that when expectations are not realized, it is the company that misses the projected earnings trend on which so many security analysts confidently and erroneously relied, whose stock subsequently drops the most precipitously. He explained the potential opportunities that lie in wait for disciplined and astute value investors by recounting what occurred when the dot-com euphoria swiftly subsided: "By 2002, hundreds of fallen tech stocks traded for less than cash on their balance sheets, a value investor's dream."
Klarman does not spare his criticism for institutional investors, which dominate the market today, who dismiss or ignore these bedrock principles about being judicious when valuing a company's growth. He wrote, "Most managers, including growth and momentum investors and market indexers, pay little of not attention to value criteria. Instead, they concentrate almost sing-mindedly on the growth rate of a company's earnings, the momentum of its share price, or simply its inclusion in a market index."
Klarman's investing philosophy has long incorporated and embraced this invariable factor of how one should value the future growth of an enterprise. He correctly asserted that value investors should abide by these principles, regardless of whether the company under consideration is Procter & Gamble (PG), Facebook (FB) or Amazon (AMZN). As is evident from his comments in the preface, Klarman has never been mesmerized by rising markets. He does not discard his value investment philosophy just because others who are engaging in speculation are too undisciplined to maintain standards of valuation.
As a note for those today who have cast aside standards of valuation because of the unbroken, decade-long rise in equity valuations, Klarman has a prescient warning: "After all, it is easy to confuse genius with a bull market."
Disclosure: I have no positions in any of the securities referenced in this article.
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The intrinsic value of PG