Investing in public markets can be a tough exercise, and during aggressive market sell-offs like we have seen over the past few weeks, it can sometimes even be cruel. Managing your emotions during these difficult periods is critical, especially controlling your “greed and fear” urges that inevitably lead to buying high and selling low and wiping out years of profitable performance gains.
In this note we outline our investment approach at Holon which will help investors become more confident in finding great investments, but to also become more confident in exploiting periods of volatility to buy these great companies at highly attractive valuations.
Research begins with read, read, read
We start our research into a new investment target by reading annual and quarterly financial reports (generally at least the past 3-5 years), as well as company websites, newspaper articles and any publicly available in-depth reports that provide further insights into our target’s business sector. Additional reading would also review key competitors and/or customers, and possibly even government regulations that determine the rules impacting how our target company must legally operate.
The purpose of this work is to gain a deep understanding of what our target company does (i.e., what am I buying?). This process can take several months and often leads to big surprises.
For example, many investors may buy shares in Amazon based solely on its successful e-commerce business, but through detailed reading they would learn that Amazon also has 100 subsidiaries across a range of industries including data storage, logistics, food retailing, media, digital TV subscription and financial services. In addition, Amazon have also made substantial investments across autonomous vehicles, drug pharmacies, movie production and robotics. As these other operations and investments grow into revenue contributors, they may begin to become substantial revenue contributors for Amazon and should therefore be understood by shareholders.
Building a financial model
We then build financial models that assist us with forecasting the future direction and valuation of a target company. This process begins by transposing the past 5-10 years of financial results of our target company into an excel spreadsheet from published quarterly and annual reports. This includes as much information as possible from the company’s profit and loss statement (P&L), balance sheet and cash flow statement.
We next need to estimate the future financial results of our target company. At Holon we generally forecast at least 10 years forward, which to many seems like an impossible exercise (given the weatherman can’t seem to accurately predict more than 2 days ahead!).
But the work outlined at the beginning of our research process (reading, reading and more reading) provides us with substantial help in making these forecasts. Public companies are required to make forecasts on their expected future performance each quarter, which include sales and profit growth estimates. We can gauge the accuracy of forecasts made by our target company’s management team over the past few years against actual financial result outcomes.
Our research also provides us with insights into the expected growth rates of the sector or business area that our target company operates within. Technology companies highly leveraged to the shift towards a digital economy are expected to produce high growth rates over the long term, but we must also consider if they are facing rising competition from technology giants like Amazon which could slow down or even turn their growth negative. Finally, making forecasts beyond 3-5 years becomes more difficult which is generally addressed by assuming much lower growth rates beyond this period.
All the factors outlined above come together and allow us to forecast the long-term financial potential of our target company. These forecasts can then be used to build common valuation metrics like Price to Earnings (P/E), Price to Sales, Price to EBITDA (Earnings before interest, tax, depreciation, and amortization) and discounted cash flow (DCF). Investors use these valuation metrics to determine whether a company is an attractive buy, hold or sell. We will expand on these valuation metrics throughout our newsletters over 2022, so watch this space.
Implied Valuation Model
An alternate approach to determine whether a company’s shares are attractively priced is through building an implied valuation model. This is slightly different from the model above in that it uses the current market share price, then estimates what changes must happen to a company’s financial forecasts for it to be valued at this current price. This is particularly useful during aggressive market sell-offs that can help to provide confidence in great investments across your portfolio.
If we look at Chinese technology giant Alibaba, we find a stock that has fallen by over 60% since November 2020 (Figure 1). While this fall was initially due to Chinese government regulators intervening to stop the listing of ANT Group (33% owned by Alibaba), and detaining Alibaba CEO Jack Ma briefly, the sell-off accelerated throughout 2021 from rising Chinese regulatory oversight and competitive tension between the US and China.
Figure 1: Alibaba Share Price
Over the period from 2016 to 2020, Alibaba has been amongst the most successful growth companies in the world (Figure 2), achieving the following average revenue, net profit growth, and operating profit margins over this 5-year period.
Figure 2: Alibaba performance over 2016-2020
So, what does HK$115 per Alibaba share imply for the company? Firstly, Alibaba’s current cash and investments make up almost 50% of its US$300 billion market capitalization, providing strong downside protection from further share price falls. Secondly, using Holon’s implied valuation model for the company, the current long-term business outcomes occur in order:
- No revenue growth for the next 10 years;
- No profit growth for the next 10 years; and
- Current operating profit margin of 18% falls to 3% over the next 10 years.
Holon, along with almost all investors who understand China, see the probability of this happening is zero. Using this implied valuation approach model, therefore, reassures investors of the facts underlying their investments and should lower the anxiety and fear that can occur during market sell-offs.
An opportunity to find great investments in market sell-offs.
It may seem entirely logical, but the goal of investing is to “buy low and sell high”. However, as we stated at the beginning of this article, the panic and fear that can grip investors during a market sell-off often leads them to do the opposite, destroying years of profit gains. This is particularly true in the case of ETF’s, which usually contain lots of listed assets that make it very difficult to gauge the health of each individual company in the ETF and, therefore, the likelihood they will rebound strongly from short-term market volatility.
Holon believes that market volatility (price swings) will likely increase throughout the 2020s because of a combination of factors which include overindebted foreign governments, increasing intervention from global central banks (through programs like Quantitative Easing) and the accelerating switch towards a digital world.
By using an implied model, investors can take advantage of sell-offs and add great investments to their portfolio at attractive prices, with the confidence on the underlying fundamentals of each investment. We will address this further in next month’s newsletter by providing examples on how using this detailed research approach, coupled with building a financial model, can allow individual investors to construct a portfolio of world class companies.