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Valuations - The Analyst

Valuations

Knowing what to buy, when to buy it, why you bought it and why you own it is important. However, knowing what price to pay for an asset is essential. By paying the “right” price for an asset, you can strip away a lot of the uncertainty and risk associated with owning the asset. Virtually every business has a “price”. However, the real, underlying price (as a function of the cash flows that business can generate in the future) will detach and vary from the price the market is paying for that business at any point in time.

Stock markets fluctuate wildly between fear and greed, optimism and pessimism, often assigning a price to an asset some 50% either way at any point in a longer cycle. This is related to what Warren Buffett and Benjamin Graham call "Mr Market".

The Analyst has a strategy somewhat derived from the great fundamental stock-pickers. We wait until “Mr Market” offers us an attractive valuation. At this point we will initiate our Buy recommendation and add the note to the website.

What is an attractive valuation?

This is, of course, the subjective part of the process, and every fund manager will have a different opinion and different strategy. What makes a winning strategy can only be determined after many years of investment performance.

For us, an attractive valuation is the price at which a worst-case or unlikely scenario is being discounted into the share price. For example, a company may be valued below book value (i.e. the replacement value of their asset base) because the market thinks they will not make a return on capital above their cost of capital in the future. However, if there are means within the realm of control of the company that will allow them to improve and maintain good returns then the stock is discounting an unlikely scenario. Maybe the industry structure is changing and this will allow the business to thrive in a few years time. Maybe they are growing faster than the market thinks and this is not reflected in the multiple of the stock price.

Attractive valuation - The Analyst
Attractive valuation - The Analyst

Investment universe and idea selection

We target 20-30 new ideas per year, with a typical idea duration of two years. Our investment universe is global, across the market cap range, across industries and we are pragmatic about where we look for ideas. However, we have a bias towards European mid and large caps – this is the arena that we know the best and have operated in during their professional careers.

By way of an example, as at March 2016 we had the following active recommendations:

  • 10 Strong Buys (9 Europe, 1 Emerging Markets)
  • 11 Buys (8 Europe, 2 US, 1 Emerging Markets)
  • 22 Shorts (all Europe)

Watchlists

Our potential idea universe starts with hundreds of companies that we have met in the past. Added to these are those we know well from previous research, big/strong companies and companies with issues. We will also examine companies that appear to be misunderstood by the market, where there is a strong division of opinions, greed and/or fear.

This universe is constantly monitored qualitatively and quantitatively. On the research side, we are continually speaking to, and meeting, management teams and investor relations personnel. We watch the share prices of the interesting businesses and we wait for our opportunity. We maintain our models, read the annual reports, study the competitors, industries and global peers. From a technical standpoint, we run weekly technical screens that flag up major share price moves on the upside or downside and highlight oversold/overbought situations.

Attractive valuation - The Analyst
The Final Cut - The Analyst

The final cut

Ideas will usually fall into two categories. Firstly, extreme valuation cases (50-100%+ upside) where an asset is valued at 50 cents in the dollar for whatever reason. This is likely to be because a large piece of the business is being incorrectly understood by the market. Secondly, large caps that have an extremely attractive risk/reward profile. These would be companies that have had some problems, trade on very low valuations in absolute terms and relative to their history or peer group and offer significant (20-30%) upside with low risk. Ideally we want to own and cover these ideas forever because they can grow forever – people always underestimate the power of compounding.

Process

Our business model is predicated on a belief that by operating away from the institutionalised thinking of our peer group (both geographically and mentally) we are in a better position to recognise value and stock pick. The business spends money on research, travel to meet companies and good people, not expensive office space and supplementary staff to justify our existence. We think a group of smart people on laptops with perspective and judgement wins over a group of average people in a City office exposed to noise and consensus thinking.

Our research process usually involves a number of the following projects:

Our Process - The Analyst
The Final Cut - The Analyst

Idea generation example

Givaudan – a Swiss-listed large cap in February 2011.

The research analyst covered the stock at his previous investment funds, and had watched the stock for the last eight years. He had always thought it was a great business to own at the right price. In early 2011 the stock price declined due to market concerns over input costs and currency.

We updated our forecasting model and understood that the valuation was at an attractive point after the stock dropped. We investigated the peer group (Symrise, IFF and others), had calls with the Investor Relations department, and followed this up with a trip to Switzerland to attend the company’s capital market day and spend time with senior management. The idea was regularly discussed in investment meetings. Four notes went on the website (two in February, one in March, one in April), with an accompanying model. Price targets were set, and the idea was highlighted to subscribers via email. We aim to “cover” the stock as long as it remains an attractive investment in absolute terms.

We visited the company again in Switzerland in December 2012 and have continued to cover the stock and push the idea to our clients.

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