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COMMENT: Time for Back to Basics investing

Created:
1 October 2008
Written by:
Julian Chillingworth

''The price was right, the people were right, the terms were right, and I decided to write a cheque. Otherwise it’s a bit like saving up sex for your old age – at some point you’ve got to use it.'' Thanks to the Daily Telegraph for highlighting this gem from Warren Buffett, following his $5bn stake-building in Goldman Sachs. A brave move, but perhaps not enough to cajole investors back into the market. But, as Buffett demonstrates, there’s (relative) value to be had. So where do investors start? With so many variables and almost esoteric valuations at play, is there an argument for getting back to basics? In other words, in the spirit of Buffett, is it time to revive the value-based approach?

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To caveat this debate, at the time of writing, the $700bn drama that is the US Congress is still rocking the markets. Distressed assets with intrinsic value are, no doubt, plentiful, as everything has been dragged down in the general mire. The problem lies in valuing assets in the current environment, illustrated most poignantly by the banking sector. The bottom line is price/earnings ratios are out when trying to establish 'value patterns' or price levels. Instead, we prefer a longer-term methodology based on free cashflow yields, ROIC (return on invested capital) versus WACC (weighted average cost of capital), EV/EBITDA (enterprise value/earnings before interest, tax, depreciation and amortisation) and P/B (price to book), the latter of which is particularly relevant to the banks.

For us, these ratios, coupled with other fundamental assessments, hold more weight than price/earnings. Why? Because price/earnings can be driven by discretionary considerations, and current volatility renders it even more vulnerable to distortion. Our value metrics form only part of the equation, however. Strong market positions in end markets, and visible earning streams are equally as important, and help to delineate 'good' from 'bad' yields.

For some time, 'value' has been discarded by those who were only too willing to see 'growth' ad infinitum. This has led to huge underperformance and de-ratings, based on little more than style theories and sentiment. On the back of these de-ratings, value assets should start to perform as we enter an economic and earnings recession.

These stocks have already been priced for the wars, and history suggests they should emerge earlier, too. No bell will ring when the tide turns, and that is why it is worth sifting through these assets now, albeit while keeping your powder dry. Granted, it will take time before investors are truly mollified, but there will be a point of capitulation. Earnings might be peaking and lending will be tighter, but money can still be made. Buffett’s foray provides some reassurance. Time to warm the bed, at least.

Julian Chillingworth is chief investment officer at Rathbone Unit Trust Management

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