G.A.U.P – Growth At An Unreasonable Price

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During his recent interview with Tobias, Vitaliy Katsenelson, author and CEO of Investment Management Associates discusses G.A.U.P – growth at an unreasonable price. Here’s an excerpt from the interview:

Tobias Carlisle: What’s the difference between a growth at a reasonable price investor, and a Buffett style franchise, DCF style investor?

Vitaliy Katsenelson: God, this is a good question. I still struggle to find the difference. I think if you buy a company… Let’s step back for a little bit. Okay, let’s talk about what value investing means to me now, which has changed over time. If you and I talked 15 years ago, 10 years ago, I would have told you value investing is basically buying cheap companies, which would basically mean statistically cheap by below 10 times your earnings or low price to book or whatever. But I realize that’s a very primitive way to look at it.

Vitaliy Katsenelson: And value investing to me is a philosophy. It’s a philosophy, which is basically, I described the name. I wrote this chapter for my next book, which if I ever finish it, it will be in that book. But I call the six commandments of value investing. The old Testament has 10 commandments, this one has six. I didn’t want to compete with. Value investing is a philosophy where, and you know all of them, you trade stock as a business, not as a piece of paper or a symbol. You have a long-term time horizon. Mr market is there to serve you, not the other way around. You treat risk as a permanent loss of capital, not as volatility. In the long run stocks revert to their fair value, et cetera.

Vitaliy Katsenelson: So this is the six commandments. It’s a philosophy. And the interesting part, you can apply this philosophy to stocks that may not look statistically cheap. And I’m going to give you an example. So a few years ago we bought a company that was growing revenue very rapidly but was not profitable, it was losing money. I forget the numbers now, but we basically paid more of five times, five or six times sales and it was Twilio.

Vitaliy Katsenelson: And I did a write up on the Value Investors Club and I basically said by posting this right up, you guys are going to kick me out of the Value Investors Club because this does not look like your traditional value investment. But one thing I realized that actually you can apply this framework even to… At that price, I could have applied it to Twilio because a couple things, the company might’ve been losing money but it was losing money because they were spending $100 million in R&D.

Tobias Carlisle: Right.

Vitaliy Katsenelson: Which was basically… I’ll give you this example, which is really an account anomaly. When the Walgreens opens a store, it could just depreciate the cost of the store for a long period of time. If company invest in R&D it expands on day one.

Tobias Carlisle: Right.

Vitaliy Katsenelson: Okay. So if you look at Twilio and you say, okay, two things. First of all, their expenses are really too high because if you amortize the R&G investment over time, they actually would be making money, number one. Number two, this is a company that has fixed cost. If you’re certain the revenues will continue to grow, you cannot help but you see the margins expand. And this analysis, I realized, “If I’m very conservative with the sales, and at the time of growing 50% a year, I took them down to 20%. 20, 25%.

Vitaliy Katsenelson: In three years there would be trading at maybe two and a half times revenues, which is for software company that’s actually probably the low end, as bad as it gets. So I realized if I’m very conservative in the worst case I won’t lose money. So long-term time horizon, I was looking at three to five years out, probably five years out, there was margin of safety. So if you go through the six commandments framework, you can see how a company like Twilio would be able to actually fit into this framework and it was incredibly successful investment for us.

Vitaliy Katsenelson: I think the stock went from 25 to it’s over 100 today. But again, statistically, it would not fall into value investing. Anyway, so going back to your question, how I transitioned? I started out as looking at value investing as basic buying cheap stocks. And today, to me it’s more of a framework philosophy than just doing arithmetic say, “10 times earnings.”

Tobias Carlisle: That’s cheap.

Vitaliy Katsenelson: That’s cheap, yes.

Tobias Carlisle: I understand the process that you’ve gone through and I sometimes think growth at a reasonable price, you might correct me if I’m wrong about this, but I understand that you just looking at dividing the growth rate by the price earnings ratio and if you’re under one. I think is that you want to be below one, which indicates that you’re getting a sufficiently high growth rate divided by a sufficiently low price earnings ratio that you get. That’s a good position. So it’s just a simple rule of thumb. Whereas the Buffett stuff framework is more of philosophical, there’s more of thinking involved in the position. Is that a fair distinction?

Vitaliy Katsenelson: I think that is probably right. To me GARP was too limiting.

Tobias Carlisle: Right?

Vitaliy Katsenelson: Because, let me tell you the limitations of GARP. That it assumes, actually I wrote about this in my first book, it basically assumes that company can maintain this growth forever.

Tobias Carlisle: Right?

Vitaliy Katsenelson: Which is usually not the case. At some point if you grow at 20% a year forever, you become the economy. Or you become the industry. So you have to assume that the growth rate at some point will slow down and I still think in the terms of discounted cash flow analysis, because that corrals me into thinking about business. So if companies growing at a fast rate, I do have to make an assumption that at some point this growth will slow down. Otherwise it will become the industry. So GARP, as I started to use it more and more, I started to see limitations of GARP. And this is in part why I transitioned, what made me value investor not just a GARP investor.

Tobias Carlisle: Sometimes I find it, it’s funny though, that I point out that some of the best investors who I know, who are Buffett style investors, their analysis isn’t much more involved than a GARP style investment at the valuation point. Because we’ll simply look at, and they’re using some variation of Gordon Growth Model, dividend discount model, and approximately what are the cash flows this year? What’s the growth rate and what’s the appropriate discount rate?

Tobias Carlisle: And they just use that because all of the work is done on the business and all of the work is done outside of that. They’re just simply looking at what is a reasonable valuation for this company roughly. And then I’m going to go and do a whole lot of work and think about where this business is going to be in five and 10 years time and so on. So I think that sometimes value investment is kind of put the growth at a reasonable price, but I don’t mind simple rules of thumb for figuring out at a very high level whether something is worth considering further.

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