How do you define intrinsic value investing?
Rick Snowdon, CFA:
The philosophy at its core is that we're trying to buy companies for less than they’re worth. It doesn't sound very complicated, but that's really what we're trying to do. That discount does two things for you. First, it's a source of return as the gap between that undervalued valuation and fair value closes. The other thing is that it provides a margin of safety in case we're a little bit wrong in our estimate. So, it's not an exact science; mistakes are going to be made. We might estimate the value of a company to be higher or lower than it really is, and we will, but the margin of safety helps protect our clients' capital. If we underestimate the value of a business or overestimate it by 10%, but we have a 30% margin of safety, then our client's capital is going to be safe.
Getting a discount though, paying a price that's a discount to what it's really worth requires you to know what it's worth, and that's what we call intrinsic value. It's not what the stock is currently priced at, it's not what the stock market value or current valuation is. Intrinsic value really requires us to estimate the cash flows of the business over time, and it's not easy. It requires you to understand the business model, the end markets, the competitive landscape, all industry developments—you need to know if developments are to the favor of whatever company you own, or maybe a detriment to that company. That all helps us estimate the revenues and margins out through time and allows us to come up with an estimate of intrinsic value, so we can, again, going back to the beginning, make sure we're getting a discount.
Austin Hawley, CFA:
I'd maybe just add one thought about intrinsic value—that definition that Rick offered—which maybe will help people conceptualize what we do at Diamond Hill compared to the large universe of value investors out there in the world. And when people talk about value investing, oftentimes what people are talking about is just buying stocks that look cheap relative to book value or some near-term estimate of earnings power. And that's just kind of a crude estimate of intrinsic value.
And I want to be clear that that's not what we're doing. As Rick referenced, we are trying to think more like owners and really understand the dynamics of the business. And to us that includes explicitly modeling out and thinking about the growth of the business over a number of years—not just quarters—but over the long term, and also incorporating qualitative things like our assessment of the quality of the management team and the potential to earn returns on capital that are well above the cost of capital.
So when we think about the search process, sometimes that search process can lead us to companies that are cheap relative to cash flows and earnings in the near term. But at other times that search process can lead us to companies where we think the long-term growth prospects of the business and the returns on investment are not properly valued in the marketplace. And that gives us an opportunity to own that business and participate in that growth and have that growth really present us with the margin of safety and the ability to earn an excess return over a long period of time.
And so if I can try to sum up both what Rick said and that comment I provided, I'd really like people to think about us as intrinsic value investors and owners of mispriced businesses, rather than buyers of just cheap stocks. We are trying to be owners of the businesses and think deeply about the economics of those businesses, and that's what provides us, I think, with our biggest advantage over time, is taking that long term perspective and thinking like owners.