Last week, I published the third post in my Stock Picking series (see Parts I, II & III), and it got me thinking – I haven’t seen a good mystery/blind stock challenge in a long time! There’s obviously tonnes of great investing advice out there to harvest, but the lessons we really take to heart are those we learn via trial & error, and hard won experience…
As I’ve been banging on about, stock picking is really composed of two very distinct processes: Stock Valuation & Stock Selection. But investors often tend to confuse & conflate the two… Just like meeting a person for the first time, stock selection often boils down ultimately to a first impression – a gut feeling Company X is dodgy/above-board, enjoys positive/negative investor sentiment, is well/poorly run, always/never delivers, is high/low growth, is financially weak/bullet-proof, has huge/no business or upside potential, etc. Basically, we’re making a snap decision whether it’s a good or bad company…
Such first impressions often exert a substantial & pernicious influence on our stock valuation process. We cherry-pick data, we discern & extract more favourable or unfavourable trends, valuation multiples contract or expand, inconsistent ratios are conveniently ignored, etc. etc. Given similar financial/operating histories, quite often we (wittingly, or unwittingly) end up arriving at radically different valuations for different stocks/companies.
Of course, their respective prospects may entirely justify wildly different valuations. Sure, but for the majority of companies, they generally don’t experience hockey stick growth out of the blue, nor do they suddenly fall off a cliff… [Novice investors are particularly susceptible to the ‘hockey stick’ assumption, blithely ignoring the fact they/other investors have sometimes been waiting years already for the same exceptional growth surge!] In reality a company’s future tends to reflect its past, good or bad, far more often than investors might credit – its management & culture, for example, can be a powerful institutional imperative ensuring this is true.
Multiply this potential for valuation bias across all investors, and inevitably you tend to end up with a pretty inefficient/irrational market…at least in terms of individual stocks & sectors. [Ooh, the heresy!] But a mystery stock challenge can wonderfully illustrate how under/over-valued individual stocks can actually become in the market. Plus it’s a highly effective way to separate the (quantitative) stock valuation process from the (more qualitative) stock selection process – and when the companies stand revealed, investors can examine (individually & in aggregate) their stock valuation process & potential biases in a far more detached and objective fashion. Ideally, it also provides some up-close insight into the perspectives & valuation techniques of a broad selection of investors.
But obviously I can talk more about this in my follow-up post, and reader response & results will also be highly relevant! So, onward to the main event, let’s introduce you to four mystery companies I’ve chosen for this exercise – just for shits & giggles, I’ll call them the Four Mystery Horsemen:
Conquest, War, Famine & Death!
As per usual with these challenges, I’m only providing selected data for each company – too much for some perhaps, too little for others… But I should stress, I haven’t set out to deliberately cherry-pick flattering/unflattering data. And if I shifted the dates/timeline by a year or two, there really wouldn’t be any drastic change in terms of ratios & growth rates. I’ve also re-based each company’s revenue to 1 billion & normalised accompanying data accordingly – hopefully, this deters people from playing guess the company! Here’s the data:
And here’s the Excel file version: The Four Mystery Horsemen
[NB: All amounts in millions (ignore currency). LTM = Last Twelve Months. CAGR = Compound Annual Growth Rate. For each company, LTM Revenue & Adjusted Net Income (as provided by management) are taken from the latest annual (and/or interim/quarterly) P&L. LTM Depreciation & Amortisation, Free Cash Flow & Net Cash Interest Paid are taken from the Cash Flow Statement, while Net Debt & Pension Deficit is taken from the latest Balance Sheet. Revenue & Adj Net Income are provided from 5 & 10 years ago (except for Conquest, 10 yrs is N/A). For convenience, I also provide 5 & 10 yr Revenue & Adj Net Income CAGRs. And finally, I include 5 & 10 yr Adj Diluted EPS CAGRs to highlight any share issuance/dilution over the years.]
Now, different stock challenges demand different results…I’m not looking for your margins of safety here, or prices at which you’d actually buy or sell these companies. I’m also not asking you to estimate what current market valuations might actually be, or the average valuations readers might submit, or even these companies’ enterprise/take-out valuations. What I’d actually like to see is your best estimate of each company’s current Fair/Intrinsic Value (in terms of its Equity capitalisation):
i) Conquest: X Millions, Fair Value of Equity
ii) War: X Millions, Fair Value of Equity
iii) Famine: X Millions, Fair Value of Equity
iv) Death: X Millions, Fair Value of Equity
[NB: It’s reasonable to assume this Fair Value should/would approximate each company’s actual equity market cap…on average over time]:
Also, if you had to choose going long one company & short another, which would they be? [Without actual market caps to reference, this is obviously a call based purely on your qualitative judgement and/or gut feeling…]:
v) Long: Company X
vi) Short: Company Y
Obviously, I’d greatly appreciate if you’d comment on/explain/justify your valuations & your long/short (as detailed, or as brief, as you wish). Ideally, this is the most interesting part of the exercise, so please share with other readers by responding via the Comments section of this post. [If you’re feeling bashful, please respond to firstname.lastname@example.org instead, with an email titled ‘Four Horsemen’]. [And if by any chance, I’ve missed something here which needs obvious clarification, please comment/email me & I’ll post a comment/edit accordingly]. Ideally, please respond within the next week, as I’d like to publish a timely follow-up post.
So go on, have a go…the more readers who participate, the more useful & interesting this challenge becomes. And remember, comments are anonymous (if you wish), and I certainly don’t intend singling out anybody in particular – well, unless they happen to really nail one (or more) of these companies’ actual market valuations! And please email/tweet/share this post & challenge with anybody else who might be interested in reading and/or participating. Thanks!
[EDIT (01-Mar-2015): In the comments here & the emails I’ve received, what seems like a crucial question & stumbling block for many readers is the shortfall in each company’s free cash flow vs. adjusted net income:
Specifically, is this a recurring shortfall, or simply a once-off..?!
Well, I did stress I hadn’t cherry-picked data, and that shifting dates by a year or two shouldn’t mean any drastic change in ratios & growth rates…obviously cash flows are volatile, but broadly speaking this applied to free cash flow also. To better illustrate, I’ll include one final set of data points here – each company’s Free Cash Flow vs. Adj Net Income ratio for the Last Twelve Months (which I’m sure you’ve already calculated), and the same ratio over the Past 5 Years:
Conquest: LTM: 36% Past 5 Yrs: 62%
War: LTM: 40% Past 5 Yrs: 29%
Famine: LTM: 52% Past 5 Yrs: 50%
Death: LTM: 43% Past 5 Yrs: 65%