RATIONAL REFLECTIONS
By Bell Institutional
Thinking Backwards
Every day, investors all over the world turn on the television or check their phones to see what the markets are doing. Is the S&P 500 up or down? What about my favorite stock(s)? When people are looking at prices, what are they really doing? Whether they realize it or not (most don’t), investors are actually checking if the market is incorporating their beliefs about the future.
At Bell Bank Wealth Management, we believe that stock prices are the best indicator of the market’s future expectations for an investment. We also believe that the price of a stock is nothing more than future cash flows discounted back to the present. Bearing that in mind, it makes sense that the key to successful investing is determining whether the expectations built into a price are achievable and whether or not the market is likely to revise its estimates. If an investor is able to successfully and consistently anticipate revisions in expectations, they will be sipping Mai Tais on a tropical beach in no time!
How Investors Actually Think
In our opinion, the majority of analysts and investors are lazy and short-sighted. Heavy focus is placed on earnings and revenue figures over the recent past or near future (typically last 12 months or next 12 months). While important, the vast majority of a company’s intrinsic value comes from time periods beyond one year. In fact, most valuations result in the majority of company value coming from the terminal value.¹
Along this same vein, sizeable dependence is also placed upon multiples, which typically incorporate the last 12 months’ or next 12 months’ financial figures. This is because they are easy to use and take little time to analyze. Commonly cited examples include price-to-earnings, enterprise value-to-sales and enterprise value-to-EBITDA ratios. Analysts and investors are so reliant on this short-hand version of valuation that nearly all sell-side research reports and the majority of acquisition valuations are based on multiples. However, we do not believe that easier is always better. Besides having a near-term focus, multiples also introduce numerous inconsistencies due to accounting methodologies, which will be covered in a later Rational Reflections piece.
To compound the errors of being myopically focused on the near future (past), many “investors” place an even more aggressive set of blinders on themselves and only focus on the next quarter (we call these speculators). This focus on the near-term comes at the expense of developing a coherent picture about what the more distant future (beyond one year) requires in order to substantiate a current stock price. As such, focusing on the short-term is likely to lead to underperformance.
Dismissing everything beyond the immediate future (past) leads to flawed valuations and unforced errors.
Invert, Always Invert
When performing a discounted cash flow analysis, investors typically apply their investment frameworks in a forward-looking manner. Identifying the value drivers is the first step (we believe these to be growth, reinvestment needs and risk) and arriving at the value of equity is the last step. All of the steps in between follow a natural flow. When thinking backwards, we turn the above framework upside down. We start with the price (value of equity) and work backwards to determine what expectations are currently priced in. Integrating price-implied expectations into an investment process allows for a more robust analysis and helps investors make the right decisions. If an investor thinks the expectations can be easily beaten, the stock is likely a buy. If the expectations imply absolute perfection for years to come, the stock is probably a sell.
While there is no difference in the mathematics between the two approaches, the reframing offers several advantages. First, it reinforces the connection between fundamental value drivers and market expectations by linking to the necessary operating performance. Second, it facilitates more intuitive understanding. Instead of abstract growth rates or financial figures, investors can more easily assess explicit expectations (threat from competition, switching costs, required market share, etc.). Finally, the reframing forces a focus on the essential drivers of value. In reality, there are only a few.
Backwards Thinking in Action
Without properly understanding what expectations are built into a current stock price, it is challenging to determine the quality of an investment. This lack of understanding can hinder decision-making. It can also reduce confidence in past decisions, making it difficult to hold during price declines or sell during rallies.
Humans naturally seek validation and conform to group norms. This tendency allowed for our ancestors to have a better chance of survival by promoting peace and protection. This trait is still present in modern day humans, yet it can be detrimental in investing. However, if an investor has done their homework, going against group consensus can be done with success. Doing the work results in increased confidence that the analysis is correct and will allow for an investor to make decisions that look peculiar in the shortterm but yield long-term benefits.
Meta provides a good example of how thinking backwards can prove to be beneficial. Meta’s price per share peaked at $378.69 on September 10, 2021 and hit bottom at $90.79 on November 4, 2022. The drop in price equated to a drawdown of 76% over the near 14-month timeframe. The cause of the price drop was increasing investor concern with excessive capex spending on the Metaverse coupled with Apple’s App Tracking Transparency (ATT) initiative.² At Meta’s nadir, the expectations for the company reached extreme levels. Investors, in their haste to sell (because everyone else was doing it), assumed extremely low growth rates coupled with declining profitability. However, investors forgot that Meta still had over 3.6 billion monthly active users. They also forgot that although ATT hurt Meta’s advertising business, it was still one of the best available and likely to continue to produce large amounts of cash flow. Meta’s network effects never went anywhere and were never likely to do so. It turns out that capex spending on the Metaverse aligned nearly perfectly with the boom in artificial intelligence. It also turned out that Meta was able to develop its own system to determine advertising effectiveness.
In reality, Meta’s intrinsic value never changed materially. The only thing that changed was investor perception and a shift in the mentality of the herd. If someone were to jump off a cliff, it wouldn’t make sense for the next person to do the same. Investing is no different. Don’t let one person’s bad decision become yours too.
Conclusion
Stock prices provide a reliable real-time gauge of the market’s current expectations for an investment. Investors who are able to interpret these expectations and anticipate future changes are more likely to achieve superior returns. The backwards thinking approach leverages discounted cash flow analysis but instead starts with price and then solves for implied operating performance expectations. Those who focus solely on short-term operating metrics are likely to underperform, as market pricing is driven more by the long-term.
Keeping the Feedback Loop Open
It is entirely possible that you disagree with a variety of the assumptions in this article. Rather than dismiss alternative analyses as wrong, we are better served by keeping our feedback loop open. If you would like to share your opinion and/or critique ours, please feel free to share your thoughts. One of the great aspects of investing is that if you get something wrong, you always have the opportunity to change it. Refusing to change a narrative just because it is yours is nothing more than hubris.
Jordan Bancroft, CFA, CAIA® VP/Portfolio Manager
jbancroft@bell.bank
Fargo
End Notes
¹Terminal value is the value of an asset beyond the explicit forecasted period when future cash flows are estimated. Terminal value represents when a company reaches steady-state growth.
²ATT is a privacy framework from Apple that requires iOS apps to ask users for permission to collect and share their data. Advertising companies such as Meta used this data to determine conversion rates on advertising. Without the ability to determine advertising effectiveness, digital advertising was less valuable and less certain.
Disclosures
This communication reflects the personal opinions, viewpoints and analyses of the Bell Institutional Investment Management (BIIM) employees providing such comments, and should not be regarded as a description of advisory services provided by BIIM or performance returns of any BIIM client.
The views reflected are subject to change at any time without notice. Nothing in this communication constitutes investment advice, performance data or any recommendation that any particular security, portfolio of securities, transaction or investment strategy is suitable for any specific person.
Any mention of a particular security and related performance data is not a recommendation to buy or sell that security. BIIM manages its clients’ accounts using a variety of investment techniques and strategies, which are not necessarily discussed in the commentary. Investments in securities involve the risk of loss. Past performance is no guarantee of future results.
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