At Nikko AM, we are firm believers in active value investing. We believe that through a thorough examination and understanding of a company's fundamentals we can achieve superior risk-adjusted returns. With alpha in excess of 2% over the 23 year life of our process, it is fair to say that there is strong evidence to support this assertion.
Nikko AM Australia values companies based on their sustainable earnings capacity. That is, we determine the intrinsic value by capitalising the sustainable or mid-cycle earnings of every stock under coverage. Using these valuations in conjunction with our forecast dividends and franking credits for each stock, we can then compute an expected return for each company under coverage. This provides us with strong signals as to where the best opportunities are in the market.
Our analyst team spend their days examining company financial statements and discussing industry dynamics with the company, its competitors, its suppliers, and customers to gauge an all-round view of the outlook for the industry and the company's position therein. From this our analysts form a very strong view as to the likely sustainable or ‘mid-cycle’ earnings of that company. We then apply an appropriate capitalisation rate (or multiple) to those sustainable earnings to determine a share price forecast, from which we derive an internal rate of return for each stock under coverage, as described above.
We refer to our approach to value investing as being an intrinsic value style.
It is interesting to note that our intrinsic value approach is highly consistent with the investment approach practiced and taught by Benjamin Graham, who is commonly known as the father of Value Investing.
Benjamin Graham’s seminal work, Security Analysis (co-authored with David Dodd and first published in 1934), sets out his process and views on value. In summary, Graham believed that there are three sources of value: assets, earnings and growth. Graham would seek to buy companies at a significant discount from his assessed value, i.e. he would seek a 'margin of safety’).
The three sources of value
The first, and most certain, source of value comes from the company’s tangible assets. Recognising the flaws in accounting methodology, Graham wouldn’t rely purely on balance sheet measures. Graham ideally sought to buy companies at a discount to the value of net current assets. Of course, investing during the Great Depression presented such opportunities. In modern markets, such valuation anomalies are extremely rare.
Beyond this, Graham would consider the net current assets plus the value of property, plant and equipment. In a business considered to be a going concern, the appropriate valuation of these hard assets is replacement cost. In a liquidation scenario, these assets should be valued at scrap or disposal value.
Unfortunately, in modern markets opportunities to buy companies at a discount to hard assets are very rare. That said, these values are certainly a consideration in downside protection for uncertain investment situations.
The second source of value that Graham observed was the potential cash or earnings generation of company and an appropriate capitalisation of that income stream. Graham referred to this as the ‘earnings power value’. Recognising the difficulty of forecasting, Graham would rely on historic reported earnings.
Graham was also aware that many companies have earnings that fluctuate with the business cycle. Consistent with our approach, Graham would:
- make an allowance for where company was at in its business cycle and adjust earnings to the level a company would earn on average through a cycle;
- adjust a company's earnings for non-recurring items of revenue or expense.
The third source of value that Graham recognised was growth. Graham considered this the most uncertain part of the valuation. As a consequence there were limited situations in which Graham would factor growth into his valuation. Essentially Graham would only include an element of growth in his valuation in situations where the company had an extremely strong competitive advantage. Where this is not the case, Graham’s assertion was that any investment for growth will only achieve a return in line with the cost of capital and therefore does not provide incremental value.
We differ modestly from Graham in our approach to valuing growth. We do recognise that only companies with barriers to entry and sustainable competitive advantages can deliver value-adding growth in the long term. For this reason, it is only for companies with such characteristics that we allow an extended franchise period and above-average growth. Further, even for such companies, we limit this period of excess growth to a maximum of eight years. This recognises that even for the highest quality stocks, excessive growth and elevated returns on capital are not often a permanent state but more commonly of limited duration.
As a direct result of the success that famous value investors such as Graham and his students including Warren Buffett enjoyed, efforts were made to understand and systematise this value approach. This effort gave rise to the use of ratio-based valuation measures as proxies for an assessment of value. Such ratio’s include price-to-book and price-to-earnings, and were only the first step in the stock selection process developed by Graham.
Using these ratios, academics have consistently found that portfolios comprised of stocks with low price-to-book and low price-to-earnings, etc. outperform broader share market indices. As a result of these findings, a cohort of value managers now exist that pursue this style of value investing. We refer to this style as academic value.
Graham and Dodd (1934) recommended not relying on simple fundamental metrics, but instead to gain a more complete understanding of the underlying security’s intrinsic value. The reversion to reliance on price multiples began to gain traction in the 1980s. The introduction of computers and the associated development of financial databases acted as the catalyst.
Further, Kok, Ribando and Sloan (2017) from Berkeley argued that the simple ratios are not good substitutes for value-investing strategies that use comprehensive approach in identifying under-priced stocks. They noted the following:
- The price-to-book ratio systemically identifies securities with overstated book values that are subsequently written off.
- The trailing price-to-earnings ratio systemically identifies securities for temporarily high earnings that ultimately fall.
- The forward price-to-earnings ratio systemically identifies stocks that sell-side analysts offer more optimistic forecasts of future earnings.
In our view, while there is some information in such ratios, in isolation and without further investigation they are of limited use. They say nothing of a company’s future prospects - its growth potential or the threats to its existence. As a result of this lack of insight, this academic approach to value investing is sometimes also referred to as naïve value.
Superior risk-adjusted returns
We believe that our intrinsic value approach is consistent with that of Benjamin Graham, the father of value investing. Moreover, we believe that using our valuation framework, coupled with portfolio risk controls, means we can deliver the value premium with lower volatility than is possible via a strict adherence to the academic value style.