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In the National Gallery in London there is a stunning painting by Paul Delaroche of Lady Jane Grey about to have her head chopped off. It reminds me of SpaceX.
Highly prized for his photorealistic style, Delaroche was the most fashionable painter in France in the period after Napoleon — that is, until the invention of the camera, when the sale value of his canvases plummeted and he cried melodramatically: “From today, painting is dead.” Buying a Delaroche then would not have been a good investment — you should have bought a Delacroix.
That’s the problem with assets that have “intrinsic value” but no cash flows. All you’re relying on is what you hope someone will pay in the future, and that can change when the hype evaporates. Think Dutch tulip bulbs, non-fungible tokens, bitcoin or Beanie Babies.
But don’t tell Mrs Edelsten any of this. Hypocrite that I am, I still pretend my purchase of those first-edition Raymond Chandler books was an “investment”.
And so to SpaceX and the key lesson, which seems self-evident but apparently not: valuation is fundamental to any investment. The most reliable way of investing well over the long term is to follow old-fashioned valuation rules — OFVRs for short.
When I started out, people bought shares based on the yield. That worked reasonably well if dividends were well supported. But it didn’t help with fast-growing tech stocks that used all their income for reinvestment.
Other measures are needed. Growth investors tend to focus on cash flow expectations; value investors think more about the balance sheet and assets. I like to look at both.
The discounted cash flow — in other words, the money you expect to be generated in future — must underpin the price of the shares. It should reward you appropriately for the risks you take when you could just put your cash in the bank instead. Either that or the sale value of the assets of the business should be greater than the enterprise value — the market cap plus debt.
Applying OFVRs to SpaceX, I reckon it’s worth about 20 per cent of its IPO price. The company doesn’t have much cash flow. Even on the made-up numbers, where Elon quickly manages to build his data centres in space, the share price only just comes close to realistic, but leaves no upside to reward you for the massive risks. It has the whiff of tulips about it.
But SpaceX isn’t the only company that fails OFVRs. With the concentration and massive growth in tech valuations, active managers who stick to their valuation guns have lagged behind global indices in recent years.
There are two key reasons why I believe sticking to these OFVRs will benefit you in the long run. The most important is that they help when things don’t work out as you expect or hope. They prevent you from paying too much and being hurt badly.
Second, they can help you identify out-of-favour stocks at exceptionally attractive price levels.
Two years ago we noted that Intel shares were trading around what we believed to be the firm’s intrinsic value, namely what its plant, market position and intellectual property were worth, despite the company making very low cash profits at the time. Technology shares generally trade on multiples of cash profits, reflecting their growth potential. Few ever trade near intrinsic value. Because of this, most technology sector analysts had Intel as a “sell”.
It was only after we had bought shares that a new chief executive was hired, the US administration bought a stake and the semiconductor foundry results started to improve. We didn’t know any of that would happen — we just analysed the upside potential of the shares if anything much improved.
A very low purchase price makes all the difference to returns when you’re investing in stocks with a long-term — five-year — perspective.
Taking a long view requires you to look through the ridiculous short-term volatility we’re experiencing today, where share prices constantly flip-flop. For instance, the outstanding Micron profits recently announced — a 15-fold jump in quarterly profits and a very bullish statement — led to the shares opening over 10 per cent higher. But this jump only got the shares back to the price they were at four days earlier! It can be easier to have a view on where a share should be in five years than in five weeks.
Yes, there are signs of bubble conditions in the technology stocks and the SpaceX IPO may have marked the point where that bubble deflates. How the market will cope with the OpenAI and Anthropic IPOs remains to be seen. And there are more big ones coming: India’s Jio Platforms, ByteDance, Waymo, Revolut and Stripe are all heading for floats. Each will have its own investment case.
However, much of the rest of the global equities range works well on OFVRs. UK property shares are trading below asset value, as illustrated by Prologis trying to buy Segro on the cheap. There have also been bids for EasyJet, following Schroders and Tate & Lyle. The UK is running out of listed shares just as US tech can’t stop issuing shares. In previous articles I’ve also mentioned growth companies outside the technology arena which have OFVR support — for instance, Thermo Fisher, Netflix and SLB.
The technology bubble may now be deflating, but this needn’t hit all equities. If you own shares well supported by OFVRs then you should be well set for the long term. And at least these rules give you a toolkit to use if things turn out trickier than expected.
Buying shares should not be the same as guessing whether Monet, Manet, Delaroche or Delacroix will be the flavour of tomorrow. Or whether a tech trillionaire will make it to Mars. Stay disciplined and focused on valuation.
Simon Edelsten is a fund manager at Goshawk Asset Management. He owns holdings in ThermoFisher, Netflix and SLB
