Simon Jaffé, Director and portfolio manager at OLIM, argues that the rules of value investing have changed with three new factors for investors to consider in addition to the classic principles of Benjamin Graham and Warren Buffett.
The traditional focus for value investors has been on appraising the intrinsic value of each business and investing where the discount to that valuation was largest. The founding father of value investing, Ben Graham, liked to look at the Net Asset Value (NAV) of each potential investment. Graham would not simply take the published balance sheet figures but rather adjust each item based on his own analysis. The final value he would arrive at would represent his estimated minimum value that the company’s assets would be worth after all liabilities had been paid off 1. Although Graham later developed valuation methods that incorporated earnings, and even growth assumptions, it was left to Warren Buffet, Graham’s disciple, to significantly refine the process. Buffett became dissatisfied with what he termed “cigar butt” investments and began investing in those companies where a strong business franchise was protected by having “a moat around the economic castle.”
Three new rules for value investing
Learn to prioritise – the amount of information available to investors has expanded enormously in recent years as new forms of media have allowed an ever greater volume of data and opinion to be published. Traditional sources of information have also grown hugely in scale. For example, in 2015, Deloitte reported that the average annual report was more than 50% longer than the 85 page average prevalent in 2006. In addition, the universe of potential investments has continued to expand. For these reasons investors need to prioritise their efforts. Firstly, by avoiding illiquid stocks. Secondly, by screening for value and fundamental factors to identify stocks that look attractive on a prima facie basis. Thirdly, by paying attention to neglected areas of the market. In this way a short list of companies can be identified for further analysis.
Quality matters more now – during certain periods, such as the TMT bubble which peaked in 2000, the divergence in valuation between the highest-rated and the lowest-rated companies can be extraordinarily high. In this environment, investors can often maximise future returns by simply buying the lowest multiple stocks. Currently, however, valuations are relatively clustered around the median. In this situation there is an increased need to differentiate, hence the importance of the quality of company. This can be defined in different ways but a good starting point is to look for businesses with a high and sustainable Return on Invested Capital (ROIC).
Free Cash Flow not Earnings – historically investors have focused their attention on the growth in earnings per share (EPS). However for some companies a large portion of these earnings may be needed either for working capital or for capital expenditure (capex) to maintain existing assets. This means there is less cash available for paying dividends or investing for growth of profits. For these reasons it is better to pay attention to Free Cash Flow (FCF) which is simply the earnings of the company, before financing costs and depreciation but after tax, working capital changes and capital expenditures 2. Thus instead of looking at Price/Earnings (PE) ratios, value investors should also pay attention to FCF Yield which is simply FCF divided by the market capitalisation of the company. Our backtesting of stocks in the FTSE 350 index indicates that FCF Yield is a significantly better predictor of future investment returns than PE.
1 B. Graham and D. Dodd, Security Analysis, McGraw-Hill (1934) Graham further developed his balance sheet analysis through his concept of “Net-Net” investing. The net-net method was more conservative since it involved deducting total liabilities from current assets rather than total assets.
2 To be exact only maintenance capex should be deducted in order to avoid penalising companies that are genuinely investing for growth.