OLD ARTICLE – Original posted on October 5, 2018
Fundamentals are what you get but valuation is how much you pay for it. The less you pay for a given set of fundamentals, the more you weight the odds in your favour that the investment will have a positive outcome.
Hence, even if fundamentals are poor but the valuation is low enough, it may tip a poor company towards being a great investment. Likewise, if you pay too much for a good company, then it may end up being a poor investment.
Thus, valuation is almost always a key topic for investors and the market in general. Broadly speaking, valuation always matters.
But could there be times when valuation doesn’t matter?
The short answer is: yes.
Instead of listing when valuations matter, let me rather list a series of examples for when valuation (probably) just doesn’t matter:
En route to zero:
Almost all bad businesses eventually go bankrupt. In this event, shareholders are the last in the queue to be paid and, typically, will receive pretty much zero of their capital back.
Hence, the valuation of a company and its share that is en route to zero just doesn’t matter.
Why pay any amount for a company that will likely become worthless?
For example, consider most of the listed construction sector in South Africa. Does valuation really matter here for most of these near-bankrupt counters? It will definitely matter for the survivors but (other than probably Afrimat, WBHO, Raubex and Stefanuti Stocks) who are going to be the survivors?
Never going to “unlock” the fiefdom:
Some companies (especially some investment holding companies) have created artificial fiefdoms around their management teams and/or key shareholders or executive. These companies have wide moats protecting those in control of the boardroom. While these companies pretend to exist for shareholders, they, in fact, exist to remunerate their “controlling” management richly through various structures.
For example, consider Naspers (NPN) that is trading at a discount to its major investment, despite holding a large portfolio of paper-rich investments (that are all pretty much loss-making). Notice how the mysterious -N- structure protects this management team from being fired by public shareholders? Who is running Naspers for whom?
(There are many ways of extracting value out of a company without owning its ordinary shares. Just ask MTN about Nigeria…)
OK, saying that Naspers’ valuation doesn’t matter is quite extreme, but consider for example Grand Parade Investments (GPL) and African Equity Empowerment Investments (AEE) as potential examples of fiefdoms that may never unlock their “discounts” to NAV.
Activist investors (with sufficient capital) and/or private equity can sometimes unlock the values embedded within these shares (look at what is happening at Grand Parade right now), but in many an instance the management has entrenched themselves too deeply and cannot be shaken out.
Hence, it just does not matter what “discount to NAV” or other valuation metric exists these shares trade at, as the companies do not (really) exist for shareholders. There will never really be an unlock of value in some of these and, thus, the valuation just doesn’t matter.
Fraud, “dirty data” & known unknowns:
For valuations to matter, the inputs must be reasonably reliable. Hence, valuations depend on the actual assets, liabilities, incomes and expenses that a business holds, owes, earns and pays.
Forecasting the future is hard enough, but also having an uncertainty about the present and the past just makes this task utterly impossible.
The existence of fraud (especially, large-scale, systemic fraud) creates the risk of dirty data and implies that the valuation’s inputs are potentially unreliable. Hence, the valuation is unreliable. This is true even if it is not fraud, per se, but just misstatements, inaccuracies or very poor disclosure.
Essentially, if you cannot rely on a company’s financial statements, then you do not know what you are actually investing and, thus, valuation does not matter.
For example, obviously, look at Steinhoff (SNH) but this is not the first and it won’t be the last either.
I admit that there may be plenty of other special circumstances–like lack of liquidity–when valuations don’t really matter much. I tend to view many of these situations as creating discounts in valuations, though, and this is not the same as making a valuation worthless.
Likewise, just because you can build a valuation, it does not mean that the figure you arrive at is the cosmic truth.
Valuations are just risk-adjusting future scenarios to arrive at a balanced view of a reasonable price that will generate a reasonable return on capital (and then comparing it to the share price). The future, though, does not play out on a risk-adjusted basis, but in a binary manner (when the future becomes the present, there is only one version of it).
Thus, only one future actually turns up with only one outcome and only one value being realized.
Despite the above scenarios that nullify the merits of valuations and the binary nature of outcomes, valuations are the still the single best tool we have to managing risk and making sure that we tip the scales of fundamentals in our favour.
In other words, valuations pretty much always matter.