Thinking like a Private Owner

Andrew Clifford,

Andrew co-founded Platinum in 1994 as the Deputy Chief Investment Officer, having worked alongside Kerr Neilson for several years at Bankers Trust and perfecting the craft of.. More

25 Jun 2019

During Platinum’s 2019 Roadshow, CIO Andrew Clifford used a real life example to demonstrate how an investor might try to obscure the noise of the stock market, by thinking like a private owner when making decisions.

A framework is required to assess potential returns from an equity investment. The proposition is that “thinking like a private owner” is a sensible approach, and protects investors from the affliction of “loss aversion”.  To illustrate this we use a real example, a company Platinum owns in several portfolios. Profits have been indexed to simplify this paper, but reflect that company’s reality.

2009 earnings indexed to $100.  Source: Data from FactSet, Platinum Investment Management Limited.

The company earned $100 in 2009 and its shares cost $1,236 on 1.1.2010*, for a P/E ratio of 12.4x, or inversely, and preferably, an earnings yield of 8.1%. The share earned 8.1c in 2009, for every $1 invested. If this continued forever, 8.1% would be the rate of return.

Prior to this time, sales had grown steadily, even during the GFC but as a cyclical business, profits had been volatile, so the earnings yield may not be reliably maintained, though the track record was of earnings growth. The company illustrated is large and a global leader in its key business segments. It has strong technological leads over its competition.  Our analysis led us to believe that the company had good prospects of increasing its earnings over time.

At the start of 2010, US 10-Year Treasury Notes yielded a “guaranteed” 3.8% p.a.  The shares provided an uncertain, but probably growing, return starting at 8.1% p.a, looked solid.

Looking out over what happened in the next six years is informative.

2009 earnings indexed to $100.  Source: Data from FactSet, Platinum Investment Management Limited.

Based on the initial cost ($1,236 per share on 1.1.2010*) the company generated an earnings yield 13% in 2010, and averaged 17% per year out to 2015. This looks far superior to the guaranteed 3.8% from US government bonds, or the S&P 500, which averaged 9% over the same timeframe.  

The sole owner of a private company would have evaluated returns this way. Ironically, though most stock market investors just focus on the share price.  On that basis, with the price at $1,921 after six years, this represented a total return, including dividends of 9% pa.

For the same period, the S&P500 Index returned 13% pa including dividends.  Most investors would prefer this to the company, even though a private owner would have chosen the company’s earnings outcome. When focussing on the share price, it changes investors’ thinking.

This is a mirage. The share price is an abstraction, not the business itself.  Investors should be more concerned with underlying returns of the business than fluctuations in the share price.

The S&P 500 Index far outperformed the underlying earnings of its constituent companies.  This simple re-rating is good fortune for their shareholders. An investor in our company would have hoped for the same, but despite the underlying value of the business increasing significantly, it did not happen.

This is one of the hardest parts of investing.  By 2015, many shareholders of the company would have felt despondent, and it would have been tempting to sell, and invest elsewhere.

However, in 2016 and 2017 the profits really took off, reaching record levels. And finally, the stock price followed.

By the end of 2017 the shares had returned 16% pa including dividends, beating the S&P500’ (now 14%pa) and trouncing the bond’s 3.8%.

Indexed to 2009 profits = $100.  Source: Data from FactSet, Platinum Investment Management Limited.
Moreover, on 2017 earnings, the company still had a starting earnings yield of 12%. Compare this with S&P 500 Index below 5% and 10-Year US Treasury Notes at 2.4%.  

This company is Samsung Electronics.

True Value Investing

The core of true value investing is to look at implied returns from securities as this Samsung example illustrates.

An investor should seek to build a portfolio of equity and debt securities with good implied returns and achieve appropriate diversification across geography and sector. This should achieve a good result over time if we have the requisite level of skill.

The challenge is the assessment of any company’s earnings potential.  This requires a true understanding of what the future holds for a company, not just observing a set of numbers. 

At no times, do we use an index as a reference point. For adequacy of returns, we can look at the risk-free rates of return on government bonds or bank deposits, and, the implied rates of return from all the individual companies that we choose to examine. To assess the index, requires an assessment of all companies, which is a huge task. We can assess a company against a broad range of alternatives, rather than every single alternative.  

At no time, does one need to predict the company’s future share price.  The efficiency of markets should eventually bring the company’s share price to reflect its intrinsic value.

*Source: Factset

DISCLAIMER: The above information is commentary only (i.e. our general thoughts). It is not intended to be, nor should it be construed as, investment advice. To the extent permitted by law, no liability is accepted for any loss or damage as a result of any reliance on this information. Before making any investment decision you need to consider (with your financial adviser) your particular investment needs, objectives and circumstances. The above material may not be reproduced, in whole or in part, without the prior written consent of Platinum Investment Management Limited.

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