Back To The Future
2022 has been a year for investors that has been largely shaped by macroeconomic factors. Rising interest rates have clobbered both the stock and bond markets. As we move into the end of the year, I have thought about the appropriate course to take for 2023. Because inflation, interest rates and economic growth have had an outsized influence on returns this year, I find myself giving them more attention than they deserve. I have written before about the futility of forecasting in "Dependent on Stupidity," and chastise myself every time my thoughts go down the path of thinking about macro factors for 2023 and beyond. A couple of astute readers pointed out that investing legend Howard Marks published a similar letter on the futility of forecasting a few weeks after "Dependent on Stupidity." I have read his letter several times and realized neither his nor my letter addressed a very important question. If we accept that we cannot predict the future, how do you move forward and invest appropriately?
Did you know the word 'gullible' isn't in the dictionary?
I am going to steal a few points from Mr. Marks before I fully address this question. Marks points out there are two types of forecasts. First, most forecasts are merely extrapolations of the recent past. These extrapolations are usually correct and are already built into security prices. When these extrapolations that are following a long-term trend turn out to be correct very little money is to be made because they were already anticipated. The second, more valuable, prediction is when an event occurs that deviates substantially from the long-term trend. These deviations are infrequent and correctly predicting one is rare because most forecasters are focused on extrapolating the recent past.
"Dependent on Stupidity," was dedicated to a few examples of how we trust "experts" to accurately predict moving targets despite evidence showing it isn't possible. It's human nature to trust experts, if we went back a thousand years, kings hired soothsayers to look at sheep guts to predict the outcome of an upcoming battle. It was crazy then and it is crazy now to trust predictions. The methodologies may have changed but the accuracy hasn't.
A friend studying epidemiology recently shared with me a few research papers in her field that have broad applicability to economics and investing. I did not realize until I read these papers that epidemiology was a fancy word for calling bullshit on bad science. Extrapolation of data from a sample for the purposes of making definitive conclusions across a broad population is incredibly difficult and has implications across many disciplines including investing and medicine. The main problem is that no one wants to hear their hired expert in any field say, "I don't know." So, the experts provide an answer and people trust and act on these potentially flawed conclusions. But that is where opportunity lies. Markets occasionally will extrapolate information that implies a silly conclusion, and we have the opportunity to call 'BS' and express our own opinion.
CEOs proudly claim their businesses will grow to the sky and Wall Street believes them. Soothsayers look at sheep guts and tell their king he will be victorious in battle. A do-it-yourself orthodontia business says you can straighten your teeth with a few pictures and smartphone app. It shows just how gullible humans can be in the presence of an authority.
"All I want to know is where I'll die, so I'll never go there" Charlie Munger
But let's return to the purpose of this letter. If we accept that we cannot predict the future, how do we move forward and invest properly? By saying "I don't know" we are being honest with ourselves and sets us on a different path than the clairvoyant herd. What we can do is spend time understanding where we stand in the current economic and market cycle. If we have a strong sense of value based on historical facts, we can generate a sense of whether security prices are overvalued, undervalued or reasonable. With investing all I want to know is what is extremely overpriced; by doing so we can avoid the train wrecks. The best foundation for strong long-term performance is to avoid the disasters. The quest for consistency and downside protection is what guides our investment process.
If you turn on CNBC, it's programming is filled with analysts discussing their stock picks and price targets. Instead of trying to predict future stock prices, we can invert the process and look at the information the current stock price is providing us. The value of any investment is the sum of all future expected cash flows generated discounted back to a present value. Instead of trying to predict future profits many years into the future, we can just approximate the future profits required to justify the current stock price. From there we can make an assessment as to how likely the business is able to achieve those results.
Real-time example: Home Depot
It’s a fairly safe assumption that Home Depot has saturated the North American market with its stores. The company has only added 3-5 new stores per year and when considering the impressive return on invested capital Home Depot earns on each store, management would have built more if the opportunity was there. Instead, they have returned their excess cash to shareholders through dividends and stock repurchases. Therefore, we can conclude its future growth will come from selling more stuff at higher prices out of its existing stores.
Prior to the pandemic Home Depot sales grew 5-6% a year driven by 1-2% growth in the number of transactions and 3% growth in average ticket size. Transaction growth tracked fairly close to the increase in population and growth of the nation's housing stock and ticket growth grew slightly above inflation indicating modest market share gains. Turning to the second chart we can see Home Depot's gross profit (sales price less cost of items sold) has been stable around 34% and its operating profit (gross profit less operating costs) has slowly grown from 10% to 15%. Home Depot was able to generate this leverage because it owns most of its real estate which fixes a material portion of its operating costs.
With this information, now have a reasonable template for understanding the drivers of Home Depot's profitability. Home Depot is presently valued at $322 billion which means that is how much future profit investors are expecting to receive from the company in the future. If Home Depot maintains its margin profile, it will need to grow its revenue by 3% a year to meet that hurdle. This doesn’t seem out of reason, considering population growth is slowing and the expectation that the present rate of inflation will normalize in the low single digits.
Now we can also repeat the exercise and say Home Depot's growth will slow to just 1% and at that level its margins will fall because operating costs outpace sales growth. In this pessimistic scenario we get a stock price of $260. Conversely, we can also come up with a scenario where Home Depot continues its historical trend growing mid-single digits and profit margins continue to expand. In this case we could justify $450 for Home Depot. We now have a valuation range we can use to gauge whether the stock is overvalued, undervalued or reasonable without having to explicitly attempt to predict the future. These valuation estimates serve as a measuring stick in the continuous rising and receding tides of the markets. Note: I do not own Home Depot and this is not a recommendation of its purchase.
What all this boils down to is that there is a difference between an
average and a distribution. I have built my entire career on Wall Street based on that premise and I am continually surprised at how many people do not understand that point. The price of any investment security is the average of the market's expectations, and its future price is dependent on a range of hypothetical outcomes. Extrapolations of the recent past occasionally cause prices to drift into areas of the distribution curve that make investments statistically overvalued or undervalued. Don't think your opinion is always correct and maintain assumptions that are neutral and modest.
Thoughts on the Market
I have gone through the exercise above with dozens of companies and on average most valuations are falling in the reasonable to modestly pessimistic range. Which seems sensible given the expectation of a recession in the near future. I think inflation, interest rates and a looming recession will continue to drive an erratic market. I will reiterate I have no idea where these factors will go over the next year. What I can say, is the overpriced stock and bond markets that we faced at the start of the year are looking reasonable as we start a another. Of course, you shouldn't be surprised given the magnitude of the market correction. What I continue to caution is over the past decade many businesses have become reliant on ultra-cheap money that is no longer available. You may think now it is safer to invest with stocks significantly lower and junk bonds with 8-9% yields. Cheap money isn't a substitute for sound business plan. When it runs out, I fear there is still more pain ahead for many. More detailed thoughts on this subject are reserved for premium members. At To The Front, we continue to favor high quality businesses that will do better over the next decade and bonds of issuers likely to pay their principal and interest.
Be wary of the averages,
To The Front
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This commentary is provided for general information purposes only and should not be construed as investment, tax or legal advice. Past performance of any market result is no assurance of future performance. The information contained herein has been obtained from sources deemed reliable but is not guaranteed.
