Oct 07 2019
Lawrence Lam

How to determine if the trend is your friend

This article was first published in Livewire Markets, 18 September 2019: https://www.livewiremarkets.com/wires/is-the-trend-really-your-friend

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At a recent lunch with another fund manager, I found myself engaged in a discussion about the state of the current market, ‘From your perspective, are you seeing many good opportunities?’ I asked.

‘I’m seeing good companies, but prices are toppy,’ he said, wincing before continuing. ‘More than I’d like to pay. But we’ve recently deployed more anyway.’ He shrugged his shoulders, ‘Momentum in the market is strong – the fed is decreasing rates. Despite the high prices, we wouldn’t want to miss this momentum.’

I nodded as we both acknowledged this unique investment environment of decreasing rates and high stock valuations. Yet stock prices have continued to climb steadily.

Walking back to my office I reflected, and asked myself: ‘Is now a good time to be a momentum investor, or is it time to go against the herd?’

Look at a market cycle to assess how much is left in the tank

Momentum investors have much to gain if the wave of popularity is caught early. However, be the last one to the party and you will be left with all the cleaning up. The real question is: how much more of the wave is left to catch? The solution to this contradiction can be found by understanding the long-term context.

The ratio of a company’s stock price-to-intrinsic value tells us how much the market is willing to pay for the company. It’s a useful measurement of sentiment at one point in time. There’s a clear link between sentiment (the stock price) versus fundamental value (intrinsic value).

But it doesn’t give us the full picture. To understand this contradiction, we need to see how sentiment for the stock has changed over a significant period of time – over entire market cycles. Extend the ratio of stock price-to-intrinsic value over a 15-year horizon and you’ll now gain a multi-dimensional view of just how manic-depressive Mr Market is.

As an example, here is the change in sentiment for the founder-led aerospace electronics company HEICO Corporation.

During the GFC, Mr Market was very pessimistic. He was only willing to pay 1.8x the intrinsic value of HEICO. But alas Mr Market is as fickle as they come. More recently, he has been very bullish. He’s willing to pay 4.8x intrinsic value. A large proportion of the returns have been driven solely by the company’s increasing popularity with investors.

Now we have a better view of the context. Understanding the stock price and intrinsic value over a long time period equips us to answer the following question…

The worst time to join a party

There’s an interesting observation about parties. When do they end?

Answer? They end when the alcohol runs out. Rarely do they end immediately though; good times roll on for a while longer before the sudden realisation hits the sobering crowd.

So when is the worst time to join a party?

As you’re pondering the answer, here is another view of HEICO to illustrate the point.

Although the intrinsic value of HEICO’s business has consistently increased over time, the increase in its price has far outpaced the fundamental growth of the company. HEICO is a solid and growing company, but its impressive performance has been driven primarily by sentiment and price, rather than actual business value. The price-to-intrinsic value ratio shows this.

Risk is heightened when a company’s stock price outpaces its intrinsic value for significant periods of time. As crazy as Mr Market is, one thing is certain – his enthusiasm and pessimism never last forever. The gravitational pull of a company’s fundamental value is unrelenting.

The best time to join a party is when there’s plenty of alcohol and not too many people. But tread carefully when the crowd is pumping and booze is running low. Whilst the fun may continue for a while longer yet, the risk of an abrupt ending is heightened.

A ‘reasonable’ price

Pure momentum investing focuses predominantly on the historical price movement and pays little attention to actual fundamental value. But if you want to understand if a trend is justified, the fundamentals are critical.

Armed with this insight, we can make a judgement call on what a ‘reasonable’ price would be and whether we should join the party. Some sectors run hot. Today, technology is a classic example. But a strong trend shouldn’t be a deterrent. Prices may seem exorbitant, but in the context of the company’s historical sentiment, sometimes the high price is worth paying. What may seem expensive on an absolute basis may be reasonable in the context of history. For example, the price-to-intrinsic value of Facebook was high on an absolute basis in late 2018, but was reasonable when compared to its history. It has proven to be a good entry point so far.

But there’s more for enterprising investors – the picture is still not yet complete.

A deeper level of analysis

Competition

You may have noticed my focus on individual company analysis rather than broad-based economic generalisations. We are buying slices of companies after all. Whilst we can understand the sentiment in our target company, it is also important to have context across other comparable companies. The same price-to-intrinsic value historical ratio across a few companies will give us a sense of sentiment across the sector. We’ll be able to see if there are any other reasonably priced companies.

Potential growth

So far the focus has been on gaining historical context. Sometimes the momentum is justified if there are tangible growth prospects. In other words, intrinsic value is expected to grow significantly with price. In those situations, the trend may be your friend. For those that heard me speak at the AIA National Conference, I outlined my framework to assess the potential growth of a company.

Intrinsic value

Speculators focus on stock price movements only. Investors focus on the underlying true worth of a company.

As Warren Buffett says “Price is what you pay, value is what you get”.

The fundamentals of a company’s value is reflected in its Intrinsic value. Importantly, in determining a company’s intrinsic value, I’ve stripped out accounting distortions that may hide a company’s true worth.

So… Is the trend your friend?

If the fundamentals of a company are sound and the price is reasonable in the context of its history and other competitors, then the trend may indeed be an ally. Ride the wave and enjoy the party.

Price and intrinsic value may deviate for many years but price will eventually move towards intrinsic value over the long-term. Seeing the full picture is key to capturing sensible opportunities. In every party, everyone sobers eventually.

Happy compounding.

Note: HEICO has been used here as an example only, this article is not a buy or sell recommendation for any of the stocks listed.

About me

Lawrence Lam is the Managing Director & Founder of Lumenary, a fund that uncovers the best founder-led companies in the world. We invest in unique, overlooked companies in markets and industries beyond most managers’ reach. We are a different type of global fund – for more articles and information about us, visit www.lumenaryinvest.com

Lawrence Lam
Managing Director & Founder