Valuation and Long-Term Investing

In “Letting Winners Run”, I wrote about Robert Kirby’s coffee can portfolio, a true “buy and hold” approach to investing. As discussed in that write-up, my investment philosophy isn’t too far removed from that way of thinking, with the caveat that I’m not completely unflustered by optimistic valuations. (If we put “never sell” on one end of the spectrum and “every asset has a price” at the other, I’d say I lean 70% or 80% towards the first approach.) Today, I want to provide a clearer understanding of how I think about and quantify value. In doing so, I hope to share my take on the “more nuanced understanding of value” that Steve Romick spoke about in “The Evolution Of A Value Investor”.

As a reminder, my starting point for security selection is business quality (the first filter). On portfolio construction, I operate with a structural allocation of ~100% equities, with portfolio decisions based on relative considerations and opportunity costs (with additional consideration for portfolio construction desires), not an absolute hurdle rate or a minimum discount to intrinsic value.

Returning to individual security selection, my goal is to find high-quality companies with honest and able managers positioned to generate attractive business results over time. As I think about the quantitative assessment of value – determining the relative attractiveness of those companies that pass the first filter – my primary valuation metric is a five-year forward multiple of normalized EPS / FCF. I’ve settled on that metric because it keeps me focused on where the business is going - the movie versus the snapshot - without going too far afield on future predictions. It is similar to the approach employed by Bill Nygren: “For almost all businesses, our crystal ball goes dark after seven years, so we assume all businesses trade at similar P/E's after seven years. With an estimate of fair value seven years in the future, we discount that back at an appropriate discount rate… Whether that results in a near infinite or a negative P/E on current earnings is not of concern to us.” (You can read more about his approach in this interview with John Rotonti.)

Here’s the five-year forward P/E on my estimate of 2028e normalized EPS for each of the 11 companies I own, along with their current portfolio weights: