The Virus Plaguing Value Part 4: What Should Investors Do?

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Transcript:

Is the value paradigm still relevant? 

Brian Barish:

Part of the challenge is that when value indexes are constructed and they’re constructed on the basis of having a low book to market valuation, it’s as though the indexes are saying that individual stocks possess some commodity called value. Value is not an attribute, it’s a philosophy. The philosophy is, I want to buy at a discount to the intrinsic value of the business, and I want to buy with an adequate margin of safety. So price is very important. It says nothing about the physical replacement costs of the assets or some appraisal of the brand equity or the technology position. It says nothing about any of those things. What we want to do is not discard what is clearly a very powerful philosophy and a very sensible philosophy, because the attribute that we’ve normally associated with value being present has in fact proven to be anachronistic.

What should investors look for now in a value manager?

Given the challenges of the last 15 years, it’s hard to imagine that any quality value manager has not had a moment or two where they’ve thought about re-examining how they look at stocks and why certain stocks have worked and why certain stocks have not worked. We certainly have had our share of false positives and false negatives in the course of the last 15 years, what I would look for is managers that have re-examined their processes and tried to modernize them in light of the fact that so many basic business principles are changed as a consequence of us being in the digital age and all the implications that that means.

There’s a delicate balancing act between thinking forward, thinking through these issues and what they would call drinking the Kool-Aid and suddenly turning into something that you’re not. It’s not our job to buy stocks at very speculative valuations, where it looks like there may be a liquidity-driven market dynamic, where there may be some really unique IP that could be difficult to replicate, and that could lead to lock in propensity. Those will happen and there will be opportunities for aggressive growth managers to go after those kinds of businesses, without a lot of proof that the lock-in effect in the liquidity-driven marketplace effect are in fact coming into being. But hopefully we can find some reasonable middle ground as these dynamics unfold.

Is there a cure for the virus?

Value stocks since the 2008 financial crisis have tended to outperform when interest rates rise and conversely, they tend to underperform quite severely in some cases when interest rates fall and they’ve, the pattern has been more falling than rising since 2008. So to some extent, the question is, can interest rates ever rise again? Can we ever get durable inflation, like what the central banks are gunning for? And I don’t know the answer to the central bank question, but let me throw a couple things out. If you think about the academic paradigm for valuing stock, it is the DCF. That is the accepted academic model for how to value a stock. And it’s generally understood that if you have lower interest rates than the out years of the DCF, including the terminal value are worth more particularly for stocks that are rapidly growing.

And conversely, if interest rates rise, then those out years are worth relatively less. And that favors lower multiple stocks where the cash flows are more immediate, therefore favoring value. What I would pose to you is that it’s kind of a red herring issue. It’s certain that with lower interest rates, the out years of the DCF are worth more, but the question is, okay, well, how much more are they worth? What my understanding is, is that when interest rates were higher, let’s say 4 to 5% before the financial crisis, those out years of a fairly normal, even a growth company, DCF, were worth about 60 to 65% of the value of that calculation. And with interest rates as low as they are now, those out years can be worth more like 80% of the DCF valuation. So they are worth more, but it doesn’t explain the severity and the persistence of the growth value divide that has occurred since 2006.

We’re talking thousands and thousands and thousands of basis points of relative outperformance. I would look at it a little bit different way. Why are interest rates so systematically low? And it seems to me that we have a chronic and increasingly persistent challenge of where to invest as a credit-oriented investor. If you think about the business of bank lending, a bank is normally supposed to lend mostly to collateralized credit structures. So there’s some kind of excess collateral that’s equity in a home or excess collateral and other kinds of business assets. And we know that in the digital age, what are we doing? Well, we’re de-physicalizing all kinds of businesses, so that physical capital is becoming of much more dubious value or really need in the overall economy. And that leads to an imbalance of credit capital relative to the demand for it. And the productive uses for it.

That, to me, suggests that thinking about interest rates as a barometer for whether value is good or value is bad. You’re kind of missing the whole point, which is that the kinds of businesses that thrive and prosper in the digital age, the assets themselves, they’re more intangible. In some cases, they’re more off balance sheet and a structure of how markets work and this whole interest rate discussion is, it’s the wrong diagnosis. I don’t think there’s a panacea. I do think the answer to a vaccine for the virus plaguing value, if there is such a thing, is to look at a price-sensitive discipline that incorporates some of these drivers of digital value, and also looks at a capital discipline as an anchoring principle to how you allocate capital in a portfolio.

Understanding the variables that have plagued value, what has Cambiar done to adjust accordingly?

We’ve done several things to address these issues. Obviously, we’ve done a lot of thinking and a lot of reflecting. On a day to day basis, what we are focused on are two things. We want to be great at underwriting stocks and great at capital discipline, both in the stocks that we select for our client portfolios and how we handle those stocks once they’re in our portfolio. So capital discipline is, it’s not a line item on a balance sheet or an income statement that you’re going to find. It’s a series of tendencies. It’s a tendency to not use a lot of debt. It’s a tendency to be conservative with leverage on the balance sheet. It’s a tendency to grow expenses carefully. It’s a tendency not to engage in speculative M&A. It’s a tendency to have prudent capital return policies towards shareholders. And there’s not a bright line formula that you can articulate that says, Oh, this company has capital discipline.

And, Oh, these guys over here, they don’t have capital discipline, but you tend to know it when you see it. And conversely, it tends to be fairly clear when there’s an absence of capital discipline in an investment candidate. And if you think about the whole theory of a firm, right, what you want to do is invest in businesses that have higher intrinsic returns on capital, higher intrinsic returns on investment spending. And if they go out and blow it by spending a whole bunch of money on aggressive M&A or levering up in some aggressive way, then you disrupt that high continuous compounding of capital principle. So you don’t want to do that. For us, we believe that each investment decision is an underwriting process. So that means we want to look at the business, at the drivers of value, why we think those drivers of value are likely to persist, why we think other investors would tend to agree with that.

We want to look at where the company resides in a value chain and is value likely to accrue to that part of the value chain, or is it likely to accrue elsewhere in that value chain? And we want to look at the long term as well. Do we see technological obsolescence on the horizon? Do we see excess supply or rational competition as being possible issues? And if you engage in the underwriting correctly, that as you really appraise value correctly, it’s very powerful because then all you need to do is let the price of the stock dictate your actions. At a low price, you buy. At a medium price, you hold. At an elevated price, you sell. It’s not that complicated. It takes a ton of the emotions off the table.