I’ve been re-reading Howard Marks’ The Most Important Thing (which is excellent, of course) and an assumption he frequently relies on is the idea of “intrinsic value.” Marks is a portfolio manager and founder of Oaktree Capital Management. He has a Warren Buffet/Ben Graham-esqe value style of investing. Popular among bottom-up value fund managers, the basic idea of “intrinsic value” is what a company is really worth (in contrast to the current market price). Usually intrinsic value is based on cash flows or earnings or book value or some other discounting mechanism based on the company’s ability to make money in the future. The goal of the value investor is to buy companies trading below their intrinsic value, and then sell them when the company trades at or above intrinsic value; repeat. Find a “cheap” company, sell it when it is no longer cheap.
Or, in behavioral finance terms, buy an out-of-favor company, and sell it when everyone else in the market realizes you were right all along.
Now I want to draw a quick distinction. I’m not asking: Do stocks sometimes become oversold? or: Do cheaper companies outperform the market? It is well documented that the answer to both of these questions is a resounding Yes.
My question is: what is intrinsic value, and who decides it? Is there an Antiques Roadshow for common stocks where experts agree on the value of a stock? Is the intrinsic value of all companies based on discounted cash flows? Or do some stocks deserve higher multiples/lower discount rates due to their perceived quality or expected growth?
The core belief behind intrinsic value is “the market is wrong about what this stock is truly worth, which my models tell me is $X.XX. I can buy the stock for $Y.YY and when the market corrects its error, I will profit!” But where is it written that the market ever has to agree with the investor’s definition of intrinsic value? What if in the future investors are only willing to pay 8x earnings for stocks instead of the historical average of 16x? Or what if investors permanently decide stocks bear very little risk and multiples stick at 25x?
We like to use history as a guide, but the reality is that the concept of “value” is fleeting. All financial transactions are based on trust and confidence. We trust that the US Dollar will still be able to buy groceries tomorrow, we trust that a state government will make good on its promises to repay principal and interest on bonds, we trust that our favorite stock will keep being profitable and paying out earnings as dividends, and we trust that other people in the future will place the same (or higher) value on these things as we do today. In reality, there is no guarantee about that.
If you want to come to me and say “The intrinsic value of this stock is $45 because that is what investors have historically been willing to pay for these earnings so it is a buy at $30,” my simple question is: why isn’t the market willing to pay for those earnings today? Ultimately, intrinsic value is decided by the market. It is an odd bit of dissonance to state that today the market is wrong about a stock’s “intrinsic value” but to expect the market to get things “right” sometime in the future. There are no rules about what a stock, bond, currency, commodity, house, car, dog, cat, diamond, bicycle, soap dish, refrigerator, concert ticket, plane ride or glass of wine are worth. They are worth what people are willing to pay for them, which is what markets are all about. That’s the value.