When Inactivity Pays Dividends
Sitting tight on steady compounders - a different view on rebalancing
Introduction
Given that there was no meaningful and relevant news to report about our companies (or other related news that could be of “some” importance) last week, we thought it would helpful to address one of our premium member’s questions: valuation from both a current and historical perspective and when to buy (i.e. is there margin of safety). Thanks to Mathias from Norway for bringing up this very nuanced subject!
As you probably already know by now, our goal is to have a portfolio of all-weather companies. Companies that deliver strong compound shareholder value in any environment, although their share prices may suggest otherwise from time to time. With that approach, we’re not keen on trading too much (other than adding to existing positions (i.e. dollar-cost averaging which impacts our relative stock weightings)). Riding the winners, looking at our stocks’ risk-weighted IRRs to base our incremental investment decisions on and keeping a healthy cash position on the sidelines: that’s what we’re aiming to do.
Conviction, cash flow visibility and good IRRs
Easier said than done: how many companies should you own to reach that objective? The way we do it: quite difficult to keep track of 15+ companies (delving into earnings reports, scheduling meetings with management teams of smaller-sized companies, dialing in to conference calls). Not all sectors offer what we seek and there simply aren’t many companies that are run by rational managers.
The Compounding Tortoise
Managers who want their granted options to be in-the-money over the next 2-3 years will pump the share price by growing sales and reporting adjusted earnings that lower the perceived high valuation. Question remains: how sustainable is that growth? What’s the IRR, ROIIC… on the investments required to reach that kind of growth? What multiple does that company deserve? What’s its terminal value? A lot of moving pieces that will drive excess volatility and ultimately unstable IRRs on frequent stock purchase. For almost all investors, investing in the stock market is a process of adding and removing capital with subsequently different compounding outcomes. So how do we approach our portfolio strategy and margin of safety for new purchases?
O’Reilly’s recent valuation
Message from our fellow premium member, Mathias:
Good morning CT! Hope you're doing well. Lately I've been diving into AZO/ORLY, and I love what I'm seeing, your writing has been insightful and helpful in this process, so I'd just like to say thank you to start with! One thing that I've been looking at is valuation, and as you've pointed out the difference between current valuation between AZO and ORLY.
My question is related to ORLY: How would you think about investing in ORLY right now? I see that it's trading at a premium to most of its average valuation metrics, both blended P/E, price to FCF and OFCF, and that this current "disjointedness" from its valuation trends seems to have happened after 2022. Do you have any insight you could share on why ORLY seems to have a "longer lasting" premium the last three years? Would you guess to this being a new valuation that FCF will grow into, or are you on the bench looking for valuation to stabilize and flatten out for a while? This is all obviously guesswork, so I would totally understand if valuation is something that is hard to say something concrete about. :)
Our deep dive on AutoZone (O’Reilly will follow later this year) can be read below.
Let’s take a closer look.