Quality at the right price - Mark Wright Seneca IM
“Mr Market” is an allegory created by Benjamin Graham, one of the forefathers of value investing. It was used to illustrate how irrational investment markets can be at times; the direct result of market participants falling hostage to their own human emotions.
Mr Market, a fictional character, will always quote a price at which he is prepared to either sell an investment to you or buy an investment from you. Currently, he is infatuated with high quality companies that serve international markets and is demanding higher and higher prices to sell shares in those companies to you. But what price should investors pay for a high quality business?
At Seneca Investment Managers, we are value investors. This means that we concern ourselves with appraising the intrinsic worth of investments, spending significant time determining whether or not the current price quoted by Mr Market differs materially from our assessment of the investment’s intrinsic value and therefore whether we should be buying that investment or selling it if we already own it.
For most businesses, I utilise Economic Value Added (EVA) theory, in order to assess the true worth of its equity. This entails calculating all of the capital that has been invested in the business and then deriving what return that business generates on its invested capital. Economic profits are earned if the return is greater than the cost of that capital i.e. there is a positive economic spread.
A high quality business is one that has demonstrably been able to grow the amount of capital invested in the business and consistently generate healthy levels of economic profit. Of course, one has to judge whether or not the dynamics of the industry in which the company operates will permit further growth at similarly high returns on invested capital in the future.
High quality businesses tend to trade at higher multiples of basic valuation metrics, such as price to earnings (P/E) or price to book value (P/B). This is because these businesses earn a higher economic profit than most other companies. Indeed, many companies generate no economic profit at all. However, there is still a limit as to what an investor should pay for a high quality equity investment.
Diploma and Victrex are examples of two high quality businesses that have been very successful investments for us. The former is an international distributor of specialist components in niche markets across various sectors. The latter is a manufacturer of a specialist polymer called Polyetheretherketone (PEEK), has a dominant market share and focuses on developing innovative new forms and uses for PEEK.
Over the last few months we have recently been forced to exit both Diploma and Victrex. I use the word “forced” deliberately. As value investors, Mr Market essentially determines whether or not we are invested in an equity. If he is quoting too high a price, then we cannot own shares in that business.
Why did we think the price Mr Market was quoting was too high? Our analysis gave us the rate at which both companies would have to grow and the return on invested capital that they would have to earn in future years, in order to justify the price/valuation that Mr Market had placed on them. The two figures were high in both absolute terms and relative to each company’s own history.
Diploma and Victrex may well meet these expectations, but there is little, if any, room for error; we did not feel we would be sufficiently compensated for taking the risk that they didn’t meet those expectations.
We would rather have a portfolio tilted towards those businesses that are currently being shunned by Mr Market. For example, more cyclical businesses that serve UK markets, such as Kier Group and Marston’s.
Please note this communication is aimed at professional advisers only. The views expressed are those of Mark Wright at the time of writing and are subject to change without notice. They are not necessarily the views of Seneca Investment Managers Limited and do not constitute investment advice or a recommendation to invest in the asset class referred to in this communication. Whilst Seneca Investment Managers has used all reasonable efforts to ensure the accuracy of the information contained in this communication, we cannot guarantee the reliability, completeness or accuracy of the content. Seneca Investment Managers Limited is authorised and regulated by the Financial Conduct Authority and is registered in England No. 4325961 with its registered office at 10th Floor, Horton House, Exchange Flags, Liverpool, L2 3YL. FP18 254