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How to Actually Maximize the Value of an Investment Portfolio
Market Value Investors vs. Look-Through Investors
Most investors invest to maximize the value of their investment portfolio. While this end goal is shared among investors, the method of pursuit can take many forms. In measuring their personal portfolio performance, a key distinguishing feature among investors can be described as, a) those that focus on the current market value of the portfolio (“Market Value Investors”), or b) those that focus on their proportionate share of the underlying excess cash flows of the portfolio (“Look-Through Earnings”, and investors that focus on them, “Look-Through Investors”). Although the end goal may be directly aligned with the focus of the Market Value Investors, in practice it is the Look-Through Investors that pursue the proper indicator to maximize portfolio value.
Market Value Investors can easily determine the current value of their portfolio, typically highlighted on the home screen of a brokerage account. This number is hugely volatile, as feedback from the market is inconsistent relative to underlying earnings over any short- or medium-term time horizon. Any market value is easily compared to other market values, and since it represents the actual end goal, many Market Value Investors evaluate their investment skill based on portfolio market value at any given moment. The direct pursuit of ever greater market values also has strange influences on investors, often causing irrational decision making and the exposure of psychological biases such as loss aversion, social proof, and others. Given the loose relationship between market values and intrinsic asset values, basing investing decisions on market values is an extremely uncertain path toward maximizing portfolio value with very little documented historical long-term and repeatable success.
While feedback derived from market value is inconsistent relative to intrinsic value, measuring feedback in the form of an investor’s proportionate share of Look-Through Earnings details a measurement closely related to true economic purchasing power. Look-Through Earnings can be used to buy new income producing assets at prevailing market prices (naturally growing the underlying Look-Through Earnings over time), where the market value in a portfolio can only be exchanged (often at high switching costs) in the pursuit of more value. It is the Look-Through Investors that pursue a system that when done successfully, cannot do anything but raise portfolio value over time. As free cash flow increases in a portfolio, so too does market value. This is the only relationship that can truly be tied to portfolio value over the long term, and thus should be the pursuit of any investor looking to maximize portfolio value over a lifetime.
Maximization of Look-Through Earnings
The CEO of a conglomerate evaluating the performance of the various business units and allocating capital among them shares many commonalities with an investor building a portfolio. The goal is to keep providing investing resources to those business units with good investment prospects, and to have the business units that produce cash but don’t have the same reinvestment opportunities send excess cash to headquarters for separate allocation. An investor building a portfolio should have the same approach – their ownership share of any excess cash flow should be allocated such that the Look-Through Earnings of their aggregate portfolio are maximized over time.
Under the construct that portfolio value maximization is closely linked to effectively maximizing one’s proportionate share of Look-Through Earnings, the Look-Through Investor understands the irrationality of including businesses that don’t generate cash in their portfolio. Market Value Investors perpetuate the myth that many businesses are worth more to ownership than their underlying free cash flow may indicate. If a business doesn’t have any excess investable cash flow, the business may still provide value to employees, customers, and society, but not to owners in the form of tangible re-investible capital. Only Market Value Investors looking to the market as a signal of value will ascribe any value to assets that do not actually generate excess cash.
Owning assets that effectively reinvest excess cash flow is a tax efficient way for the Look-Through Investor not to have to do it. Making one good investment decision that has growing Look-Through Earnings over time is much easier than having to make many good capital allocation decisions in succession. To this effect, assets being held should naturally increase Look-Through Earnings over time through the investment of retained excess cash flow, assuming the company is in an industry with adequate reinvestment opportunities (itself an important investment consideration).
For the Look-Through Investor, trading should only take place when capital gains in market value (after taxes and transaction costs) can be traded for materially larger Look-Through Earnings. Sometimes Look-Through Earnings get overestimated by market values, and currently held earnings streams can be sold at excess prices. Selling should only occur when the opportunity to sell at inflated values is coupled with a present or expected opportunity to reinvest that market value into a larger stream of Look-Through Earnings than is currently held.
Although the end objective of investors will be to maximize portfolio value, the means to this end is through the increasing of underlying free cash flow attributed to the Look-Though Investor’s ownership. With this relationship in place, the importance for investors to prioritize increases in Look-Through Earnings over market values cannot be understated – at the end of the day, the most valuable investment portfolio will be that which has the highest Look-Through Earnings.