Valuation is principally important for several reasons: First, valuation tells us what expectations have been incorporated into the market. Given our focus on identifying high quality companies, we want to assess which of these high quality companies also offer an attractive return on investment. Second, in times of market distress, such as during a pandemic or a trade war, valuation allows us to accurately determine the risk-reward of companies in our portfolios, so that we can add to our positions at low risk and high reward juncture points.
When we invested in large capitalization companies with secular growth characteristics, we defined valuation as having an expectations difference between prevailing market expectations and our own internal expectations. For example, if a company claimed it could grow 5% per year, but the prevailing market expectation was only 3%, we would say that there was a valuation gap that investors could capitalize on. In this example, this 2% difference in expectations can be termed an “earnings surprise”, and if the company continues to sustain it over time, eventually, investors raise their expectations resulting in what’s termed a positive earnings revision. It has been found that positive earnings revisions are highly correlated to rising share prices, and this is a metric we monitor every quarter when companies release their results. Many large cap secular growers fit into this category, because oftentimes, market participants underestimate the longevity of a theme. For example, when Microsoft and Amazon started investing in cloud computing a decade ago, investors hardly awarded the companies any credit. But over time, as the theme delivered results, and the financial picture started shifting to reflect this, earnings revisions started to rise, leading to higher share valuation multiples. Today, earnings revisions are still on an upward trajectory, likely reflecting the longevity of the market opportunity.
In the same way we recognize expectations differences for large capitalization companies, we are also doing the same for our small and medium capitalization portfolio. However, expectations for smaller companies tend to be more wide-ranging, and to have more confidence in our forecasts, we are developing models that value a company on their own intrinsic projections of revenue and earnings. This form of valuation, where we take company projections and value their entire annuity stream, is called absolute valuation. For example, many early stage companies invest the majority of their profits back into research and development activities, making revenue or sales growth a more predictive measure of shareholder value. Therefore, projecting the sales growth of the organization, and applying a future value on that growth, provides us with a possible projected share price three years out. We believe this form of valuation will add to our opportunity in identifying early stage winners before mainstream investors develop interest.
In conclusion, valuation is much more an art than a science but its overarching aim - whether absolute or relative - is to identify where opportunities exist, where expectations may be under-recognized by most participants, and how much margin of safety remains.
As a year unlike any other draws to a close, we are grateful more than ever for our wonderful clients and continue to appreciate the trust you have placed in us. We wish you and your families a safe and happy holiday season filled with love, peace and great food! And we hope to see you in person in 2021!
Grace, Sam, Leslie and Jennifer