I made my very first investment when I was 12. The news said that the price of Beanie Babies would double, triple or even quadruple in price in a very short period, which to me sounded like the perfect opportunity to invest my hard-earned chore money. Today, I only have one of those Beanie Babies left – a well-loved white snow leopard that my five-year-old sleeps with every night called “Blizzard”. Considering that a brand-new Blizzard sells for about $5 on eBay in today’s dollars, I would say that my very first investment decision was a rather poor one.
Perhaps if I could travel back in time, I would tell 12-year-old me that the “Beanie Babies prices will go up so buy!” investment thesis is not a strong one and that I’d derive more joy buying Pogs or the (original) Tamagotchi instead. Today, I (and all of QV) use more objective and quantifiable ways to measure current value and predict future value. We look for evidence that a company is a disciplined deployer of capital, with sustainable competitive advantages and the ability to access capital to fund its future growth ambitions. We also believe that while some companies deserve to trade at higher valuations, no company is so great that it is “priceless”. While holding these investment values have meant that, from time to time, we have been outbid by other investors for shares of companies that we would otherwise have liked to invest in, we believe that paying too much for even a great company can still generate permanent losses. Value is ultimately what someone else will pay you for your asset at some point in the (hopefully distant) future. Without a concrete investment thesis or valuation framework, we would contend that it is much easier to lose conviction in what you own, increasing the risk that you may well exit an investment at the wrong time for the wrong reasons and face permanent loss of capital.
One of the reasons why we don’t own some of the very high growth companies in the Canadian technology space is because we have a difficult time envisioning how these companies can grow at the rate they need to grow, for the duration they need to grow at, to justify some of the valuation levels they have traded at. For example, in our internal intrinsic value exercise, we estimate that if Shopify stayed in a hyper growth phase for one less year than our base case assumptions, our estimate of intrinsic value of the company could drop by as much as 20%! Of course, we could dispense of valuation and discounted cash flows as frameworks of investment and just draw lines on a graph to extrapolate the share price. We could also simply point to other similar peers and say, “well those guys are even more expensive, so this makes sense.” We don’t believe the latter two methods create strong and defendable investment theses, and they wouldn’t give us the confidence to hold onto our investment during market volatility. Perhaps the volatility we have been seeing in the last few trading days illustrates that this sentiment is not shared just by ourselves.
A common argument is that without being sufficiently flexible on valuation, we risk compromising our ability to deliver strong returns for clients. For short periods of time, that could happen. However, over a longer period, we believe we can generate comparable returns without taking excessive valuation risk. For example, in the depths of the 2020 market selloff, an investor could have bought the largest Canadian company, Shopify, or the second or third largest Canadian companies, Royal Bank or TD. Nearly two years later, all three investments have yielded comparable excellent total returns, between 85% and 93%. However, as the chart below shows, an investor could have achieved a similar return with considerably less volatility. In our books, we feel comfortable in our decision to own Royal Bank and TD, but not Shopify.
Source: Capital IQ. Total Return denominated in $CAD