Tuesday, March 06, 2007

The Logic of the Stock Price

The Logic of the Stock Price

A stock price has many definitions. One of the most sophisticated definitions is that it values the forecasted free cash flows of a company. There are many financial models that try to capture this conceptual definition (e.g. EV/EBIDTA, EPSxP-E, Cash EPSxCash P-E).

The most popular among them is the discounted (free) cash flow (DCF) valuation. Mainly popularized by Mckinsey and some other strategic consultants, it sought to value 'free cash flows' (operating margins, net of investment in working capital and routine capex, after adjusting for the tax benefits of leverage) over the visible period (also called the explicit period). Mckinsey also imputed a terminal value, which assumes a steady growth rate going to infinity. This perpetually growing cash flow often created a terminal value, which accounted for up to 90 per cent of the enterprise value (EV) in a fast growing company There are problems with this model. It often arrives at valuations that are considered 'theoretical' by markets. My understanding is that the 'strategic' valuation that the DCF is prone to recommend (5 to 8 years) is simply too long for the market. The real reason why the market often undervalues a given cash flow is that it is simply too myopic.

That seems to have been the disconnect in the Tata-Corus deal. Phrases like 'winner's curse, 'arrogant acquisition' 'overpayment' and 'value destroying' have been used. The difference in perspective, I think, is purely over the visible forecasted period. Tata Steel's strategists are valuing the free cash flow over a longer competitive advantage period. This goes back to the Buffetian argument that the valuation of the stock should take into account not only the size and growth rate of a cash flow but also the competitive advantage period. This articulates a long-standing disagreement between the steel industry and the stock markets. The steel industry is a long gestation industry. The typical project (concept to free cash flow) is set up over most of the typical business (or interest rate/liquidity) cycle. Hence any steel company has to ride out a period of high liquidity and a cash crunch every time it sets up a greenfield capacity. Steelmen, therefore, are used to thinking in terms of a gestation period of 8 to 12 years. They simply have longer visibility than the financial markets.

On the flip side, they also know that an embedded player has a huge advantage. Sometimes you make extra money simply because you are sitting there. The Tatas have possibly projected a certain free cash flow grown at certain rate over a longer competitive advantage period than the markets are used to defining.

So who is right? Financial market players (my mental stereotype is of the Ketan Parekhs, Harshad Mehtas and the hedge funds of the world) or the steel industrialists? Are these market players any richer than the Tatas? Long-term investors don't necessarily do worse than spectacular wealth creators, found so commonly in the financial markets. You just have to decide what you want to be.

When Warren Buffet said, "Buy the business, not the scrip", this was what he meant. Let me explain this in detail.

I don't think too many people, bar the most cynical, are arguing that the Tata-Corus deal is going to reduce the total free cash flow (FCF) of the combined entity. Yes, there is a certain view that if the steel cycle turns, the FCF being projected will drop, but will it turn negative? And if it doesn't, then the payback will happen. Only the rate at which the payback will happen might get extended. That would increase the number of years taken to digest the acquisition.

This is what a value investor should seek. Whenever Mr Market turns apoplectic, but you find long-term, 'strategic' players who want to 'buy the business, not the scrip' on your side; go ahead, jump. This is the Buffet model. Once you know where the market stands, you should stand apart from the market. At this point in time, the broader market is definitely morose about Tata Steel. Yet, nobody is arguing with Mr Ratan Tata on his claims of "long-term value". The difference of opinion is only about the investment horizon.

Most of my regular readers would know that I am usually bearish, skeptical, 'negative'. This is especially true of the last couple of years, when I have been negative, even as I have myself joined the large mass of India's nouveau riche. Well, here is my recommendation - buy Tata Steel, and keep trading in the stock for five years (which is the payback period estimated by many analysts on current cash flows of the combined entity).

How do you trade? As you find the short-term (Mr. Market) marketmen get out, pace yourself and get in. Just like you buy a systematic investment plan (SIP), keep buying this stock on declines. Every time the stock recovers back to its previous high, sell what you bought at lower levels; then buy back the stock as it declines. This way, target to keep your average holding cost lower than the prevailing stock price. The stock will make a long, saucer-like pattern. Your average holding cost should track the falling price of the stock. As your average price drops, keep adding to your total holding. In other words, take your trading profits in the form of stock, not cash.

I will not speculate on how long the coming (down cycle?) will continue. The RBI has just hiked CRR rates again, clearly telling the country that they are determined to squeeze out liquidity till inflation slows down. As interest rates rise, the cost of capital in the markets will rise much more. That should bring temperance to the stock markets (and real estate, but that is a different story).

If you don't know how to trade, then you must buy and hold. That is a more difficult way to earn money, but Warren Buffet has proved that it can be equally profitable. For buy-and-hold investors, this would still count as a 'Buffet event', i.e., a sharp, apparently disastrous incident that looks spectacular, but does not impact the long-term prospects of the company. That is a cue for value investors to go bottom-fishing.



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