Expectation as a value driver

It is becoming increasingly common to receive surprising news about investments in start-ups or small companies where it is reported that very large sums of money have been committed or made in exchange for a minority stake, and where it is stated that “with this money, personal and business support, the founding partners hope to achieve spectacular financial results and become a company described as a “singular unicorn”,such as AMAZON. 

It is also common for the investors who participate in this investment to be small savers with important contacts who will be decisive to make the company in which they invest, become a world leader. Additionally, it is also common for the investor to be a large company that hopes that its investment will result in an exponential increase in its market share or in its turnover and portfolio of products and services. 

And one wonders how it is possible that this apparent diamond in which these savers or this large company are investing is so valuable, is going to produce such spectacular results and I, who, in some cases, have been close to it, have not seen it or have been unable to attribute a “TIFFANY” value to it with such certainty and security? 

Investor behaviour. 

Theoretically, the investor makes rational decisions, but in reality, feelings and affections take precedence in decisions. Emotions are a factor that looks into the past, to what has happened. Likewise, overreaction takes precedence because we feel more secure in the group (mimicry). The investor thinks that the chances of survival and profit are greater in a group: if everyone does it …they won’t all be making mistakes. A “herd” effect is produced. 

Empirically, there is a tendency to make decisions based on stereotypes (simplifications) or on recent events and to support these decisions on elements or data that are not relevant or significant, even if they are true, but do not affect the decision in question. Investors tend to listen to themselves, there is an excess of self-confidence. We all think we are the best with our money, although it is irrational and generalised behaviour that generates investment opportunities. 

Paul Getty stated “buy when everyone else is selling and hold until everyone else is buying. That’s not just a catchy slogan. It’s the very essence of successful investing”. 

Hedge funds vs. rational funds. 

Given the empirical realities outlined above, investment professionals can choose to offer either speculative investment products or business realities. In the case of speculative funds, the value attributed is based on perceptions or expectations of revaluation that do not have a historical background as they are projects or companies in early stages that either have to create a market (demand) or try to offer products or services that are substitutes for existing ones, and, therefore, have to overcome the resistance to change from consumers.  

When we refer to business realities, as in the case of Private Equity Funds, if there is a historical background of the company, there are business metrics that validate its viability, results, capabilities, management teams, strategies, markets, etc. 

As fund managers acting as value investors, we cannot take or offer investment opportunities where the basis for valuation is business expectations that are not based on business realities. In our case, the investment vehicles are Funds that can be labelled as “rational”, i.e. the company in which we invest must be valued on the basis of recent performance metrics that serve as the basis for designing an Investment Case that allows us to attribute a current and future value based on credible indicators and decisions, as well as good assets and experienced management teams capable of tackling this business plan in which a significant amount of money and a relevant value contribution from the management team is invested. 

Expectation as a value driver. 

In addition to the aforementioned, the investor must make an investment decision by setting an entry price, which will be the starting point for quantifying the expected return over the time horizon at which he invests. 

Any investor with some experience knows that price does not equal value. One thing is the price paid and another the value of what is acquired.  

When an investor or group of investors pays EUR 35 million for a 25% stake in a company in its early stages, with a turnover of EUR 4 million and an EBITDA of less than EUR 2 million, it is clear that they are making a decision based on sensations or feelings; their expectations of revaluation are not based on business rationale but on an excess of self-confidence and group optimism (herd optimism) that exceeds a minimum of investment rationality.  

In the previous example, investors are valuing the company at EUR 140 million (70 times its EBITDA). They reasonably think that it can reach a value of EUR 525 million in 5 years to obtain an IRR of 25%, which is a generally accepted parameter in investments with significant risk. The question is, how do they think this return can be obtained from the price paid? 

Based on the above example, in order to multiply the shares of the invested company by 3, i.e. to have a market value of EUR 525 million, it will be necessary to achieve an increase in turnover of 2.000% (i.e. multiplying current sales by 20), that the EBITDA/SALES ratio is not less than 25% and that the investor acquiring the shares from the shareholders who subscribed the contribution of EUR 35 million is willing to pay 26 times the EBITDA achieved at the end of year 5. All this without applying a adjusted coefficient for a minority shareholding.  

This would certainly be a business achievement worthy of the highest business distinction. 

Delicias Capital is a fund manager with an investment philosophy based on value creation for its investors, i.e. it offers mutual funds to invest in companies whose value is defined by their competitive advantages, the quality of their assets and management, and their ability to grow and generate cash flow, thus, Value Investing. We cannot and will not allow ourselves to offer opportunities based on mere expectations without proven business fundamentals.