Every now and again, some prospects or new clients will ask us why we do not recommend “cheap companies” for their portfolios. They may also ask why we do not sell companies from their portfolios, once they have gone up 50% or even 100%, as they must be by now “awfully” expensive, and instead we should look to identify other cheap companies.
It seems that for some of them, who are not yet accustomed to our high-quality investing process, value investing means investing in companies which are trading at low multiples. The infamous Price to Earnings (P/E) ratio is one example, others include the price to book ratio, and the price to sales ratio. Yet, ratios are not valuations; the intrinsic value of a firm is the net present value of the future discounted cashflows the firm will generate in perpetuity.
Historically, many “value investors” and their advisors have piled into banks, insurers, oil companies, automotive, miners, energy companies, and some utilities. By simply focusing on the price to earnings/book ratio, many value investors have simply bought a stack of value traps, given that many businesses within these sectors are structurally challenged.
Trapped by some myopic views, many keep missing the wood from the trees and expect (by some divine right) “value investing” to finally regain its crown! However, many factors render this situation unlikely. Spiralling debt levels (Governments, corporates, and consumers), aging populations, and the technology boom, all lead towards a deflationary environment.
Environmental, social, and governance (ESG) investing is gaining traction fast whilst the increasing importance of intangible assets is well documented. Furthermore, rather than suffer from mean reversion due to the laws of diminishing returns, many highly profitable firms benefit from increasing returns which have led to an increasing winner takes most (or all) environment.
In a recently published study by Dimensional Fund Advisors, a promoter of “value investing” using as a main measure the price-to-book ratio, it recognised the importance of intangible assets, and recognised that from an accounting perspective, external developed intangible assets are accounted for as part of the book value, as the companies pay higher prices when acquiring other companies who own intangible assets. However, Dimensional also recognised that for other companies with internally developed intangible assets, these are not reflected in the balance sheet.
Howard Marks, the CEO and Chairman for Oaktree Capital Management, a well-known value investor, explained in his last memo that “current profits severely understate the tech leaders’ potential. They currently choose to spend aggressively on new product development to expand share and head off competition, voluntarily suppressing profit margins. Thus, enormous potential exists for the tech companies to increase profit margins in the future when they become willing to moderate their growth rates.” In short, the E (earnings) in the P/E ratio for these companies is lower than it should have been, and high P/E ratios are not a good valuation tool for these companies. At the same time, as this cost is treated as expenditure and not as investment, it does not increase the book value for these companies, so they will show high price to book ratios too.
For us at N2 Asset Management, we think that the modern economy is increasingly driven by intangible assets, such as intellectual property, brands, and networks. However, common measures of value have failed to adapt to this transformation. The path forward involves both accounting reform and improved methods to directly value intangible assets. Investing in intangible-rich companies can be profitable as they are often miss-valued by traditional metrics.
At N2 Asset Management, we are value investors, but we define “value” differently. We like to buy and own companies for which the stock price remains lower than the ‘intrinsic value’ of the entire business. For us, as explained above, the intrinsic value of a firm is the net present value of the future cashflows the firm will generate in perpetuity, discounted at a proper discounting rate. We invest in companies with high Return on Capital Employed (ROCE), high barriers to entry (“wide moats”), companies which could grow their net earnings year-on-year, and which own a lot of intangible assets. Given that many of these companies are the incumbent in a sector, for us, most of the time, value is short of monopolies.
Finally, we are on the cusp of major disruptive change, helped by this pandemic, which will lead to seismic shifts going forward. Some companies will be major beneficiaries, but again, many of the so-called value stocks will be permanently disrupted. All these factors led us to believe that many so-called value stocks are value traps. Reality can and will hit hard!
IMPORTANT NOTE: The value of an investment and the income from it could go down as well as up. The return at the end of the investment period is not guaranteed and you may get back less than you originally invested.