Intrinsic Value Lessons
1. Auto pilot rules to fight behavioral minefields: If you are wondering why I put in limit orders on both my Apple short sale and my covering trades on both stocks, it is because I know my weaknesses and left to my own biases, the havoc that they can wreak on my investment actions. I have never hidden the fact that I love Apple Inc. (NASDAQ:AAPL) as a company and I was worried that if I did not put in my limit short sell order at $230, and the stock rose to that level, I would find a way to justify not doing it. For the limit buys to cover my short sales, I used the 60th percentile of the value distribution, because my trigger for buying a stock is that it be at least at the 40th percentile of its value distribution and to be consistent, my trigger for selling is set at the 60th percentile. It is my version of margin of safety, with the caveat being that for stocks like Amazon.com, Inc. (NASDAQ:AMZN), where uncertainty abounds, this rule can translate into a much bigger percentage price difference than for a stock like Apple, where there is less uncertainty. (The price difference between the 60th and 90th percentile for Apple was just over 10%, whereas the price difference between those same percentiles was 35% for Amazon, in September 2018.)
2. Intrinsic value changes over time: Among some value investors, there is a misplaced belief that intrinsic value is a timeless constant, and that it is the market that is subject to wild swings, driven by changes in mood and momentum. That is not true, since not only do the determinants of value (cash flows, growth and risk) change over time, but so does the price of risk (default spreads, equity risk premiums) in the market. The former occurs every time a company has a financial disclosure, which is one reason that I revalue companies just after earnings reports, or a major news story (acquisition, divestiture, new CEO), and the latter is driven by macro forces. That sounds abstract, but I can use Apple and Amazon to illustrate my point. Since my September valuations for both companies occurred after their most recent earnings reports, there have been no new financial disclosures from either company. There have been a few news stories and we can argue about their consequentiality for future cash flows and growth, but the big change has been in the market. Since September 21, the date of my valuation, equity markets have been in turmoil, with the S&P 500 dropping about 5.5% (through November 30) and the US 10-year treasury bond rate have dropped slightly from 3.07% to 3.01%, over the same period. If you are wondering why this should affect terminal value, it is worth remembering that the price of risk (risk premium) is set by the market, and the mechanism it has for adjusting this price is the level of stock prices, with a higher equity risk premium leading to lower stock prices. In my post at the end of a turbulent October, I traced the change in equity risk premiums, by day, through October and noted that equity risk premiums at the end of the month were up about 0.38% from the start of the month and almost 0.72% higher than they were at the start of September 2018. In contrast, November saw less change in the ERP, with the ERP adjusting to 5.68% at the end of the month.
Plugging in the higher equity risk premium and the slightly lower risk free rate into my Apple valuation, leaving the rest of my inputs unchanged, yields a value of $197 for the company, about 1.5% less than my $200 estimate on September 21. With Amazon, the effect is slightly larger, with the value per share dropping from $1255 per share to $1212, about 3.5%. Those changes may seem trivial but if the market correction had been larger and the treasury rate had changed more, the value effect would have been larger.
3. But price changes even more: If the fact that value changes over time, even in the absence of company-specific information, makes you uncomfortable, keep in mind that the market price usually changes even more. In the case of Apple and Amazon, this is illustrated in the graph below, where I compare value to price on September 21 and November 30 for both companies: