Value Investment Revisiting

In an adverse economic and geopolitical environment, retail investors appear to be withdrawing from the capital markets. I would say that the decision to capitulate is irrational and based on fear. Fear is the natural reaction to a completely unknown situation, but if you are sailing through a sea of fog, capitulation is not an option. For this reason, I believe we need to review the fundamentals of value investing and valuation to help investors assess the strategic moves while navigating this volatile environment.

An excellent reference to Value Investing is found in the book “Security Analysis” by Benjamin Graham and David L. Dodd. In the Sixth Edition of the Security Analysis, there is a compilation of articles produced by notable investment professionals. Other important references are the Benjamin Graham book “The Intelligent Investor: A Book of Practical Counsel”, and the McKinsey & Co bestselling corporate finance guide “Valuation: Measuring and Managing the Value of Companies”.

The Ultimate Creators of Opportunities

Financial markets are neither perfect nor static because buying and selling opinions never coincide, as market participants disagree on the market price of any asset given the information available at any time. But I agreed with what Seth A. Klarman wrote in the preface to the sixth edition of Security Analysis when he said that “the financial markets are the ultimate creators of opportunity. Sometimes the markets price securities correctly, other time not”. These opportunities are what value investors are constantly looking for: looking for discrepancies between the value (the "intrinsic value") of a business and its market price in the capital markets. However, you must be prepared because searching for and evaluating opportunities is slow and laborious work. Value investors need to understand the business model and how the business creates added value for all stakeholders. But perhaps the challenge is to identify long-term winners, businesses with resilience to navigate any market condition, and long-term vision.

This is extremely important because when a value investor commits to investing in a company, they plan to hold the position for a very long time, not a short-term trade. The real question is how to keep your composure and focus on long-term goals and investment strategy when the market is moving poorly against your portfolio and general economic rhetoric proclaims a doomed future. The problem here is that most investors are short-term thinkers and belong to the group of "speculative" investors. This was exacerbated during the covid pandemic when people were told to stay home on furlough plans and reduced domestic consumption created excess liquidity. Those new opportunistic traders opened trading accounts and joined the retail investment community buying and selling securities in search of big profits in a short period.

In a rising market, like the one seen since February 2009, everyone makes money and value investing seems irrelevant, but it is always recommended to follow these principles to identify the best entry point in a bull market. But for those speculative retail investors with no intention of undergoing a comprehensive investment screening process, the option was a passive investment approach with the aim of reducing the cost of investment advice and the management fee paid by professional investment managers; for example, by investing in an ETF tracker (May the trend be with you!).

In the end, value investing is not for everyone unless you develop the essential traits: patience, discipline, and risk aversion. Warren Buffet, one of the most notorious value investors, wrote in the preface to the fourth edition of The Intelligent Investor, that “to invest successfully over a lifetime does not require a stratospheric IQ, unusual business insights, or inside information. What’s needed is a sound intellectual framework for making decisions and the ability to keep emotions from corroding that framework.”

What is value and how it is created?

The main question I always have is what constitutes a good business. I will recommend a thorough read of the McKinsey & Co Valuation book. McKinsey& Co stayed the principles of value creation at the beginning of the boos which said: “Companies create value for their owners by investing cash now to generate more cash in the future. The amount of value they create is the difference between cash inflow and the cost of the investments made, adjusted to reflect the fact that tomorrow’s cash flows are worth less than today’s because of the time value of money and the riskiness of future cash flows.” (McKinsey & Co, 2015).

The relevant metric used by analysts and investors to analyze the performance of a company and management is Total Return to Shareholders (TRS), this is the combined effect of capital gains due to the increase in the share price over a period of time plus the sum of the dividends paid to them over the period. McKinsey decomposed the TRS for a thorough determination of its five key drivers. The valuation principles tell that the amount of value a company created is governed ultimately by the revenue growth (net of the capital required to grow), the return on invested capital (ROIC), improvement in profit margins (operating improvements), the earnings yield or “zero growth return” (this is the return generated without any growth and profit margin improvement), and a change in shareholders’ expectation on the share price.

Avoid a Value Traps: objectively test the management ability

A famous quote from John D. Rockefeller said, “The best business in the world is a well-run oil company. The second-best business in the world is a badly run oil company”. I disagreed with this statement. There are thousand or more cases of two almost identical businesses operating in the same industry but generating enormous differences in shareholder value, and some of them are oil and gas businesses. A business is as good as its management team. Graham and Dood knew this a long time ago when they said, “Make no mistake about it: a management’s acumen, foresight, integrity and motivation all make a huge difference in shareholder returns”.

In my experience, value investors take their time to know the management team, their vision for the business, and the ability to deliver on the business plan. Even if the share price is low enough (the relative price to the intrinsic value) to the in to buy and hold, let says at a 30% or 40% discount to its underlying value, a real value investor is not tempted to invest unless there is a thorough examination of the business plan and the management team experience to deliver on the promises. In the end, value investors are prepared for a long-term relationship with the management team so it’s a matter of trust.

This subject of value investing has many ramifications that I will be covered in other articles. Please, leave your comments and questions so I can incorporate them into the following article.

Regards,

Jhoan Cordoba