Rethinking value investing in a digital world

The growth vs. value debate has been well trodden. Growth has clearly won the day and the decade, almost solely due to the majority of technology companies falling into the growth camp. Powered by an incredible digitalisation and disruptive innovation trend, if you bought anything growing earnings it will likely have paid off.

Value investing on the other hand remains misunderstood and, in many cases, oversimplified by investors, journalists, and experts alike. Typically identified as the process of buying companies that trade below their ‘intrinsic’ or ‘book’ value, this approach has become incredibly difficult in a capital-lite world. That is, in a world where the majority of assets owned by the world’s largest companies are intangible or digital.

Even without training, I would suggest every investor looks first at the price to earnings ratio of any company they are considering investing into. This near cult-like status of the P/E ratio has been built over many decades thanks to the likes of Benjamin Graham and Warren Buffet. Yet even the latter has changed his spots in recent years.

There are some clear issues with the traditional approach to identifying ‘value’ investments. Price to book and price to earnings ratios, as an example, penalise companies for investing in themselves. In many cases, the world’s leading businesses choose to expense their research, development and innovation spend, which ultimately reducing their earnings. The result is that the P/E ratio of a company like CSL (ASX: CSL) is overstated.

P/E ratios on their own, as in comparing them in absolute terms is all but useless in this day and age. The more important comparison is a relative one across industries, yet even this gives little consideration to the differing cost of capital faced by each company. As is a reliance on avoiding high P/E companies, with history showing that this outdated ratio tends to peak right before a strong profit result, as investors position in advance.

So, what should investors be looking for?

For those who have studied finance at university, the entire premise of investing relies upon the efficient operation of markets and that investors act rationally. Both of these assumptions are proven wrong on a regular basis. It is clear that markets overreact regularly, offering opportunities for patient and prepared investors.

Cyclicality will remain a key part of the global economy and with it markets. Bad news will continue to be extrapolated into the future and as we saw in 2020, market crashes will be more violent and volatile than before. An influx of first-time investors during the pandemic has done little to dampen the herd mentality and momentum focus that has driven passive equity flows in recent years.

Despite the headlines, value investing still works. It has, however, evolved.

The evolution of value investing has moved towards more specific and nuanced measures of profitable and corporate heath. Modern value investors should be focusing on the cash flow multiple, earnings yield, shareholder yield and ultimately seeking out the ‘compounders’, or those companies delivering strong growth year after year.

Despite the popularity of loss making companies, cash flow remains key; it still pays the bills. Even if that cash flow is used to invest or develop new products, it remains a core part of a successful business. Yet looking at cash flow can be seen as old fashioned in the era of debt fuelled unicorns. Price to cash flow or free cash flow is an increasingly popular measure, as cash flow is less able to be ‘gamed’ by management than earnings. It provides a more accurate picture of a company, as high revenue growth that comes at a significant and unsustainable cost will be reflected in lower cash flow.

Other popular measures include earnings yield and shareholder yield, being the inverse of the P/E ratio. Both of which seek to determine the ongoing profitability of each company and the associated cost of said earnings. The earnings yield of stocks is typically compared to other asset classes like Government bonds and term deposits to determine if they are ‘expensive’ or ‘cheap’.

The inverse relationship between Earnings Yield and the P/E ratio would suggest that the more valuable the investment, the lower the yield, however in reality many companies with high valuations in P/E terms and low earnings yield eventually boost their earnings yields, exactly what growth investors are seeking.

There are two growing trends in equity markets at the current time, but particularly in the smaller company end of the market. The first is the search for ‘concept’ stocks and the assumption that growth, even off a low base is all that matters. It is increasingly likely that many businesses listing in the last few years may not exist just a few years from now.

The more refreshing trend, however, has been a growing trend of investment managers avoiding the popular and ‘crowded’ trades, preferring to focus on real companies that generate cash flow, not just those attached to great themes.

Drew Meredith

Drew is publisher of the Inside Network's mastheads and a principal adviser at Wattle Partners.