A PlainStripes Letter on Discipline, Mispricing, and the Long Game

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Two founders. One price tag.

Both are offered 20% of a small service business for $500,000. Unglamorous; facilities management, steady contracts, nothing that makes a good dinner-party story.

The first founder thinks: “The multiple seems fair. Comps in this space trade around here.”

The second founder thinks: What does this actually earn not on paper, but in cash? What can I take out without shrinking what I put in? And what am I paying for each dollar of that cash?

Same price. Same business. Completely different mental models.

Only one of them is thinking like a value investor.

I. What “Value” Actually Means — Beyond the Caricature

Value investing is a term with a PR problem. People who use it are often thought of as old men hunting for low price-to-earnings ratios and waiting forever for “the market to realize the value.” Not a very accurate picture of what it actually is.

But what is it? What is value investing?

Value investing is based on three ideas:

Intrinsic value is your best, conservative estimate of what a business is worth; the present value of all the cash it will generate over its life, discounted at a rate that reflects the risk of being wrong. Not a precise number. A range arrived honestly.

Price is what the market is presently asking you to pay for those cash flows. Value and price are related but are not the same. That is the entire game.

Margin of safety is the distance between your estimate of value and your price. It reflects the fact that your estimates are wrong. It is not timidness; it is intellectual honesty built into the framework of the decision.

A value investor is less concerned with the ticker symbol and much more concerned with the cash register. He begins with, “What does this make? What does it earn, and how long does it earn it?” Only then, “What am I paying for those earnings?”

This framework extends far beyond the public stock market into any decision where capital is committed today in return for cash flows that are received at some future time. It is a universal mental framework.

II. How Value Investors Actually Think

Discounted cash flows. Money has a time value. A dollar received five years from now is not as valuable as a dollar received today, because the dollar received today can be reinvested. Value investors discount expected future cash flows back to present value at a rate that reflects the risk-free component of return as well as business risk. If the price is substantially below that, there might be an opportunity.

Owner earnings, not accounting earnings. Net income is an accounting measure, and accounting measures can be manipulated by depreciation policies, special items, and capital intensity. What investors care about is what the owner can actually take away and invest at high rates without hurting the business. This is often very different from net income. The difference is one of the most important things a financial operator can learn.

Expected return vs. story appeal. Given the price paid today and the expected cash flows into the future, what is the expected return? Value investors perform this calculation and compare it to their other options. A stock might trade at 40x earnings, but that does not mean it is overpriced. It might trade at 8x earnings, but that does not mean it is cheap. It depends on what you are paying. Given what you are paying, is this return adequate for the risk you are taking? Value investing is the discipline of answering this question, and having the discipline to walk away when the answer is no.

 III. Why Value Investing Works at All

Value investing only works in an imperfect world. Value investing is impossible in a perfectly rational world where everyone knows what everything is worth. There are no “bargains” in such a world. But the world is not filled with equations; it is filled with people. People have fears, people have greed, and people have an almost visceral reaction to short-term embarrassment. Behavioral finance has documented these effects on financial markets:

We overreact to bad news, so good businesses are priced like bad businesses when the bad news is bad enough. One bad quarter, one bad earnings report, a bad macro environment, a new competitor, etc. can send the price of a good business below what we think is fair value. The business has not changed; the story has changed. Stories are what move stock prices faster than fundamental business performance. Herding into crowded themes causes mediocre businesses to be priced at levels only justifiable in a world where everything forever is exactly as good as today. When a business is fashionable, investors stop analyzing what they are paying for the business’s earnings and start analyzing how they can get into the business before they miss out.

This loss aversion following drawdowns prompts quality assets to be sold for any price after a large drawdown. The pain of loss overweighs any rational calculation of expected return at the new, lower price.

The edge of the value investor is not necessarily better spreadsheets. It is having a different emotional relationship with investing, where one is willing to look wrong over the short term in order to look approximately right over the long term. This is an available opportunity precisely because it is an emotionally uncomfortable posture for most people.

IV. The Boring Company Nobody Wanted

A client approached us with two investment opportunities.

One was a growth stock with a price 20 times its revenue. Large addressable market, great retention characteristics, management had done it before. Everyone they knew was looking at it.

The other was a regional service business with recurring municipal contracts and stable growth. The price was 7 times the owner’s earnings. Nobody they knew was looking at it.

We walked them through both opportunities from a value investor’s perspective.

For the growth stock, what were the number of assumptions that had to compound correctly in order to obtain a reasonable return from the current price? Each assumption individually could happen, but what were the chances of all of them compounding correctly? The margin of safety was low.

For the service business, what did the owner actually earn? What did inflation and moderate growth of those contracts actually mean for return on purchase price? Not very exciting, but very good. They bought the service business.

The growth stock went through a big re-rating as interest rates went up. The service business quietly made cash, refinanced on good terms, and is now worth considerably more than they originally paid.

The point isn’t that growth investing is bad. It is that thinking about what am I really buying, what are the assumptions, what is the margin of safety led to a decision that does not require the world to change in order to work.

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 V. How PlainStripes Applies This Lens

In our Strategic Growth bucket, we apply the logic of a value investor to our capital allocation decisions within the business. We ask ourselves before we make a big bet on a new product line, acquisition, or capex project: what is the implied return, what are the key assumptions, and what if some or all of those assumptions are wrong?

In our Long Term Wealth bucket, we help our clients think about the difference between two things that are both called “investing in stocks”:

Speculative investment in narratives and re-rating potential.

Ownership in real businesses at prices that make sense based on what those businesses really earn.

Three questions we ask ourselves constantly:

If this never gets re-rated and all we ever see is the cash flows, does this deal still make sense?

If we had to buy 100% of this at this price, not just a small piece of it, would we feel good about this?

Are you uncomfortable for the right reasons – because it is not popular, requires patience – or the wrong reasons – because you have not done the work?

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The Temperament, Not the Technique

The techniques of value investing; DCF models, owner earnings, margin of safety can be learned in an afternoon. The hard part isn’t the math.

It’s patience, comfortable with nothing happening until the price is right. It’s independence, willing to hold a view that the majority doesn’t share because the data supports it. It’s humility building a margin of safety into the investment because you know your guesses will be wrong. It’s pragmatism, willing to revise your views when the facts change.

To us at PlainStripes, being a value investor doesn’t mean you buy low-P/E stocks. It means you require that all major financial decisions inside your business or outside it, be based on a clear view of the price paid, the price received, and the margin of safety if you are wrong.

Not all opportunities deserve your capital. Those that do will become obvious  if you ask the right questions.

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This letter is the third in our series on capital, behavior, and operating with financial clarity. The prior one discussed the stock market as a system of coordination. The next one will drill deeper into the process of building a compounding engine for the future while you are busy with the business – Bucket Three.