This article is authored by MOI Global instructor Kevin Cope, Chief Investment Officer of Hutchinson Capital Management, based in San Francisco.
Success in finding suitable investments has always required a blend of analytical skill, intuition, and good data sourcing. Under the heading ‘data sourcing,’ I have had to add data filtering. Hardly a day goes by that I don’t receive a solicitation from a data vendor claiming to have the golden ticket to my future investment edge. Much of these new data are so fascinating that they form deceptive traps of distraction. However, ‘new and unique’ does not assure investment merit.
The nuisance of noise heightens my appreciation of John Mihaljevic’s keenly insightful The Manual of Ideas. As a subscriber, I benefit from the unique insights of the many contributors; as a contributor at the upcoming MOI Best Ideas Conference 2019, I face the exciting challenge of sharing insights that I hope others will find helpful in their own pursuits.
Value investors have not had an easy go of it recently. The distorted economic and market cycles have persisted so long that even some of the most seasoned value investors are whispering those four most dangerous words. These despondent views resemble those of Benjamin Graham in 1927, a time when Graham lamented the loss of discipline and analytical rigor. The Roaring ‘20s period was filled with investor zeal over a “New Era” of investing, one for which value investors were said to be ill-equipped. Mr. Graham disparaged the fact that investors had to apply methods of pseudo-analysis to support the delusions necessary to justify the persistence of imaginary values.
Many of us saw this firsthand during the (last) tech bubble. Twenty years ago, value investing was declared dead. The media trumpeted that Warren Buffett just didn’t get it. His style of investing was ill-equipped to understand the “New Economy.” Value investors today are grappling with significant distortions and disruption. It has gone on for so long now that it’s understandable for some to believe that ‘it’s different this time.’
As hard as it has been to remain patient and disciplined during this cycle, I continue to apply a consistent process that has worked for me during other difficult periods. Many of the statistically-cheap companies we have analyzed have become cheap because they face a disruptive challenge to their business models. I have learned the hard way not to be dismissive of such threats. Even mature industries with stable cash flows can be at risk from technological change; threats that are not always straightforward.
While I remain consistent in the way I estimate intrinsic value, I have tried to adapt to changes in the economy’s competitive landscape. Simply stated, I have become less patient with companies unable or unwilling to proactively deal with disruptive threats. For our existing holdings, where management is being proactive, I have grown more patient—giving them a slightly longer runway.
I approach the valuation function more as a business analyst than an accountant. Value is created by either increasing the after-tax earnings of all assets deployed or maintaining margins and earnings power while shrinking the asset base. The cornerstone of my valuation process is deriving and evaluating cash economic profit. Equally important is the durability or sustainability of the company’s economic profit margins. Much of this is determined by the company’s competitive position within its industry.
When evaluating value creation, I focus on three primary drivers:
1. Operating Efficiency: Increase NOPAT without increasing invested capital
2. Profitable Growth: Invest only in projects expected to generate returns exceeding the cost of capital
3. Asset Rationalization: Whenever practical, liquidate assets generating returns below the cost of capital
I set out to purchase companies that are committing increasing amounts of capital to high-return businesses while avoiding those that are pouring capital into low-return ventures. In this way, I don’t think about growth and value in discreet terms. I attempt to buy enterprises generating profitable growth in economic profits at prices sufficiently discounting the market’s uncertainty. The difficulty is always in pricing growth. Trying to consistently forecast future growth is fraught with hazards. As a sanity check, I find it useful to reverse-engineer the process. Looking at the current market price and evaluating the embedded expectations is a sensible process to me. It is made easier by focusing on the capital intensity of the business. In this way, I gather meaningful information content from management’s capital allocation decisions. How a company deploys its free cash flow tends to be a long duration decision, framed by competitive factors, and therefore more relevant to my process.
By focusing on capital intensity, I find value in growth but also in rationalization (e.g., shedding low-return assets). In the current market environment, I have to be more patient with the companies that are growing value by shrinking their footprint. Paying the right price for growth depends upon several factors:
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