Money Life Interview – Munish Malhotra
Cambiar Investment Principal Munish Malhotra joined Chuck Jaffe on his show Money Life to discuss his latest blog Cheap Isn’t Value and what it takes to be a value investor today.
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Welcome back to Money Life, where our final interview of the day should be another really interesting one because my guest is Munish Malhotra. He is Co-portfolio Manager of the Cambiar Global Equity Strategy, Portfolio Manager at Cambiar Investors. And if you want to learn more, you just need to know the name of the firm, cambiar.com, on Twitter @CambiarInvestor. And if you find Munish on the Money Life Show recent and upcoming guest page, you will find a longer link that will get you to a piece he wrote last month, about how cheap is not value. Which by the way, is one of the things we’re going to discuss.
Munish Malhotra, welcome to Money Life.
Chuck, thanks a lot. Pleasure to be here.
I guess since I’ve promo’d the fact that we’re going to send people to this piece that you wrote last month, let’s start there. Because at Cambiar, you guys are value investors, but value means different things to different people. More importantly, value is changing. In fact, earlier on today’s show, we had someone from Oakmark on, Clyde McGregor, and he was talking about value and how it’s changed in his 25 years as a portfolio manager.
Well, that’s their definition of value. Value in general has changed, to where there are now people saying, I don’t know that it works anymore. It’s been said for a while. It’s not so much is value dead, it’s how does value work now?
Yeah. That’s right, Chuck. And I think what’s really important for your listeners to understand is that value as a discipline is absolutely not dead. What we have to do is to reframe what value really means. And in that piece, one of the things we talked a lot about was this idea that P/E, just simply screening for cheap companies, using a P/E multiple is a very lazy analysis. One of the things we try to focus a lot on is what we call equity-free cashflow or distributable free cashflow.
If you think about it, for example, there’s a cruise line company in the UK that, pre-pandemic, traded at 10 times earnings. And this company, after CapEx and working capital and debt payments, the distributable free cashflow is actually only half of their earnings. And so you look at a company like a cruise line versus a software company that might trade at 20 times earnings, where that software company has very little in CapEx and can distribute all of their free cash flow to investors.
And so we don’t consider just P/E multiples and earnings as a true reflection of the value of a company or the true underlying earnings power of a company. We like to look at equity-free cashflow or distributable free cashflow. And so we might look at a company like a software company trading at 18 to 20 times earnings versus a cruise line trading at 10 times earnings. And we might say, actually, they’re the same, in terms of the underlying earnings power, they’re actually trading at the same multiple. So I think that’s one thing to understand.
And with more and more earnings in the marketplace coming from digital companies, companies that don’t have a lot of tangible assets, the importance of looking at equity-free cashflow and distributable or free cashflow is just that much greater.
We’ve had money managers on the show who have gone a lot of different ways on value. And your perspective is a very interesting one and pretty different. But the one that I’ve quoted since he said it back at the end of August, is Joel Greenblatt from Gotham, one of the better-known value investors in the world at this point. And he was talking about how, at least at that point in time, he considered Amazon to be a value stock because although it was trading at about $3,300 a share, he considered it to be a $6,000 stock.
That has been something we’ve discussed with a lot of different money managers. So when you’re talking about value, how do you feel about that statement given your metric, does Amazon qualify as a value stock?
I think the second part of how we think about value is, number one, I think it’s important to understand apples to apples, what true underlying earnings means. But I think the other point is really looking at companies from the lens of returns on capital. One of the ways we truly define what we consider quality is we look at returns on invested capital. If you look at a company like Amazon, their returns on invested capital are actually pretty compelling.
And the reason why returns on invested capital is important is because it’s a measure of how efficiently a company uses its assets. So if a company has a dollar of assets and every year generates 25 cents of earnings, that’s a 25% return on invested capital. Now that’s really impressive. And if you look at a lot of these digital companies, companies like Amazon or Google, these companies generate very impressive returns on capital.
And the reason why we think that’s important is because a company that generates, let’s just say a 25% return on capital, they have each year, 25% more capital with which they can use to reinvest back in the business, distribute dividends or buy back shares, or engaging in creative M&A. And for us as equity investors, those are all much more attractive attributes.
The other thing I think that’s important is these companies that generate very high returns on capital, Economics 101 tells you if you generate an excess return, eventually competition is going to erode that away. And Brian Barish, our CIO, has written some really great work that’s also on our website, which shows that these companies that actually generate really high returns over a long period of time, that those returns actually are sustainable and they’re durable.
And once you’ve generated a moat around your business, once you have an entrenched competitive advantage, that advantage is very hard to dislodge. You take a company like Amazon, a company like Google, for example as well, these companies have very wide moats around their business. They have very entrenched competitive advantages. Those are things that are very hard to unlock.
And so as an investor, Chuck, I mean, it’s a very simple analysis. If I give you two earnings stream, one is a dollar and I give you that dollar every year for 10 years. Versus another earning stream, which is a dollar that grows at, say seven or 8% every year for 10 years, you are naturally going to pay a higher multiple for that dollar of earnings stream that’s growing every year, consistently year in year out, because your capital can compound at a much higher rate.
And so when we look at value, we don’t look at absolute P/E multiples because it doesn’t tell you the whole story. What we’re looking at is what are the returns on capital that this company is generating? Do we believe those returns are durable? Can they sustain? Can they improve over time? We spend a lot of time as a research team thinking about that. And the multiple we pay is usually an output of that and not an input of that.
And so we don’t … What we try to do at Cambiar is we try to invest in those companies that have high returns on invested capital that we believe are durable. And also, where we think we’re not paying a very high multiple for that future cash flow stream. We want to be able to combine both attractive prices, but also by attractive businesses.
And the piece I put together on the website, which is called Cheap is Not Value, one of the things we refer to is a lot of times, cheap multiples can be a false signal for a company that’s being truly disrupted. Things like oil, or if you look at the auto industry, these are areas that are facing some severe disruption. And so buying cheap can be a false signal.
And vice versa, there is a payment company that we … There are several payment companies in Europe that trade at very, very high multiples and they’re very attractive businesses, but the burden is really on those companies to continue to compound at very high rates of return for us to get an adequate return for our shareholders.
And so what we’re trying to do is find really high-quality companies at attractive multiples. I would argue Amazon is a value stock because if you look at the value of AWS combined with all of the other optionality embedded in the business, combined with their dominance in commerce, we still think it is an attractive company. Now we have taken profits on Amazon. We bought it in the midst of the crisis in March and April. We thought, basically, you were getting the entire company at the implied value of AWS, and you were getting the e-commerce business for almost free. So we have taken profits on it, but we still think it’s very attractive.
When you talk about how value is working and what you’re looking at going forward, how much has the pandemic made it hard to determine what actually meets your criteria of value? Because of course, all the numbers have changed because with some of the metrics that you’re looking at, well, they’re impacted by the fact that businesses went to an almost full stop, or what have you, because of the pandemic. So quarter over quarter or year over year comparisons are skewed or possibly meaningless.
Yeah. So what we try to really focus on is the underlying earnings power of the company. Do we believe that the underlying earnings power of that company is impaired permanently by the pandemic? If you’re a hotel company and you’ve relied on two-thirds of your business from business travelers, people going overseas, going to conferences, and going forward, corporations are going to do 20% less travel because they can do a lot more over Teams or over Zoom, then you just have to assume that there’s going to be a portion of your business and a portion of your rooms that are just never going to be filled.
And so we are trying to focus a lot on understanding which companies have been growing through this cycle, which companies are likely going to come out of the pandemic with higher earnings power on the other side of the cycle. And so we’ve been focusing on leisure companies. We’ve been focusing on entertainment companies. We think there’s a lot of pent up demand. If you look at consumer savings rates, household net worth, they’re at all-time highs. We think there’s a lot of pent up demand. People want to go to restaurants. People want to go travel. They want to go see the world. They want to go see their family and friends. We don’t think that’s going to go away. Entertainment, concerts. Those are all things that we believe the consumer is going to do.
And also investments in green energy and alternative energy and renewals, we don’t think that’s going to stop. And so those businesses have been hit by COVID, it’s a temporary setback. We think their earnings power is going to be as high if not higher than it was pre-pandemic. And that’s where we’re focusing our time
Very quickly, because we’re almost out of time, the value picture domestically versus international. As value guys and bottoms up guys, I’m not asking you for a market call that you don’t really want to make, but are you finding it easier to find value domestically or internationally right now?
Definitely internationally. I mean, if you look at the international indexes, the international indexes are overweight, more economically sensitive parts of the economy, things like materials, industrials, financials, that’s just kind of a natural part of …the US tends to be overweight, more digital companies, more companies that have benefited from the pandemic, healthcare as well, Staples.
International companies tend to be more economically sensitive, more cyclical. And so those areas have been hit harder by the pandemic. Also, there’s just generally home country bias. When people get nervous, they tend to flood into the US, the US tends to be a safe haven. And so we think as those concerns recede, investors will start to go internationally.
And also into emerging markets. China and Asia, those regions have been hit hard by the Trump administration and some of the trade rhetoric. And we think going forward, it’s going to be a less adversarial relationship. And so we’re optimistic about Asia as well. So yeah, we think there’s more value internationally.
Munish, great stuff. Thank you so much for joining us. I hope you’ll come back and chat with us again down the line.
Thanks, Chuck. Appreciate it.
That’s Munish Malhotra. He is Co-portfolio Manager of the Cambiar Global Equity Strategy, Portfolio Manager at Cambiar Investors. cambiar.com, the website. cambiar.com/cheap-is-not-value. That’s the long link you can find at the Money Life Show website to get to the piece he was discussing here. And then on Twitter @CambiarInvestor, you want to make sure you don’t miss any of their commentary, which is worth finding.
What’s also worth finding out about? What we’ve got planned for the rest of the week. And we’ll tell you all about it before we send you home, right after this message.
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