For many value-oriented investors, the last five years have been a challenging period given an elevated macroeconomic risk and bouts of volatility, backdrop of the low growth and structural change in China. In the current environment characterized by more stable growth, value equities are likely to perform better. As of the February 29, 2016, U.S. value equities, as measured by the S&P 500 Value Index, were trading at less than one third of the P/B value of U.S. growth equities, as measured by the S&P 500 Growth Index. Further, the spread between U.S. large-cap value equities, as measured by the Russell 1000 Value Index, and U.S. large-cap growth equities, as measured by the Russell 1000 Growth Index, is greater than at any time since the bursting of the technology bubble in 2000.
Value equities typically deliver outperformance during the period when economic conditions are improving; should economic conditions continue to stabilize, value equities may be one of the biggest beneficiaries. In contrast, growth equities, which are characterized by higher earnings growth history, being higher priced and more volatile than the broad market, have a natural tendency to go through an outperformance cycle when broad-based growth becomes scarce or when investors become more willing to pay a premium.
The Assessment of Value
An equity that trades for less than its intrinsic value is considered a value equity. In another word, a value equity looks cheaper compared to its revenue figures. One key factor for value-oriented investors to consider is high free cash flow yield, as cash-based valuation approaches are more tangible, as compared to the more accounting-based P/B value. This is especially true from a sentiment perspective, where cash flow has been translating into dividends and share buybacks in many cases, with the added pressure from the rise of activist investors hurrying on the process. In the case of target/acquired companies, this immediate and near-term recognition of the value premium has been of great help to value investors starved of broad-based tailwinds.
The philosophy of value investing stresses the interrelationship between investing in value and a superior long-term performance. Underpinning this belief was Graham’s observation that, over time, the largest losses came NOT from investing in high-quality companies at seemingly high prices, but from investing in lower-quality companies at prices that appear to offer good value. The primary reason behind this is the superior resilience of value companies during periods of market stress.
In assessing the “value”, however, some parameters become more subjective, as they cannot be gleaned from financial statements, and arguably, these nonfinancial attributes are even more relevant in determining how sustainable the value of a company is likely to be. These attributes include management ability, shareholder focus, competitive advantage, industry and thematic influences, etc.
Value beyond The Financial Statements
As touched on earlier, not only financial metrics are relevant in determining the value of a company. An assessment of the experience and track record of a company’s management, as well as the motivation of its decision makers also have a major impact on its overall performance, as management determines the strategic vision of the company and path for it to deliver the vision. These can also provide important insights into the growth targets, financial plans, capital structure suitability, approach to leverage, capital allocation plans, any potential opportunities or headwinds of the company. Therefore, it is essential to gain a comprehensive understanding of a business, which can be done through meetings with the management team.
In addition, how effectively management allocates capital plays a critical role in determining the success of a company. This is a decision open to a great deal of subjectivity, from reinvesting in the company, to strengthening the balance sheet, to financing acquisitions, to rewarding management, to paying shareholder dividends or buying back shares. From an investor perspective, allocating capital to pay dividends or to buy back shares is certainly an attractive feature, as it shows a clear alignment with shareholder interests. Ideally, management will also be owners of the company, and thus, have a vested interest in the success of the company. Moreover, the incentive scheme of a management team should be achievable over a longer but reasonable timeframe, which encourages long-term loyalty. Further, the actual amount of compensation paid to management is perhaps less relevant than the path to achieving it, as what investors look for is a management team that is successful in creating shareholder value over time.