Buying and Selling: When Opportunity Knocks

A few weeks ago, I wrote about the fat-pitch approach to stock investing. In short, this method involves patiently waiting for the opportunity to invest in wide-moat companies at the right price. 

It sounds simple enough, but as you've probably discovered, those firms with the best long-term potential often have price tags reflecting their prospects. So how exactly might a fat-pitch opportunity come to pass? 

As it turns out, not everyone calls pitches the same way we do at Morningstar. Different types of investors have varying assumptions, outlooks, and motivations when valuing stocks. And as you'll see, these differences can occasionally be the windup to the fat pitch you've been waiting for.

Our Approach
Morningstar publishes research on about 500 companies, and estimating a fair value for each of them takes up a good deal of our analysts' time. Here's how we define fair value:

The sum total of all future free cash flows of a company, discounted to the present at a rate commensurate with the riskiness of the cash flows.

As you can see, there are two explicit components to this type of fair value, which I'll refer to as the "intrinsic" fair value throughout this article:

1. An estimate of the sum total of all future free cash flows
   
   Will  Advanced Micro Devices (AMD) still be around in 10 years? Will  Flextronics International (FLEX)? How about  JDS Uniphase (JDSU)? How about in seven years? In 12? Who knows? But to value a stock, we have to make an assumption about the company's life span in order to estimate future free cash flows. Sometimes this is easier--it's likely that  PepsiCo (PEP),  General Electric (GE), and  Wal-Mart (WMT) will still be around in 20 or 30 years. But even so, how is it possible to know what their cash flows will look like that far out?

   The answer: It's not. It is possible to make an educated guess, however, and that's what we do. In fact, that's what all long-term investors do when they attempt to place an intrinsic fair value on a stock, whether they're using the price/earnings ratio, the PEG ratio, the price/book ratio, or a discounted cash flow model such as ours. It's all the same thing--figuring out if the current price accurately discounts the long-term free cash flows of a business.

2. An estimate of the riskiness of the cash flows
   
   The discount rate we use for a company is based on the level of confidence we have in our projections of future cash flows. We don't really care much about the volatility of those cash flows per se, just the accuracy of the sum total. In essence, what we're trying to conjure up is the probability that we're overestimating a company's future prospects. For predictable companies such as  Coca-Cola (KO) or  Gillette , we use a low discount rate. For unpredictable companies, such as  Check Point Software Technologies  (CHKP) or  PMC-Sierra , we use a high rate because the odds are much greater that our long-range estimates won't pan out.

These are the explicit assumptions that go into our valuation model. But embedded within our methodology are at least three implicit assumptions:

1. Our customers are long-term investors.
2. Our way of looking at the market is the "right" way.
3. Eventually, Mr. Market (Ben Graham's fictional character) will agree with us.

Other Time Horizons and Motives
There are many different submarkets within the stock market, and thus, many different fair values for a stock depending on who's doing the valuing. Consider the following:

• The submarket for corporate control: Plenty of companies have been acquired at prices above what our analysts would consider to be intrinsic fair value, yet that doesn't stop these firms from being acquired. Fair value for an acquirer may be different than fair value for a minority shareholder, because an acquirer is often willing to pay a premium to own all the shares to control the strategic direction and management of a company. We don't factor this control premium into our fair values because we don't assume that our average customer will be buying whole companies.
   
• The submarket for short-term gains: This is probably the most visible and important submarket because it creates the most opportunity for long-term investors. People who play in this submarket don't really care what intrinsic fair value is--they care whether a stock will go up (if they're long) or down (if they're short) in the next few minutes, hours, days, weeks, or months. They use technical analysis, momentum, money flows, or other nonfundamental indicators for an idea of where a stock might head in the near future. These market participants aren't investors, they're speculators, but they do affect stock prices.
   
• The submarket for dividends: Some investors, particularly those who need regular income from their stock portfolios, place a premium on stocks that have high dividend yields. These investors aren't so much worried about the future total return of a stock, but its dividend stream over the next one to five years.
   
  Morningstar analysts don't factor a premium into a stock's intrinsic fair value just because it has a high dividend yield. We assume our customers are more interested in a stock's total return, including a mix of capital gains and dividends, rather than just a high dividend yield regardless of the potential for capital appreciation. Thus, stocks that consistently carry a high dividend yield will often look slightly overvalued, or at best, fairly valued, under our valuation methodology. But a lot of market participants don't care--they'll hold on to a stock even if it's overvalued based on its intrinsic fair value, because they need the dividend income. That means high-yield stocks rarely sell below the fair values we calculate, and rarely make it to 5-star status under our system.
   
  You might ask why short-sellers don't come in and drive these stocks down if they get too far above their intrinsic fair values. Short-sellers avoid high-yield securities because these stocks typically aren't volatile enough to be interesting. Plus, the dividend yield is inverted on a short sale; a 5% yield to a stockholder becomes a
  -5% yield to the short-seller. Short-sellers lose money every time a company pays a dividend.

More Submarkets
There are, of course, other submarkets within the broad stock market. Examples include the submarket for highly liquid mega-cap stocks (large mutual funds can't invest in small, thinly traded companies), the submarket for companies with earnings momentum, the submarket for companies that are inversely correlated with other stocks in times of turmoil (e.g., gold mining stocks), the submarket for stocks that Warren Buffett has been buying, the submarket for stocks that will benefit from a modernization of the Chinese economy, and the submarket for stocks that look good on paper just as a fund manager is getting ready to send out his quarter-end report to shareholders.

So, at any given time, various submarkets within the stock market are inefficiently priced--and more often than not, they're overpriced compared with their intrinsic fair values. Often, participants in these various submarkets are willing to pay a premium for stocks that meet their coveted criteria, and these stocks temporarily sell above their intrinsic fair values. Eventually, though, this divergence will correct itself--it's not a matter of if, but when.

All these different submarket participants interact daily, and the average of all their valuation guesses shows up in a stock's closing price. Different investors have different motives for buying a stock, and different time horizons for holding on to it. So it's no wonder they also have different estimates of fair value for the same security. Typically, this whole process results in a reasonably efficient market, but there are times when things get way out of whack, when one market subset dominates the trading in a stock, causing a wide divergence between price and intrinsic fair value.

And that's when things get interesting.

The Market for Long-Term Total Returns
Based on this discussion, it seems possible to isolate the three crucial ingredients of successful long-term investing:

1. The ability to identify when a submarket is dominating a stock's price.
2. The ability to act fast when you identify this situation.
3. The discipline to do nothing unless you can identify this situation.

In plain English, this means your goal is to figure out when a stock is inefficiently priced for no other reason than sentiment. When market participants who do not have the same time horizon and motives you do are negative on a stock, and your estimate of its long-term cash flows hasn't changed, it's time to back up the truck. This doesn't happen too often, but when it does, it's a beautiful thing.

When the opposite happens--market participants with a different time horizon or set of motives are high on a stock--consider taking some money off the table, or at least refrain from buying any more shares.

In the absence of these conditions, do nothing. Hold on to your stocks and wait for an opportunity.

Next week I'll discuss some practical ways to do this.