By Raj Sharma
Raj Sharma has 12 years’ teaching experience as a Golden Gate University Adjunct Professor teaching Equity Analysis. He is also a Portfolio Manager at Polestar Capital LLC, a value-driven, contrarian investment fund and research boutique, which he founded in May 2005.
Golden Gate University has a reputation for focusing on the real skills our students will need today and are taught primarily by people currently working in their fields. Like many of my peers at GGU, I teach a very practical course and draw on my current work as a securities analyst. No textbooks allowed! Here are a few of the fundamentals of analyzing companies that I teach, and what I call a contrarian attitude that can be profitable in the long term:
- A detailed and instinctive look at financial statements going back a decade – financial history of a company can tell us a lot about the likelihood that this company would succeed in the future.
- Studying and understanding the culture of a company and how important it is in determining future success.
- An opportunistic look at strong companies during times of minor missteps and bumps – affording them attractive valuations for investment.
Recent News in the Market
Tesla’s dramatic rocket display may not mean that the actual value of the stock is going to get to the Red Planet. Tesla seems to be everyone’s darling now; but you can, as a professional investor, ask pointed questions. Is there new competition? Well, VW says they are going to put 3 million electric cars out by 2020, and Tesla barely makes 300,000.
When Amazon bought Whole Foods that was big news, but it is best to talk about specific situations that a given company may face—not just M&A. Amazon also announced this year a potentially market-changing partnership with Berkshire Hathaway and J.P. Morgan announced focused on healthcare. Many questions have to be answered to make investment decisions based on this news. What does that do to the existing companies? What happens to CVS (pharmacy benefit manager) or Walgreens (pharmacy stores) or McKesson (drug distributor)?
It is essential to understand what consumers want and what are the demographic trends influencing the healthcare companies. And what is the industry structure that serves these aging consumers? Everyone complains that healthcare costs are high and you can cut costs, but cutting costs (and austerity) also brings down the overall GDP contribution of this massive industry and who likes GDP reductions! Which companies in this space will be best positioned to help reduce healthcare costs while improving outcomes for their consumers and for the country?
Like many of my peers at GGU, I teach a very practical course and draw on my current work as a securities analyst. No textbooks allowed!
IPOs and Tech Stocks in the Silicon Valley
Tech companies have had a huge impact on our lives and on the economy of the country. How to best invest in tech companies at levels and valuations that seem to head into the stratosphere every day making them riskier investments. Not all tech companies are risky though, and a careful analysis of their business models, their competitive positioning and their balance sheets can help an analyst and an investor separate the wheat from the chaff! Tesla on one had may appear sexy appear to have a lucrative future but investing in it at today’s levels could be fraught with significant capital loss! On the other hand, certain leaders like Amazon, Apple, and Google could still be excellent investments into the future.
As recently as ten months ago, the market had assigned Apple shares a low value because of repeated concerns that Apple was just a hardware company with a massive reliance on iPhones as its primary source of revenue and that all hardware companies eventually approach zero-margin profitabilities. When you do the fundamental analysis the right way, you see that the company exists in a broader ecosystem. When consumers use an iPhone or iPad, they don’t want to switch out because there is a time hurdle. That user base can keep consuming and add to revenues.
Apple is not a hardware company but more of an ecosystem with a massive installed base that should get a much higher multiple than usual hardware companies. It is not just that you sold someone a printer knowing that people don’t buy printers every year, so you price it really cheap (at zero margins) so that you can get lucrative printer ink business from these consumers till they come back for a new printer (and ink) from you. What Apple has done (and is doing) is creating an ecosystem that is very successful at keeping its users happy and satisfied, consuming digital products and expanding the ecosystem at solid profit margins – such ecosystems should sell at higher valuation multiples than the ones accorded to low-margin hardware companies!
The actual price of a stock relates to the mood of the market and to the current attitude to the industry that it is in. Being a contrarian can help. Being a contrarian versus going with the herd, your answers from a disciplined analysis can often be very counter-intuitive.
I teach that it is very important to know invest in what you know. Buying a great company is important but so is buying the great company at a reasonable price – and that usually only happens for great companies if they are experiencing an operational hiccup or are currently out-of-favor in the market. The actual price of a stock relates to the mood of the market and to the current attitude to the industry that it is in. Being a contrarian can help. Being a contrarian versus going with the herd, your answers from a disciplined analysis can often be very counter-intuitive. When everything is “hot,” and things look great, it is typically not a good time to invest. People and investors have pushed the stock up in their excitement.
If you generally buy businesses only when all the news is positive, it may not pay off in the long run. If you buy based on this confirmation bias (that trends will continue) — and your friends are saying that you will always make money on this company – you may be falling into a psychological trap. Smart investors go step back and be skeptical of this hype. When there is fear in the market, be “greedy” and roll up your sleeves and get to your analytical best and deploy the cash into solid companies at hopefully reasonable prices!
When Bad Things Happen to Good Companies
Contrarian investors may step back when there is hype. This is an important mind-set and skill set that feeds the ability to spot what I call a “contrarian situation.” You can look for solid businesses that are run by smart people and have competitive advantages. If they are having issues, the market may see them as a big deal because they are focused on the short term. Buying when a great company has had a misstep or people are questioning their strategy can be something to consider. After your analysis, you may realize the company may work through the current problem.
A way to see if you’re paying a good price for a great or a good company is to use its steady state (past three years’ average) free cash flow and estimate its present value. If the company is not growing much at all but its free cash flows are steady and very reliable then that $1 in annual free cash flows should have a value of at least $1 divided by the average return you would expect from a company in the U.S. to yield on a yearly basis
Getting Going in Investing Research
Valuation of the company is as important as picking a good or a great company to invest in. Warren Buffet is fond of saying that it is far better to buy a great company at a good price than a good company at a great price. A way to see if you’re paying a good price for a great or a good company is to use its steady state (past three years’ average) free cash flow and estimate its present value. If the company is not growing much at all but its free cash flows are steady and very reliable then that $1 in annual free cash flows should have a value of at least $1 divided by the average return you would expect from a company in the U.S. to yield on a yearly basis. That average over the last 100 years has been around 10%, to keep things simple and to be able to compare different companies using the same discount rate.
So perpetual free cash that flows to you from a steady, no-growth, solid company should be worth at least $10 ($1/0.10). I should be willing to pay $10 for a $1 in annual free cash flows from an asset with no growth or a Price-earnings Ratio (P/E) of 10x ($10 value / $1 in free cash flow). Now if you know that this company is growing and is expected to grow at least 5% a year for a long time, the value of that steady state $1 becomes $1 / (discount rate of 10% minus growth rate of 5%) or $20. The P/E on this growing asset is then 20x ($20 / $1) accounting for the growth in the free cash flows every year. If the asset is not growing it is worth $10 and if it can continue to grow its worth $20. Now, this is a modest risk company in the U.S.
If the company resides in an emerging market with greater market and political risks, then we would use a discount rate higher than 10%n (because we should expect a higher return in this riskier situation) and subsequently get a value lower than $10 for no growth and lower than $20 for growth. Again this is a way to put a conservative value on a $1 in free cash flows in the market. Now you may say the discount rate to value a stream of free cash flows should be a lot lower — in case you haven’t noticed the historically low interest rates in the US! That’s why we take a super long-term average of the discount rate to see how companies would compare apple to apples.
More about Raj Sharma
Prof. Sharma is currently Portfolio Manager of Polestar Capital LLC, a value-driven, contrarian investment fund and research boutique, which he founded in May 2005. Prior to Polestar, he was a Managing Director, Equity Research, at Merriman, Curhan, Ford & Co., a boutique investment bank in San Francisco where he covered specialty growth companies and special situations. Before Merriman, he was a co-founder of Landmark Research Group, active in the last few years in advising U.S. hedge funds, mutual funds and corporate clients in investment strategy. Prior, Mr. Sharma was Vice President at Onyx Partners, Inc., an investment banking and buyout boutique analyzing equity and mezzanine debt investments in companies in various industries in the U.S. Mr. Sharma was responsible for due diligence, financial analysis and operational nurturing and turnaround management of portfolio companies. Prof. Sharma is passionate about pursuing leading, successful companies as long-term investments and is particularly interested in those companies that excel in business and in social responsibility. He counts Warren Buffet, Peter Lynch, and Joel Greenblatt as his primary influences in the shaping of his investment philosophy. Mr. Sharma has an MBA in Finance from the McCombs School of Business at the University of Texas at Austin and a BS in Engineering from the Indian Institute of Technology (IIT) at New Delhi, India.