Value is Not the Opposite of Growth
A key point of differentiation of our value approach versus deep value managers is the second pillar of our investment philosophy: The Ability to Grow. We have always believed that value is not the antonym of growth, and a forward-looking path to growth is an essential component of a value investment decision along the lines of i) downside risk management, ii) future revenue, earnings and book value growth and iii) the potential for resource conversion, i.e. dividends, buybacks, acquisitions or a sale of the company.
Downside Risk Management
We believe many value managers stumble into “value traps” by an over reliance on historical measures of profitability or current price to book value metrics. While these measures can be an important indicator of business strength and potential undervaluation, we believe that they are only one aspect of financial analysis and should not be relied upon in isolation. Every business is continually challenged to identify and adjust to new technologies and new competitors, and those enterprises that cannot, or do not change to meet future conditions are likely at high risk of failure. Even once seemingly stable and high cash flow businesses, like long distance phone service, have ceased to exist due to new technologies, like low-cost fiber optic networks that disrupt the traditional competitive landscape.
Competition and Change are Constant
Competition and change are constant factors in our economy. Traditional or quantitative approaches to value investing that rely on historical factors in isolation are, in our view, at high risk of sinking into dreaded value traps. Is the book value or historical cash flow profile of an internal combustion engine manufacturer meaningful if they do not adapt to the transition to electric vehicles? Metrics like profit margins, price to book value and free cash flow yield are backwards looking – the job of an analyst is to determine whether a company that achieved strong financial metrics in the past can continue to do so in the future.
A Fundamental Analysis Approach
Determining a company’s ability to grow, in our view, is the necessary step to discern if a company that looks cheap on traditional metrics actually represents an attractive investment. The important questions to consider, in our view are 1) can the company’s traditional markets continue to grow? 2) is the company well positioned along the lines of Michael Porter’s five forces model? and 3) perhaps most importantly, Governance – does the management and the board have the awareness and the willingness to adapt capital allocation and business strategies to meet and conquer new challenges?
The Ability to Grow
We believe the focus on a company’s ability to grow is an additional tool in the value investing toolbox. Valuation always matters, and we are not recommending that value investors abandon traditional metrics and focus only on growth. Companies that trade on discounted metrics, like low price to book, low price/earnings multiples or high free cash flow yields are an appropriate starting ground for identifying value investments. Value investors realize that without some issue that is causing investor fear and neglect, the stock of a company would not be cheap. Our focus on a company’s ability to grow can help provide clarity to an investment decision versus a deep value manager who may buy a cheap valuation and just hope that at some point the valuation discount reverts up to a past average valuation level.
Rewey Asset Management is a registered investment advisor in the State of New Jersey
This material is for informational purposes only and is not a recommendation or advice. Investments and strategies mentioned are not suitable for all investors. No one can predict or project performance, and forward-looking statements are not guarantees. Past performance is not indicative of future results. Investing involves risk, including the loss of principal.