Podcast Summary
Adapting to the new reality of intangible assets in value investing: Value investors must find ways to quantify and value intangible assets like brands and networks to remain effective in today's economy, and identify companies with future growth potential despite current valuation.
The traditional value investing approach, which relies on measuring a company's cheapness based on tangible assets like factories or inventory, may not be effective in today's economy where intangible assets like brands and networks hold significant value. The ongoing challenge for value investors is to adapt to this new reality and find ways to quantify and value these intangible assets. Additionally, the market's consistent flow towards certain firms and the overvaluation of these companies pose a significant challenge for those who miss the initial cycle. The ability to identify and invest in companies that are positioning themselves for future success despite their current valuation is crucial for value investors in the current market environment.
Understanding intrinsic value through comprehensive valuation methods: Identifying undervalued companies requires a more complete understanding of intrinsic value using robust valuation approaches, not just relying on historical data or cheapness metrics.
The discussion highlighted the importance of identifying undervalued companies not just based on historical data or cheapness metrics, but through a more complete understanding of intrinsic value using robust valuation approaches. The debate around value investing has historically focused too much on cheapness and not enough on intrinsic value, leading to subpar performance for many investors. Rafael Resendiz, the co-founder of Applied Finance Capital Management, has dedicated his work to addressing this issue and moving beyond the limitations of traditional value investing frameworks. He emphasized that understanding intrinsic value through comprehensive valuation methods is crucial for identifying deeply undervalued companies and generating good returns. The ongoing debate around value investing and its performance can be traced back to the 1970s, when empirical finance emerged and the focus shifted from net present value and security analysis to the efficient market hypothesis. However, it's essential to remember that the term "value" has been misconstrued, and a more holistic approach to valuation is needed to unlock its true potential.
The Evolution of Finance: From Mean Variance to Security Analysis: Mean variance finance emphasized stock price analysis and testing hypotheses in the 70s, but security analysis was revived in the late 90s with the help of systematic rules and economic frameworks.
The world of finance has seen significant shifts over the past few decades, moving from a focus on security analysis to mean variance finance and back again. During the seventies, the availability of computer methods and data led to the birth of mean variance finance, which emphasized the study of stock prices and testing of hypotheses. This resulted in the decline of security analysis in finance and the shift of security analysis courses to accounting departments. However, in the late nineties, a company named Applied Finance attempted to link mean variance finance and security analysis by creating systematic rules for analyzing companies and linking the output to economic frameworks. Since then, they have been calculating intrinsic value estimates for companies on a global scale, with live out-of-sample estimates since 1998. It's important to differentiate between back testing, which is used to formulate ideas, and evidence, which is obtained after ideas have been released. Some factors, such as book to price and profitability, have had varying degrees of success in back testing versus evidence. As a leading real estate manager, Principal Asset Management provides a 360 degree perspective, delivering local insights and global expertise to uncover compelling opportunities for clients. Investing involves risk, including possible loss of principal.
Estimating a firm's intrinsic value: The speaker's investment approach focuses on estimating a firm's intrinsic value by adjusting accounting data for various factors and determining economic margin to identify wealth creators
Instead of focusing on traditional metrics of cheapness, the speaker's investment approach begins with estimating a firm's intrinsic value. To arrive at this value, they make adjustments to accounting data for items such as R&D capitalization, operating leases, inflation, and asset life. By calculating the economic margin, they determine if a company is investing in projects above or below its cost of capital. Companies with positive economic margins should grow, while those with negative margins should shrink or rationalize. Monster Beverage, with its high returns above cost of capital and double-digit growth, is an example of a classic wealth creator.
Determining Intrinsic Value Beyond DCF: The investment firm uses an 'economic profit horizon' to estimate how long economic profits will persist, providing a more accurate assessment of a company's true value.
The investment firm uses a unique approach to determine a company's intrinsic value, which goes beyond traditional Discounted Cash Flow (DCF) methods. Instead of assuming the world is static and capitalizing all future cash flows via perpetuity, they apply an "economic profit horizon" based on a firm's fundamental characteristics to estimate how long economic profits will persist. This approach helps them understand a company's true economic return, reinvestment, risk, and competitive landscape. Using Monster as an example, the firm consistently identified it as undervalued despite its low trading price relative to intrinsic value. Similarly, they've owned tech stocks like Apple, Facebook, and Netflix, as well as value stocks, since they've found them attractive from an intrinsic value perspective. Even during periods when these stocks were considered overvalued by others, the firm continued to hold them, eventually selling when they believed the intrinsic value was realized.
Understanding Company Valuation and Attractiveness: Valuation depends on economic profitability, growth, competition, and risk. Intrinsic value reflects a company's fundamentals and market perception, and growth and investment in new technologies can keep a company attractive despite perceived undervaluation.
Every company is growing, and valuation depends on the intersection of economic profitability, growth, competition, and risk. Value and growth are not mutually exclusive, and attractiveness is determined by the market's perception of these factors. NVIDIA, for instance, was identified as undervalued in 2011 as a graphics chip producer but evolved into a leader in AI technology. The company's continued growth and investment in AI kept it attractive despite its perceived value. Intrinsic value is not a causal or correlated variable but rather a reflection of a company's underlying fundamentals and market perception. The market's sentiment towards a stock can significantly impact its price, but intrinsic value remains an essential metric for long-term investors.
The relationship between book to price ratio and intrinsic value: Book to price ratio alone doesn't add value to investing, but when supported by intrinsic value, it generates significant positive alpha. Conversely, unattractive book to price stocks negatively impact returns.
The relationship between book to price ratio and intrinsic value is crucial in understanding the performance of stocks. The data from 1998 to 2020 shows that book to price stocks, on their own, have not added value to investing, generating no alpha when not supported by intrinsic value. However, high multiple book to price stocks that are undervalued and supported by intrinsic value generate significant positive alpha. Conversely, unattractive book to price stocks, particularly those that are overvalued, generate negative alpha. The correlation between book to price and intrinsic value is often confused with causality, leading to the birth of an entire industry based on this misunderstanding. The quantitative investing world is starting to recognize the importance of valuation, but it's essential to understand that investment and return on investment cannot be separated. Companies should invest, but only if those investments generate positive future returns. The correlation causality argument is a valuable perspective to consider in understanding the performance of stocks.
Narrow focus on underperformance can lead to flawed investing worldview: A more nuanced perspective is needed to evaluate investments, considering economic profitability and future growth prospects of companies.
A narrow focus on the apparent underperformance of companies that invest, without considering the economic profitability and cost of capital, can lead to a flawed investing worldview. This perspective overlooks the importance of investment in generating future returns and overlooks successful companies like McDonald's, Walmart, Pfizer, Intel, Apple, Google, and Facebook, which have all made significant investments in their businesses. The data showing negative returns for companies that reinvest is an incomplete view, as it fails to account for the wealth creation aspect of these firms. The cost of capital and capital funding decisions, such as share buybacks and borrowing from the market, also impact the performance of traditional value investing in today's market. The ongoing trend of decreasing interest rates has favored high-growth companies with longer durations and greater sensitivity to discount rates. Therefore, it's crucial to adopt a more nuanced perspective that considers the underlying economic profitability and future growth prospects of companies when evaluating their investments.
Impact of Discount Rates on Stocks with Lower Durations: Principal Asset Management's perspective on lower duration stocks' potential increase in value due to discount rate shifts, and the market's response is uncertain. Intangible assets' true value may not be fully captured using current methods, and intrinsic value frameworks can diverge from market perception, creating opportunities for active investors.
The value of stocks with lower durations could potentially increase in value due to potential increases in discount rates and cost of capital over time. This is because further out cash flows become less valuable. However, this doesn't necessarily mean these stocks will be undervalued, and it remains to be seen how the market will price in this potential shift. Principal Asset Management, as a leading real estate manager, leverages a 360-degree perspective to uncover compelling opportunities in the market. Another key takeaway is that the intrinsic value framework of some investors, like Principal Asset Management, may diverge from the market's perception of fair value. This divergence can create opportunities for active investors to exploit. The rise of passive investing, growth investing, and value investing are all segments that can be traded against due to their systematic biases. Intangible assets, such as research and development, are becoming increasingly important in valuing companies. However, current methods of dealing with intangibles, such as capitalizing R&D expenses and adding them to book value, may not fully capture their true value. Intrinsic value-adjusted analysis of large caps shows that they performed poorly when intangibles were taken into account. The key is to understand that intangibles are not just a valuation issue, but rather a complex issue that requires a nuanced approach.
Consider ROI when evaluating intangible assets: When assessing a company's investments in intangibles like R&D and advertising, focus on ROI to determine their impact on performance and accurate valuation.
When evaluating a company's investments in intangible assets, such as advertising or R&D, it's crucial to consider their impact on corporate performance and generate a return on investment (ROI). Treating intangibles as a valuation concept immediately is incorrect, as companies that consistently generate positive ROIs on these investments will see their returns increase, while those that don't won't. Additionally, backtesting studies that add intangibles as a variable to evaluate historical data should be approached with caution. It's difficult to be objective when technology firms, which have spent the most on R&D and have seen significant stock price growth, are the ones dominating the historical data. To create an accurate valuation model, it's essential to let the data marinate out of sample and calculate the efficacy of the model going forward. This investment in time sets firms apart and leads to more accurate results.
Navigating Market Dynamics as a Quantitative Value Investor: Staying true to a well-defined investment process is crucial, even during challenging market conditions. Adjustments may be necessary, but maintaining the core strategy is key to long-term success.
Despite having a well-defined investment strategy since 1998, the identity of quantitative value investing has become less clear over time. The speaker emphasizes that their models have not changed structurally, but they have had to make adjustments to keep up with market dynamics. In 2020, they underperformed value indexes but outperformed the S&P 500 with their core strategy. They learned the importance of staying true to their process, even during challenging times, and made only two trades during the year. Additionally, they issued two market calls, one in March stating the market was undervalued and another in August stating it was overvalued. Despite some missteps, they remain committed to their process and the value of staying true to it.
Staying disciplined and adaptable during uncertain markets: Even when markets are uncertain, investors should stay true to their strategy and adapt by selling underperforming holdings and replacing them with new ones that align with their approach.
Even when market conditions seem uncertain, it's crucial for investors to stay disciplined and true to their investment strategy. In the case of the discussed investment firm, they identified the market as potentially overpriced in August 2020 but didn't call for an exit. Instead, they sold specific holdings that didn't align with their current investment approach and replaced them with new ones. This approach, which has been successful for the firm since its inception in 2004, underscores the importance of staying adaptable while maintaining a long-term perspective. The conversation also touched upon the shifting nature of valuation and the challenges of defining value in today's market. Despite the ongoing debate about the effectiveness of value investing, the firm's unique approach, which focuses on intrinsic worth beyond traditional metrics, has proven successful in various market conditions.
Discussion on the effectiveness of traditional value investing factors: Criticizing reliance on price-to-book and price-to-earnings ratios as sole indicators of value, Resendez argued against frequent model changes and questioned the intuitiveness of quant strategies like value and momentum.
The traditional value investing factors, such as price-to-book and price-to-earnings ratios, may not be as effective as they once were in delivering outsized returns. This was a key point of discussion during a recent episode of the Odd Lots podcast featuring Rafael Resendez. Resendez criticized the reliance on these ratios as the sole indicators of value and argued that backtesting and making frequent changes to models can be detrimental. He also expressed skepticism towards quant investing and the idea that different quant strategies, such as value and momentum, are not intuitively connected. The debate highlights the importance of defining what we mean by value investing and understanding why traditional ratios may no longer work as they used to. It's essential to keep in mind that the investment landscape is constantly evolving, and successful investors must adapt and adjust their strategies accordingly.
