The Uncertainty of Price Movement Versus the Certainty of Underlying Value in Bear Markets

The Age of the Bear. There's no guarantee the stock will stop falling despite buying it at a bargain. But never mind that, because the intent anyway is to capture gains not necessarily through stock price appreciation but through consistent, predictable underlying value.

This is Part 1 of a Series.

The following was my response to an online forum inquiry regarding bottom-fishing and timing the exact, opportune moment of getting into the bear market.

While bargains even during a bull market are possible, a bear market, such as what we're experiencing now, offers the best opportunity for fire sale stocks. You can never be so certain when the stock price will stop falling. You can only be certain, nonetheless, that the stock is already a bargain relative to some underlying value.

Capital Preservation and Rational Potency of Earnings

This is Part 2 of a Series. Go to Part 1: On Discount Rates, Required Rate of Return, and Conservative Purchase Price.

The idea behind capital preservation is defensively allocating capital in a safe investment position (thus, preserving your money’s worth) but at the same time exposing it to the prospect of profits (or capital gains)—Simply, it is earning without risking losing money. The cardinal concern shouldn’t really be profits—it should first be preserving capital. Profits only come secondary after making sure we don’t lose money. If we start concerning ourselves on this primary consideration, then we’d undoubtedly be diligent and be very cautious in our allocations.

Earning without risking losing money. Capital preservation should remain top priority, with earning profits only being an afterthought.

So if that be the case, then why not just easily opt to hold hard cash, you may think? Well that’s hardly the solution. Complacently leaving your cash lying in the room or under your bed or pillow would diminish its worth because of that value-sucking animal called inflation—the real enemy. Capital preservation is therefore achieved only through placements in value-enhancing instruments which, at the least, beats inflation.

In the realm of stocks, capital preservation can be ascertained by banking on very conservative assumptions of underlying value. Why underlying value? Because that can only be your best bet towards consistency and predictability. If you rely on market value, you’d be subjecting yourself to the whims, emotions, and ups-and-downs of the market. And that would certainly not preserve capital. (An aside though: take note that this is only true if we exempt arbitrage plays; in arbitrage scenarios, the pursuit of value is not found on the underlying business, but rather on the difference between prevailing market price and the publicly declared market tender offer—the arbitrageur viewing the discrepancy as his source of value gain). Nonetheless, certainty is key.

So Where Have All Those Free Cash Flow Gone?

This is Part 2 of a series. Go to Part 1: The Corporate Cash Hoard Theory

Flow Accumulation. Doesn't the thought of where free cash flow has been accumulating merit contemplation?

A company’s cash hoard is similar to the idea of accounting profits being accumulated in equity’s retained earnings. In this case, however, we're talking money—that is, cold hard cash, not booked accruals, or capitalized expenses. If one is so conscious about observing free cash flow and one subscribes to the idea of it being the true measure of cash profits, the more so should be with how and where it accumulates. That is, that “free cash equity” base where all those free cash has accumulated.

Remember that free cash flow tracks internally-generated earnings realized in cash. That being so, it does not give any bearing or value to booked receivable sales, booked payable expenses, externally sourced cash, as well as prepaid expenses, inventory, and capex assets which are all actual cash outlays. Following this bias on internally-generated cash, the balance sheet accounts can appropriately be reclassified as follows:

ASSET SIDE

• Free Cash Assets – they include cash & cash equivalents and non-core business investments (stocks, bonds, real estate, etc.)—these are the primary free cash flow outlets—the asset base of cash hoard.
• Capex Assets – while these are investments on enterprise infrastructures, these are actual cash outlays.
• Trade Assets – these are accounts receivables (accrued sales which are yet to be collected), and prepaid expenses and deferred tax assets (actual cash outlays).

By Sheer Business Instinct, We Know that Cash is King

The Color of Money. Businessmen and entrepreneurs are instinctively money-conscious. They are very mindful of not only profits, but cash profits!

This is Part 1 of a Series.

I've always admired businessmen or entrepreneurs who have not a clue or idea about the stock market, but when they start speaking about their private companies, you can visualize the excellent fundamentals, and cash-generating power of their business models. They have a quick eye on the things that matter—they are mindful of large expenditures and always expect return benefits from cash outlays (such as an investment on an equipment and the potential savings it eventually brings). They hardly talk about accounting profits; instead, they focus on cash flow and return on investment. It’s reminiscent of that business-minded, typical Pinoy concern of "Magkano ba kikitain ko jan?" When you hear him ask that, you know he's concerned about how much cash he will get in the end.

But why has this Pinoy concept of kita been so obscured when it comes to actually evaluating companies listed in the stock market? Perhaps that is the challenge: being able to read, interpret, and translate conventional, corporate financial statements into simple, common-sensible information relevant to a cash-conscious, inquiring businessman investor—more than seeing the accrual side of things, we also try to ask: “Magkano ba talaga ang kinikitang pera ng kumpanyang ito?” and “Saan ba talaga nanggagaling at napupunta ang pera?”

Compounding Power of Stocks

Money begets money. The compounding power of stocks can be observed in its underlying business' return on equity (ROE). Like an interest rate in a bank, the higher it is, the more the business proportionally generates wealth to the shareholder. As an investor, what you're after are businesses able to maintain the highest, consistent ROE's spanning years and decades.

As a lot of fellow long-term investors are enthusiastic about the compounding advantages of buying and holding for the long haul, I began to contemplate where this compounding power is derived. Most would try to express this magical stock attribute in market terms—they’d pick a stock which has performed considerably well and then easily point out the stock’s market price in two points in time (e.g. had you bought some shares of Company A at a certain price a decade ago, held on to it up to this day, with its stock now trading at this price, your holding should now be worth twice or more, compounding money at a rate above 15%). While it concretely presents the effect of compounding, it’s too bias on the market (i.e. stock price), and tells you nothing of the economic merits of the stock as a true, performing business. After all, the compounding power of stocks is found not in its stock price, but in its underlying business.

Being Intimate with Equity Value

How does a stock market investor, as a businessman, despite all the stock market noise, immerse himself and connect his consciousness in the underlying wealth of a company he invested in? Or to ask simply, what value does he immediately get upon acquisition of the stock? Crudely, the simplest, and easiest reference of shareholder value can be observed in the balance sheet account called equity. Equity, in theory, represents that residual value attributable to owners after paying all company debts or liabilities. Of all measures of value, it is perhaps the most objective, readily available financial figure for the inquiring investor (in contrast to an intrinsic value estimate which may have been derived from a financial spreadsheet model which in itself is prone to the “garbage in, garbage out” risk.

Value of the book. Equity value or book value is that residual value attributable to the shareholders. Increase in it through internally-generated earnings has a lot of business sense in it.

The idea is to view the value of one’s interest in a business not in terms of what its stock price is doing, but in terms of what its book value is doing. With this frame of thought, you’ll have the luxury and peace-of-mind to view your wealth in book value terms, and be able to subscribe to the idea that each increase in book value enhances the value of the business. Although I am well aware there are a lot of ways to measure value (e.g. discounted cash flow model), I foster this straightforward mentality (at least for now) for the sake of bluntly psyching the price-obsessed, market-conscious investor into a simple, rational business paradigm.

Focusing on equity (or book value as it is commonly referred to by accountants) gives the investor an idea or easy reference of how much value he gets from what price he pays for. Assuming this is the immediate value you get, one will have an easier time to accept that earnings—that which adds internally-generated value (i.e. by virtue of business) to book value—do really have a direct impact on the value of the enterprise, and consequently, your wealth (since you are a shareholder); thus, when the company earns, you do really have a share in those earnings. Commitment in internally enhancing book value engages the company to focus on profitable operations. Plainly, book value has a lot of business sense in it.

The Price-Value Breakeven Theory of Stock Investment

Introduction: In the early stages of my investing career, I tried to develop an independent way of thinking about stocks—my intention was to focus on the stock’s underlying business financials and utterly disregard how its price performed. The idea was to put myself in the shoes of a rational, long-term shareholder (and have the sort of pure mindset of an entrepreneur). The exercise led me to ponder on very basic but key financial concepts. Note that this is, admittedly, a very extreme, crude approach and wouldn’t seem practical. It has yet to consider cash flows and the time value of money. But I think it’s worth a review to touch base with our business mind or entrepreneurial psyche when dealing with stock investments...

From a purely business perspective, the moment you buy a stock, what you immediately possess as a part owner or stockholder of that business is its current net worth, its equity, or book value. In addition to its present net worth, you also possess its earnings potential which is realized in the future. Premium is therefore understandable, but not to such extent it already escapes rational potency of earnings. Overpricing risks permanent loss of capital.

Taking a feasibility and payback approach to stock investment, this valuation theory treats the buy price of a stock as an initial outlay. The investor, stoic to market price fluctuations upon entry, therefore, takes on the conservative position of eventually breaking even when book value per share, through comprehensive earnings and stock dilution/accretion gains, overtakes price. Upon breakeven, the investor’s rate of return approximates the Return on Equity (ROE).