31
Jan
2020

Share

Does valuation not matter for high quality businesses?

One characteristic of a high-quality business is its ability to grow its intrinsic value over time. So does that mean that it’s possible to overpay for a high quality business and then wait for it to “grow into its valuation”? This depends on a number of things which we will attempt to tease out.

At Montaka, we view a high-quality business as one that has characteristics that enable it to deploy capital at high rates of return and sustain this into the future. A company with the ability to reinvest large amounts of capital back into its business and earn a high rate of return on that incremental capital will see its intrinsic value grow (at the reinvestment rate x the return on incremental capital). If the intrinsic value of this high-quality business continues to grow, is it possible to initially overpay for the stock and then still do well with the investment over time? This depends on what we mean by overpay.

The term “overpay” is subjective. Paying a 30x earnings multiple, for example, might prima facie appear pricey, but there are some high growth businesses where a 30x P/E multiple represents a bargain purchase. However, we think about intrinsic value in terms of the discounted value of all future cash flows a business is likely to generate over its lifetime. If one were to pay a price that represents the present value of all the future cash flows that business will ever generate, then that investor can expect to earn a yearly return equal to the discount rate used – no more, and no less.

In this sense, if the magnitude of overpayment is great enough and the price paid captures the value of all future cash flows a business is capable of producing, then mathematically an investor will not benefit from the intrinsic value of the business increasing over time. Said another way, no matter how high quality the business is and how high the rate of intrinsic value growth, if you initially pay a price for a stock that fully captures these aspects, you will cease to benefit from them.

While we view business quality as important, it is a wholly insufficient condition alone for investment success. These high quality businesses must be bought for less than the discounted value of their cash flows, otherwise the only way to earn above the cost of capital used to discount those cash flows is if someone is willing to buy the stock off you for greater than what that stock is worth (i.e., the greater fool theory).

Assuming that one pays for less than what the business is worth (i.e., a sensible price), then time is the friend of the investor who puts their capital into the stock of a high-quality business. As the intrinsic value grows over time, then over longer investment holding periods the performance of the business will depend less on any changes to the earnings multiple, and more so on the growth in that company’s earnings power. Again, all this is predicated on not paying a price that bakes in the entirety of that business’s growth.

An overarching tenet of our investment philosophy is to identify these great businesses that are likely to grow in value over time, and to buy them at cheap prices. Over a longer investment horizon, these businesses provide a safeguard of growing their intrinsic value, as opposed to low quality businesses that may trudge along, or even see their intrinsic value dwindle over time. Finding these fabled businesses, pressure testing the sustainability of these company’s competitive moats, and then figuring out a sensible price to pay for these businesses is the crux of what we do.

Our Funds

The Montgomery Fund

  • AUSTRALIA/NZ
  • Concentrated high conviction equities
  • From $25,000
Learn More

Montgomery Global Fund

  • GLOBAL
  • Concentrated high conviction equities
  • From $25,000
Learn More

Montaka Global Access Fund

  • GLOBAL
  • Access long/short global equity portfolio
  • From $50,000
Learn More

Montgomery Global Equities Fund (ASX:MOGL)

  • GLOBAL
  • Concentrated high conviction equities
  • No minimum investment - see your broker limits
Learn More

Montgomery Small Companies Fund

  • AUSTRALIA/NZ
  • Concentrated high conviction equities
  • From $25,000
Learn More
Close

Our Funds

Concentrated High Conviction Equities

Listed

Montgomery Global Equities Fund (ASX:MOGL)

Global
Available on the ASX as an Exchange Traded Managed Fund, invests in 15 to 30 quality global businesses for long-term capital growth with a target distribution yield of 4.5% per annum. Mirrors the strategy of the Montgomery Global Fund.
Unlisted From $25,000

Montgomery Global Fund

Global
Invests in 15 to 30 quality global businesses for long-term capital growth. Priced daily. Mirrors the strategy of the Montgomery Global Equities Fund (ASX:MOGL).
Unlisted from $25,000

The Montgomery Fund

Australia/NZ
Aims to provide long-term growth and income by investing in 20 to 40 high-quality Australian and New Zealand businesses trading at attractive valuations. Priced daily.
New Fund

Montgomery Small Companies Fund

Australia/NZ
Aims to provide long-term growth by investing in 30 to 50 high quality, undervalued, Australian and NZ small and emerging companies with strong growth potential. Priced daily.
Unlisted from $1 Million

The Montgomery [Private] Fund

Australia/NZ
Seeks to deliver absolute returns from a portfolio of high-quality Australian and New Zealand businesses. Capital preservation is paramount. By invitation only.

Alternate Equity Strategies

Unlisted from $50,000

Montaka Global Access Fund

Global
Aims to generate materially higher risk-adjusted returns, net of fees, than is generally available in the equities market over the medium term. Priced monthly. Provides retail investors access to the Montaka Global Fund.
Unlisted from $1million

Montaka Global 130/30 Fund

Global
Provides the opportunity to benefit from both the gains of extraordinary businesses and the declines of deteriorating businesses through a global equity active extension strategy, which has the potential to significantly outperform the broader equities market over time. Seeks to generate double-digit annual average returns, net of fees. Daily priced.
Unlisted From $1 Million

Montaka Global Fund

Global
Aims to generate materially higher risk-adjusted returns, net of fees, than is generally available in the equities market over the medium term. By invitation only.