the recency effect - an investor's best friend

I have been a keen student of a psychological condition called the Recency Effect, insofar as it applies to investment markets.

The Recency Effect, in psychology, is a cognitive bias that results from disproportionate salience of recent stimuli or observations. People tend to recall items that were at the end of a list rather than items that were in the middle of a list.

For example, if a driver sees an equal total number of red cars as blue cars during a long journey, but there happens to be a glut of red cars at the end of the journey, they are likely to conclude there were more red cars than blue cars throughout the drive.

As a more practical example applicable to investment markets, QBE's share price has been - and still is - subject to the Recency Effect, where the market, seeing rising domestic interest rates, and a concomitant strong A$, as well as multi-generational low US interest rates, extrapolated (wrongly) those conditions to perpetuity.

To the extent that these observations being made under the Recency Effect were out of step with "normalised" conditions, the stock presented an undervalued situation. (As an aside, while I bought QBE in the anticipation of normalisation, aka Reversion to the (Appropriate) Mean, I expected this to occur maybe over a one- to two-year timeframe. It happens to be unfolding more rapidly than that.)

Onto WOW:
WOW, I believe, is being subject to all sorts of Recency Effects, namely:
1) Interest rates are rising and will therefore continue to rise
2) Consumer sentiment has slumped and will continue to remain in slump status
3) Consumer spending is weak and will therefore remain weak
4) Retail sales growth is currently weak and will therefore remain weak (in blatant ignorance of the laws of basic arithmetic that dictates "comparing current period performance against weak previous corresponding periods tends to flatter current period performance, and vice versa")
4) Discounting is endemic and will therefore be a permanent feature of the retail landscape to perpetuity
5) Some overpayed spreadsheet geek whose prominence belies his analytical acumen is grandstanding a contrived accounting oddity, which has resulted in undiscerning market participants running scared without determining the veracity of the assertions made against the company's accounting practices

Again, I take the view that because historically, for a very long time, the consumer has behaved cyclically and that the Consumer Cycle is not dead. Normalisation will occur:
1) Interest rates will not rise indefinitely (in fact, I take the view that they have peaked, and have a chance of falling by this time next year)
2) Consumer sentiment will recover (independently of whether rates fall or not....for consumers, too, are currently suffering the Recency Effect of rate hikes in 2010, but they will, at some stage as they always do, become immune to their cost of borrowings once the sticker shock has worn off)
3) Consumer spending will recover. Just as we currently "feel" that consumer spending is weak, a lot of it has to do with the fact that we do these comparison on previous corresponding periods(pcp), and the pcp in question was particularly strong, hence the industry jargon of "cycling strong comps". This time next year, we will be cycling the current "weak comps", ergo: the retail cycle will live on...in part, destined to do so, simply by the laws of maths.
4) Pricing indiscipline won't last forever; the structure of the Australian retail landscape doesn't lend itself to protracted discounting. The discounting revolution in Australia always ends up eating its own children as the strong gobble the weak.
5) I have trawled over WOW accounts for many years, and have found them to be (very) conservatively struck. Woolworths records above the line many items that many other ASX200 companies would strip out and argue to be "abnormal". Accounting quality and Woolworths have become almost synonymous, in my more-than-merely-cursory assessment. Just as the Merril Lynch analyst got the WES call horribly wrong ("don't buy at $15", he was saying), so too will he be proven wrong when WOW reports its results of DH10, JH11, DH11, JH12, DH12, JH13, etc. etc. add nauseam.

So, while the storm buffeting WOW right now might not be as abundantly perfect as it was for QBE in mid-2010 (or for WES at $15 in 2008, for that matter), it has many of the hallmarks of the Recency Effect.

All that remains, then, is an assessment of valuation: WOW's valuation metrics are as follows:

FCF/EV = 5.9%
EV/EBITDA = 8.3x
DY = 5.1%
P/E = 14.4x

Now, this falls outside of my usual investment criteria of FCF/EV > 10%, EV/EBITDA <6x, DY >6% and P/E <10x, which would normally exclude WOW from investment opportunity.
However, WOW - and very few other companies like it - are unique entities that require a unique investment approach. That approach is described in greater depth in the thread entitled: ?VALUATION THEORY APPLIED TO A TRUE GROWTH STOCK? which can be found under the ARP.AX stock code. I have only extracted for this post what I consider to be commentary relevant to WOW:

To wit:

Only a handful of companies I have found truly fit the mould of the pure "growth stock". These are companies that have the following attributes:
- business model scalability
- pricing power,
- low capital intensity so that all growth can be funded internally,
- granular customer base,
- supplier reliability,
- credentialisation of industry partners
- management team who understand and practice reinvestment above cost of capital

The list is far from extensive...in Large Caps: ASX, CCL, COH, WDC, and WOW; and Small Caps: ARP, BRG, CPB, DTL, IVC, REH, RMD, SAI, SDI, SEK, TWO and WTF.

For these sorts of stocks a different valuation approach is necessary, specifically a Net Present Value (NPV) obtained from the discounting of future free cash flows.
Now valuation theory will teach that NPV's are fraught with assumption errors, notably in the forecasting long-term cash flows. So what I do is I only explicitly forecast future cash flows out two years, and the add the present value of those two-year cash flows to the terminal value cash flows, derived from the formula:

T = Y2,FCF/(WACC-g),

where T is the terminal value of the cash flows from Year Three to perpetuity,
Y2,FCF is the Free Cash Flow in Year Two,
WACC is the Weighted Average Cost of Capital (normally between 9% and 12%),
and g is the long-term FCF growth rate.

Let?s apply this to WOW. For WOW my FCF forecasts are as follows:

FY10 (actual) = $1.84bn (OCF of $2.76bn less Stay-in-Business Capex of $0.92bn)
FY11 (forecast) = $2.096bn (OCF of $3.08bn less Stay-in-Business Capex of $0.98bn)
FY12 (forecast) = $2.30bn (OCF of $3.38bn less Stay-in-Business Capex of $1.07bn)

WOW's WACC I estimate to be about 9.1% (Cost of equity = 9.5% and Cost of Debt = 7.5% and assuming a target Debt-to-Eqity Ratio of 20:80), and the long-term FCF rate I believe can be maintained at 4.5%pa, i.e. WOW can generate real FCF growth to perpetuity)

So, for WOW, the net present value of the terminal (Year 3 and beyond) cash flows is given by:

T = $2.30bn/(0.091-0.04) = $53.8bn, or $45.2bn in today's terms (after discounting at the group?s WACC)

Add this to the NPV of the cumulative FCF next two years, which is $4.2bn, to yield a total NPV for WOW of $49.4bn.
This compares to WOW?s current Enterprise Value of $35.7bn (Market Cap of $31.9bn plus Net Debt of $3.8bn)

So, by my reckoning WOW is trading at a 35% to 40% discount to my assessment of its NPV of FCF.

So while it looks reasonably fully valued on near-term (FY2011) valuation metrics (FCF yield of 5.9%, EV/EBITDA = 8.3x, P/E = 14.4x and DY = 5.1%), on longer-term valuation measure (Discounted Free Cash Flow) the stock is now undervalued enough, in my opinion, for me to have commence buying, which I did yesterday.

Of course, it warrants mentioning that stocks - even blue chip ones such as WOW - can spend long periods trading away from their intrinsic (and academically-derived) NPV valuations. So while, WOW is unlikely, tomorrow or next week or even next month, to gap up to the $33 Discounted Cash Flow based Net Present Valuation I have for the stock (concerns over the hardware strategy, for starters, will maintain some semi-permanent undervaluation, I suspect), I do think that, at a 35% discount to NPV, the rubber band of undervaluation has become fully stretched. I deem the downside risk (a further 8%-12% for the share price, on my assessment) to be adequately outweighed by the 35% upside potential.

A Sanity Check:
One way to test the veracity of the target price is to solve the equation for the long-term FCF growth rate as implied by the current market value of the business.
In the interests of brevity, I will omit workings (unless anyone explicitly requests them), and give the answer as 2.5%pa.

In other words, the current share price is saying that WOW will only be able to grow its FCF by 2.5%pa going forward. For a company that has historically grown FCF at rates in the high, single digits, I think it is fair to say that 2.5% is laughable. Certainly, I am willing to stake my children's future (indeed I just have) on 2.5% being exceeded handsomely.

Prudent Investing

Cam