Evaluating Value

Value investing is paying less for a business than it’s worth. This concept is common sense and easy to articulate.

Over extended periods of time, value investing outperforms. Common sense is applied. Companies that trade too high relative to their fair market values revert to lower levels. Similarly, stocks that trade at depressed levels tend to rise back to fair values.

Mainly because the economy has been robust, interest rates are relatively low, and technology stocks are running high (AI, eh?), value styles are out of vogue. Despite the long-term evidence in their favour, value funds are now greatly outnumbered, both in number of actual funds and by dollar volume.

Value Investing Styles

The investors with the best long-term track records claim some version of value investing. It’s essentially practiced in two different ways.

Warren Buffett, the most famous value investor, has practiced it both ways over his career. His early record was established based on his mentor’s philosophy. Ben Graham, the father of investment analysis, espoused buying businesses at prices so low that the discount alone led to the brunt of returns, despite the quality of the company. Later, influenced by long-time business partner Charlie Munger, Buffett bought high-quality franchises that were expected to compound earnings for years. These companies were generally purchased at fair prices rather than discounts. Same investor, same underlying principle, two different applications.

Most of the field is broken down into two camps. One group looks for businesses that have durable competitive advantages, earn high returns-on-capital employed, and have sufficient reinvestment opportunities. Since these high-quality companies rarely trade at material discounts, managers tend to pay fair prices and hold at fair prices, to benefit from compounding over time.

Others, deep-value investors, look for bigger bargains—businesses trading well below their asset values or historical valuation multiples. This requires more patience and a different temperament, since companies trading at material discounts often do so because of underlying issues that can persist for some time.

Studies have shown that both approaches have produced strong long-term results.

Each has a blind spot though, based on the manager’s style box, and most managers spend a career practicing one or the other. The quality buy-and-hold group misses out on good business at better prices. The deep-value buyer rules out high-quality businesses that aren’t cheap enough.

Requiring a Discount

Each company we evaluate must pass the same test—a price below our estimate of value by a margin wide enough to matter, and each can be sized against how confident we are in the estimate and magnitude of the discount.

We may hold a high-quality company expected to compound earnings at high rates whose price declined in a broad selloff, a lesser quality business whose margins we expect to lift based on a restructuring, a good business whose price has fallen way too far from our estimated value, or a company with a defined corporate event such as a takeover.

These aren’t distinct strategies. They are united in that our expectation of the future isn’t reflected in a company’s price.

We constantly estimate business values and require a price below that estimate before investing. A company typically becomes interesting to us when its share price is below 80% of our estimated fair market value (i.e., a 20% discount), and it becomes even more interesting as the gap widens.

Stock prices carry a set of assumptions about the future: growth rates, profit margins, and returns on capital. We extract embedded expectations and contrast them against our own. Our investments are sensible only if we hold a defensible view of the future.

This requires judgments about the same and whether the market is overconfident or too cautious. Once we identify a sufficient gap between what the price implies and our defensible expectations, we can ascertain whether the position is worth pursuing.

Pursuing Value

We first cast a wide net to source potential mispriced opportunities. Before making an investment decision, we conduct internal research and analysis on the most compelling opportunities.

Wellspring^™, our in-house research platform, has been designed to screen for ideas across a broad universe of companies, based on fundamental research and estimates of fair value. It allows us to rank opportunities based on discounts to value estimates and ward against deteriorating business fundamentals, which may foreshadow a value trap—a company that is cheap but likely to decline further in price because its underlying business is declining.

We are generalists who do not necessarily specialize in particular industries. We specialize in the valuation work itself, the estimate of what a business is worth and the discipline of buying it at a discount and selling it at fair value.

Buy Low, Sell High

Buffett’s adage has become, “It’s better to buy a wonderful company at a fair price than a fair company at a wonderful price.” This philosophy is based on having a smaller opportunity set, making fewer decisions and fewer mistakes, and deferring taxes.

We believe we can have the best of all worlds. Since most large companies trade between fair value and a 20% discount, we aim to buy companies at a discount to estimated value (as substantial as we can easily defend), and to sell once an investment approaches our value estimate.

We don’t want to buy-and-hold companies, even high-quality ones, since all companies are susceptible to decline once fair value has been achieved. And we intend to jettison holdings when vulnerabilities increase if business metrics deteriorate, especially since all companies are subject to competition, which is heightened by technological advances that have become more pervasive.

In our view, holding periods are situational. A high-quality ever-growing company builds value over years, so it’s sensible that one might continuously hold. A turnaround or a corporate event may only lead to the elimination of a defined gap between price and value, and once the gap closes, the upside is eliminated. Therefore, holding periods for these companies may be confined. That said, holding periods are clearly unknown in advance and only determined once positions are ultimately sold.

The quality buy-and-hold group draws from company selection, whereas the deep-value group selects based on valuation metrics such as earnings multiple analysis. But we aren’t buying and holding. Nor are we simply buying cheap stocks hoping they rise.

We begin with discount-to-value—where we calculate the estimated value not just relying on valuation multiples. We check that the quality of the business is not deteriorating, form a clear view of the business future for each position, and look to sell it if our thesis changes or if fair value is achieved.

If quality is out of favour, we can own it without paying a quality multiple. And take advantage of the natural ebbs and flows.

Since value investors differ based on how they execute their trade, clients should assess how managers apply value investment philosophies. We have spent years refining our own philosophy to ensure it stands the test of time.