I’m the holder of a great business, which has appreciated significantly these last few years, to the point that its overvalued. So what do I do?
One of my gems, is now significantly overvalued. Its caused me internal conflict.
I invested in what I believe is one of the highest quality businesses in the world at a time when it was in significant distress. I own a company called Cochlear. This company makes the famous Cochlear implant for profoundly deaf people.
It’s one of the few options for the profoundly deaf to enjoy a reasonable quality of life. These implants don’t come cheap and run many thousands of dollars. Implant patients rely on generous subsidies from various governments around the world to make their implant a reality.
Cochlear has majority market share in this business with around 60% share. It is the leader in a fairly cozy oligopoly with two other players that also have material marketshare. This is really a beautiful business. Cochlear has consistently posted returns on equity that are in excess of 30% for much of the last decade. In addition it has operating margins that are generally above 20%.
Best of all Cochlear has been posting solid revenue growth for the better part of the last decade, generally in excess of 10%. The company estimates that it’s probably only captured 2% of the total addressable market which means that the company has effectively a runway for growth for much of the next decade.
The company has solid support from surgeons for its reliability and technical expertise. The same surgeons recommend these devices to their patients who are candidates for a cochlear transplant and also incur moderate switching costs (in the form of retraining) should they decide to go with another competitor.
It’s no surprise when you consider all of these factors that Cochlear is a high-quality business that’s in high demand from investors In fact the chance to pick up such a great business at a reasonable cost is few and far between. I was lucky enough to have one such opportunity to do so back in 2011.
At that time Cochlear was hit with a product recall for a new to market device. It was the first blemish in a long track record for the company. However that the way it handled itself during this event was pretty remarkable. They quickly recalled defective units and ensured that impacted patients had an option to fall back to older models. The company was upfront and honest about its product failings.
Unlike other competitors, Cochlear’s recall was due to a device that malfunctioned rather than one that caused death or serious injury. Cochlear eventually came out of this episode unscathed, however concerns about what this episode may do to its market share sent it share price plummeting. I took advantage of market panic to snag myself some of the business at a bargain basement price. Since that time the company is up close to 250%.
While the company was materially undervalued when I got on board, I believe that the business is now significantly overvalued. Poor alternatives for investment returns have led to high-quality, high-performing companies being bid up in price.
The opportunist in me thinks of selling this business to redeploying my funds in a undervalued opportunity to try and capture some of that eventual return to fair value. However the “quality investor” in me wants to continue to hold quality for as long as possible. If Cochlear is one thing it certainly quality.
In fact, this is the main reason that I’m loathed to part with this business, even though its run higher. The way I rationalize it is this. There are very few businesses that have the quality of Cochlear. As far as returns on equity, consistency of growth and future potential, I’ve been struggling to find something that’s as good.
My fear is that I run the risk of diluting the quality of my portfolio in chasing near term returns, in an otherwise inflated market by dumping Cochlear and substituting it for something else that’s more at “fair value”.
Instead I’ll continue to hold Cochlear, because I believe it will be substantially higher in 10 years than where it trades today. It’s one unique situation where I can justify for myself holding onto something that’s more than fully valued, even though I theoretically should be able to exit the invest and deploy those funds somewhere else for better returns.
The reality is that business value is driven by earnings growth in the long run, which is a function of returns on capital and growth opportunities. Once you have managed to nab such a business that has a favorable outlook on these measures, then you should be loathed to let such a business go, even if its run a little ahead of where it should be,
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