Regular readers of my work will attest to the fact that I am an avid proponent of valuation. So much so, that I cannot recall writing an article where I didn’t discuss the importance of only investing in a stock when it was fairly-valued, or better yet – undervalued. This obsession with valuation inspired one reader to dub me as “Mr. Valuation.” Frankly, it is a mantle that I covet proudly. I bring this up for an important reason. Long-running bull markets like we’ve been in since the end of the Great Recession are very difficult markets for value-oriented investors to navigate.
The reasons are simple and straightforward. First, it is very difficult to find attractively valued stocks when investor sentiment is wildly optimistic. Rising stock prices lead to investor overconfidence which often further leads to complacency. Consequently, valuations based on fundamentals, even when they reach dangerous levels, are easily ignored. Rationalizations overtake logic; therefore, bull markets can persist far beyond reason.
This exuberant environment is a scourge to value investors like yours truly. As a result, I have often lamented to clients that I live in money manager hell. At precisely the time when clients are lavishing me with compliments (the height of bull markets), I find myself in a state of what can only be described as depression. All I see is danger, while all clients see are the recent profits even when they are unjustified by fundamentals.
However, reality inevitably takes its toll. Unfortunately, the “when” is rarely predictable but inevitable nevertheless. Consequently, selling overvalued stocks that have performed far above what fundamentals dictate creates client unrest and even reprimands, even though it’s the right thing to do. This leads me to sharing what I found as fascinating comments on an article I read on 3M Company (MMM) while conducting research for this article. I will provide excerpts of these comments, but the authors will remain anonymous.
To me, this first comment was both on the money, and perhaps the most interesting: “Same company it was 3 months ago. You should be buying now.”
This comment led to a second comment that I also considered credible: “Correction: you should have been selling 3 months ago.”
However, this third comment was the inspiration to the title of this article, and I believe speaks to what I have written above: “You realize both could be true right? Anyone with a crystal ball might have sold 3 months ago and could be buying now. I personally don’t have a crystal ball, so I’ll just stay long and sleep well.”
The Importance and Benefit of Being Grounded in the Principles of Valuation
In my opinion, possessing a firm grasp and understanding of fundamental valuation principles is as close to having a crystal ball as investors can get. Admittedly, understanding valuation will not serve as a perfect short-term market timing tool, but nothing ever has, will, or can. However, understanding the principles of fair valuation will empower investors towards making sound and prudent long-term investing decisions. But most importantly, and in the same vein, understanding valuation can help prevent investors from making obvious mistakes.
On the other hand, sensible investors should also recognize that calculating fair valuation precisely is not possible. There are many nuances to ascertaining fair value. This simply means that there is no one-size-fits-all valuation metric or equation. Consequently, when dealing with valuation, it’s enough to be essentially correct. Part of the reason for this is that valuation is really a measurement of rational ranges of value. Stated more directly, it’s rarely about a precise P/E ratio or a precise price to cash flow ratio, etc. Instead, valuation is best thought of as an array of prudent measurements. Warren Buffett once stated this perfectly when he said: “It is better to be approximately right than precisely wrong.”
3M Company: FAST Graphs Analyze out Loud Video
3M is a perfect example of a blue-chip Dividend Aristocrat company where Mr. Market has a long history of valuing it at a higher multiple of earnings than other lesser quality companies with similar fundamentals. On the other hand, the correlation between price and operating cash flow for this Dividend Aristocrat is most profound. Consequently, with the following FAST Graphs analyze out loud video, I intend to demonstrate that 3M is better valued based on operating cash flows than it is based on operating or even GAAP earnings. When it comes to valuing a business, there is more than one way to skin a cat.
Summary and Conclusions
As illustrated in the video, 3M was clearly overvalued in 2017 and the beginning of 2018. Since that time, and because of its high valuation, the company’s stock price has fallen approximately 20% off its high set in late January 2018. However, even after such a precipitous drop I would currently consider the company fully valued. To be clear, I do not believe it is overvalued any longer, but it is not yet a bargain either. On the other hand, this high-quality blue-chip Dividend Aristocrat might be worth keeping a careful eye on. For those that are already long the stock, I would rate it a hold.
Disclosure: No position.
Disclaimer: The opinions in this document are for informational and educational purposes only and should not be construed as a recommendation to buy or sell the stocks mentioned or to solicit transactions or clients. Past performance of the companies discussed may not continue and the companies may not achieve the earnings growth as predicted. The information in this document is believed to be accurate, but under no circumstances should a person act upon the information contained within. We do not recommend that anyone act upon any investment information without first consulting an investment advisor as to the suitability of such investments for his specific situation.