In today’s Money Morning I’m going to take a different tack. I’m going to talk about valuation…as in fundamental, old school asset valuation. I’m also going to talk investor psychology and how when you get the two of them working together, or in this case against each other, the results can be spectacular.
The topics are close to my heart. I use fundamental valuation analysis in my investment advisory Crisis & Opportunity. And I combine this with an assessment of the ‘psychological state of the market’ via charting analysis.
If that all sounds a bit confusing, it will become clearer by the end of this essay.
The company I want to talk about in relation to these topics is Blue Sky Alternative Investments Ltd [ASX:BLA]. This company, a sort of private equity style fund manager, has been the target of California based short seller Glaucus Research over the past few weeks. It’s a very public slanging match over who is right in their analysis. The final arbiter of that is, of course, the market. And judging the results so far, Glaucus is winning the argument.
Before we take a look at the numbers, keep in mind this is hindsight analysis, where everything looks much clearer than it does in foresight. In the past, I briefly looked at the company from time to time (given the trajectory of the share price, which was ‘up’) but always thought the stock looked a little rich for me.
When a stock is expensive, and I don’t really understand how it makes its money, I just give it a miss. There are plenty more opportunities where you don’t have to take such risks.
But given the recent controversy over Blue Sky (why that name…why?) I thought it would be interesting to perform an intrinsic value calculation to see where actual value is for the company.
In calculating intrinsic value, I use a methodology espoused by Brian McNiven in his excellent book, A Wonderful Company at a Fair Price. It’s a methodology driven by logic. As a simple example, if you as an investor have a required rate of return of 10%, and the company you’re looking at generates a return on equity capital of 10% (and pays out 100% of earnings as a dividend) then the most you would pay would be the equity value of the company.
Put another way, you’d pay a price-to-book multiple of one and nothing more. If you paid two times book (‘book’ is another name for equity) you would only earn 5% on a company generating a 10% return on equity.
Let’s apply this same logic to Blue Sky’s 2017 reported numbers. Last year, the company generated a return on equity (ROE) of around 18%. It paid out 60% of its earnings as a dividend and reinvested the remaining 40%. Given that generating high returns on reinvested earnings is the engine of wealth creation, a good valuation model must take that into account.
I won’t go into the detail of those calculations here, but I’ll just say it’s not as simple as the ‘paying out 100% of earnings’ model. You have to account for the effect of compounding.
Number crunching Blue Sky Alternative Investments
Say my required rate of return for investing in Blue Sky is 10%. How much should I pay for the business, which generates an 18% ROE? Taking into account reinvested earnings and an equity value at the end of 2017 of $142 million, I’d pay $337.4 million for the business, or $4.35 per share.
Now, if you look at the chart below, following the 2017 results (in mid-August) the share price quickly jumped to $11, more than double intrinsic value. By that stage, investors would’ve been looking to 2018. They must’ve been, because they certainly weren’t looking anywhere else…
[Click to enlarge]
For example, they weren’t looking at the cash flow statement. Operational cash flow of just $8.4 million didn’t inspire confidence in the net profit figure of $20.6 million. After making some investments and paying dividends, Blue Sky had a cash deficit for the year of $26 million. It increased debt levels by $34 million to keep the cash balance healthy.
That in itself isn’t a reason to panic. But when a stock is expensive and the company isn’t generating enough cash to sustain the business, you want to know why.
If we look at earnings estimates for 2018, the stock is expected to generate a return on equity of 22.6%. That’s being optimistic, but let’s go with it anyway. Using a required return of 10% and a 65% payout ratio, I calculate an intrinsic value of $6.05 per share.
That compares with a current share price of $5.75. Realistically, though, the share price should trade at a much bigger discount. There is clearly uncertainty about the earnings of the company and uncertainty about its equity, or book value.
No doubt Glaucus thought the same thing, and licked its lips at the shorting opportunity as the share price spent most of the past four or five months above $12.50, more than 100% above a reasonable estimate of intrinsic value.
This is where psychology comes into it. 50%, if not more, of the market value of the company was due to belief. That is, investor belief in the model and the growth trajectory. This is why Glaucus’s approach is to be highly public. It wants to erode the value of that belief. And if it’s got its research right, it will do just that.
That’s why the share price has collapsed recently. Belief in the story, and the company’s management, has collapsed. The thing is, I’m not even assuming a decline in the intrinsic value of the company, which there surely will be after a public relations disaster like this.
My guess — and it’s just a guess — is that the share price is going lower. In a black box vehicle like this one, trust and belief in the people plugging the numbers in is everything. If that goes, I’m not sure if there is any ‘value’ left.
Editor, Crisis & Opportunity