The most important idea in investing.
This article incorporates elements of an article published in the January 2013 issue of Morningstar ETFInvestor. Download a complimentary copy here.
The main tasks of the active value investor are to estimate intrinsic value, buy assets trading at sizable discounts to their estimates, and sell or avoid those trading at premiums. The assumption is that asset prices can't help but gravitate to their fair values over time. However, history shows that prices can become untethered from fair value for years at a time and move in self-fulfilling cycles of fear and greed. A full account of investing needs to acknowledge and manage these short-term movements, but the beating heart of investing should always be fair value.
Many popular books on investing don't even touch upon the details of estimating intrinsic value as well as the conceptual apparatus justifying its use. I find that odd, as intrinsic value is perhaps the most important idea in all of finance. As Charlie Munger likes to say, not understanding basic quantitative investing concepts is like being "a one-legged man in an ass-kicking contest."
Being an active investor without understanding intrinsic value is a terrible mistake. But being a passive investor doesn't get you off the hook, either. Every once in a while, markets go nuts, and a passive investor with a strong grasp of fundamental investing concepts like intrinsic value can take advantage of the madness or at least avoid participating in it. A good example is when Treasury Inflation-Protected Securities sold off in late 2008--even normally passive investors such as Larry Swedroe identified in real time the incredible risk-reward payoff TIPS offered.
This article is the first part of a two-part series on intrinsic value, discount rates and expected returns, and how they relate to each other, as well as some practical advice on applying these ideas.
Time, Money and Risk
Before we get into intrinsic value and all that good stuff, let's talk about the relationship between money and time. When someone borrows money, he is pulling future earnings to the present. In a real sense, he is taking money from his future self and giving it to his present self. Likewise, when he lends money, he is taking money from his current self and giving it to his future self. The interest rate on borrowing or lending is the conversion rate at which money can be exchanged through time.
Interest rates differ, depending on the creditworthiness of the borrower. Suppose your uncle--call him Sam--wants to borrow $100 from you for 10 years, promising to repay $131 at the end, for an annualized interest rate of 2.7%. If he's anything like the typical uncle hitting up a nephew for cash to be paid back a decade hence, your wallet should be shut tight like a vise. You could, after all, lend to the other Uncle Sam--the one with the printing presses and nukes--for the same rate today and not run any credit risk. Lending to the less creditworthy uncle only makes sense if the interest rate he offers is high enough to be competitive with yields on similarly risky investments available to you.
Let's step back for a second. First of all, why can the U.S. government borrow money at the lowest rates possible? Because investors widely consider U.S. Treasuries to be "risk-free." The U.S. government has taxing power over a huge economy, a lot of accumulated good will, and control over its own currency. Furthermore, investors have been clamoring for safe assets since 2008 and are willing to tolerate low yields. Of course, Treasuries are not actually risk-free. Aside from negligible default risk, they bear reinvestment risk, the possibility that interest rates will unexpectedly rise, and inflation risk, the possibility that unexpected inflation eats away at the value of future nominal-dollar payments. Both risks usually show up as an upward-sloping yield curve: The longer a Treasury's maturity, the higher its interest rate.