“To value or not to value? That is the question" - Value Insights by Lingohr & Partner [Archive 2016]

“To value or not to value? That is the question” (if Shakespeare were alive today)

Every thoughtful investor should reflect on his own investment philosophy from time to time. This typically happens when his investment approach has been challenged by the market. Are my principle assumptions still valid? Have there been structural changes? Any sound investment strategy should have an economic and philosophical foundation which aims to achieve its long‐term goals.

“The fundamental law of investing is the uncertainty of investing” (Peter Bernstein)

Our “genre” of value investing has been “out of style” for the longest duration in decades. We therefore pose ourselves the question: Will value investing still work in the future? Have slow growth, quantitative easing, and negative interest rates, coupled with demographic trends, moved the investing environment towards highly successful asset‐light business models and thereby permanently disadvantaging business models which are asset intensive? Are asset intensive companies and sectors doomed and therefore rerated by the market permanently? To put it differently: Does the new economy negate some or many of the value investor’s principle underpinnings? It all depends on how you define value! 

We believe value investing is much more than factor‐ or style investing. Rather, it is a philosophy that requires, among other qualities, a large degree of a contrarian mindset. Investment styles go in and out of fashion or are generally associated with different parts of the economic cycle. Value, the way we embody it, is present at all times, however, to varying degrees. The question is therefore: Does the value we seek manifest itself overtly? How do we find it? We strongly believe that Value investing must be focused on long-term returns rather than joining the (momentum) crowd and thereby chasing short‐term returns. Value investing will continue to provide greater risk‐adjusted returns in the future. 

To set the stage, let us provide some of our core beliefs: 

·        First, we believe that company fundamentals drive stock prices in the long‐run. [1]

·        Second, the most important task of every active manager is to distinguish between the company’s fundamentals and the expectations implied by the price.

·        Third, emotions and heuristics systematically cause investors to make forecasting errors and are therefore the main reasons why mispricings occur.

·        Fourth, the future is not predictable and if it were, it would probably be priced in already.

·        Fifth, we focus on the long‐term and consider short‐term investment results transitory only and meaningless to evaluate an investment process.

·        Sixth, implied by Graham’s maxim, valuation plays an important role for understanding what might already be discounted and will therefore not contribute to long‐term returns. 

Let us return to the question posed at the outset: Do asset‐light companies represent better investment opportunities compared to asset intensive companies? No doubt, the question is a tricky one. If the question is posed to decide which business model will be able to generate higher returns on capital, the answer would definitely be: asset‐light businesses! To put matters into perspective, we address a number of issues that we believe are important to contemplate within this context:

·        High returns on capital attract fierce competition especially in dynamically fast moving markets and product cycles. First movers invariably make mistakes as the opportunity set is frequently ill‐defined. This circumstance gives copycats the chance to learn from the first mover’s experiences and helps them to avoid making the same errors.

·        There appears to be widespread belief by the market that, in order to justify high multiples, growth is largely predictable. Empirical evidence, however, suggests that to a large degree, growth is not foreseeable, and is particularly prone to mean reversion. This is particularly true for new industries and new product spaces. Also, product‐ and economic cycles make it impossible to extrapolate linearly. The market is in the habit of extrapolating negative as well as positive data for too long into the future based on short-term events or even emotions. Thereby the market often times under/overestimates company-specific performance, the product- and economic cycles, which are often difficult to predict with a high degree of confidence. 

Looking at historic data, it is one can observe that growth rates, with respect to revenue and earnings, have rarely managed to be sustainable for an extended period of time[2]. For that reason, sales and margins experience a large degree of mean reversion. The [only delete?] rational conclusion of the prudent investor is: high multiples are very speculative as they imply expectations which empirically are not sustainable for most companies. One should avoid to exclusively focus on a handful of successful companies but instead keep an eye on the never ending list of companies that did not meet the challenge. In other words: We should focus on the base rate – not the case rate.

·        Particularly over the past 5 years, investors preferred to buy stocks offering high quality and growth, irrespective of price. Conversely, weak fundamentals cause investors discomfort, leading them to avoid these stocks. In order to consistently outperform the market, it matters little what you know, but rather what you know that the market does not know. This disconnect between a company’s fundamentals and its current price, however, is mostly found in places where investors do not like to look, because it creates emotional discomfort. Emotions in combination with heuristics cause humans to make systematic forecasting errors.

·        It is important to distinguish between a good company and a good investment. The central question therefore is: What is already priced in? Can an investor beat the “wisdom of crowds”? Most of the time, the investor tends to agree with the consensus ‐ well‐illustrated in the cases like Google, Facebook and Starbucks. The only possibility to outperform the market with these stocks is for them to continuously surprise on the upside in the long term.

·        What does the market know? Even though the market is perceived to have predictive power, it is to a large degree only reflecting sentiments of market participants about a company, sector, country or the overall market. Sentiment by nature is likely to be more reflective than predictive. When thinking about the highest return opportunities in the recent past, what comes to our minds? The post‐crisis years 2009 and 2011. At both points in time, sentiment happened to be extremely pessimistic; coupled with very attractive valuations, this resulted in subsequent superior returns for opportunistic investors. 

Consequently, the question is not asset light or asset intensive but rather how can the investor achieve the highest risk‐adjusted returns? Value can hide in many places. Sometimes it is evident and sometimes it is not. We do not think value is simply buying cheap assets, however, this is potentially a good starting point in order to avoid overpaying.

Our core beliefs are translated into an investment process that is repeatable and sound. Picking the “winner” out of 4000 companies is not what we believe we can accomplish on a consistent basis. We have, however, “out‐selected” almost all country indices in the long-run by relying on our transparent and repeatable process by aiming to beat the benchmark on average and not trying to find the very best company, the next Apple or Alphabet. Our primary task remains to purchase shares in companies that are undervalued compared to their fundamentals. In order to achieve this goal, we chose to approach investing holistically, emphasizing the above mentioned beliefs and sidestep as many systematic mistakes as possible. In order to take advantage of mistakes by “Mr. Market”, one has to be disciplined and adhere to a repeatable approach which considers a company’s fundamentals as objectively as possible – keeping emotions at bay.

Sincerely,

Goran Vasiljevic & Team

Disclaimer:

Lingohr & Partner Asset Management GmbH is a financial services institution as defined by the German Banking Act and is subject to supervision through the Federal Financial Supervisory Authority (Bundesanstalt für Finanzdienstleistungsaufsicht - BaFin). Its registered office is in Erkrath, Germany.

This presentation is intended exclusively for individuals who, professionally or commercially, buy or sell securities or other investments for their own account or on behalf of others (institutional investors).

Lingohr & Partner Asset Management GmbH is the author of this presentation. Reproduction of this presentation, duplication of the information or data contained therein, particularly the use of text, graphics or image material, whether entirely or partially, is permitted only if specific approval thereto has been given by Lingohr & Partner Asset Management GmbH.

Lingohr & Partner Asset Management GmbH reserves the right to change or add to the information contained in this presentation.

Past performance of financial instruments is no guarantee of future results.

We do not provide any guarantees regarding the accuracy or completeness of the information.

[1] As also famously expressed by Benjamin Graham: “In the short run, the market is a voting machine but in the long run, it is a weighing machine.“

[2] e.g. ?Why bad multiples happen to good companies”, McKinsey & Company, May 2012