Valuation Techniques: Discounted Cash Flow, Earnings Quality, Measures of Value Added, and Real Options

DEALING WITH MACRO RISK

Investors have several ways to attempt to control the macro risk in their portfolios: eschew the wrong systemic framework, hold liquid cash and gold, or hedge with options. Ironically, in modern capital theory, the taught response to an assertion that the future is uncertain is for investors to be “fully invested” in the “market portfolio.” But if the goal is to preserve capital in real terms, then investors should be willing to not own certain parts of the market portfolio—for example, those parts where property rights may not be respected, or where the government is the leading shareholder with a primary goal to maximize employment and not cash flow, or where valuations are excessive, or where imprudent management behavior is creating impairment risks.

Being fully invested at all times is also not a precondition for success. Some investors argue that if cash has a low real return, a portfolio should never hold any cash because it creates a drag on performance. Cash can be a residual of our investment approach. Because our goal is absolute—to find great businesses with good prices or good businesses with great prices—if the markets become ebullient, as they were in 1999 and 2007, and we cannot find sufficient opportunities, then we wait. The cash builds in the portfolios. It is not a market-timing call. It is about having the flexibility and patience to commit to an absolute set of standards for underwriting across time. The return on the cash is not only ...