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Value investing’s challenge

There was equity investing before Graham & Dodd and it was powered by snake-oil salesmen and voodoo economics. Then came the publication in 1934 of Security Analysis, the book always referred to as ‘Graham & Dodd’. Since then, the analysis of equity investing has acquired the trappings of rigour as more and more algebra has taken the place of alchemy, but the psychology of the game remains stuck in the past.

It’s understandable why psychology should lag rigorous analysis or – to put it the other way around – why analysis should have so little impact on investors’ psychology. After all, by instinct we’re still in the stone age and this helps explain why styles of investing swing in and out of fashion. The style with which the Benjamin Graham half of Graham & Dodd is always associated is value investing, which has been as fashionable as Bri-Nylon these past few years.

Thus it has been encouraging to see obituaries to value investing dotted around these past few months. Nothing new in that, which is the point. The demise of value investing has been predicted often enough over the years. Most especially, it featured during the exuberance of the late 1990s when, for example, a cover from Institutional Investor magazine asked, ‘Value investing: can it rise from the ashes’?

It did. As the dot-com boom was consumed by its own excesses, those value investors who had resisted the temptation to boogie on down – and looked all the more square for their restraint – started looking prescient, even a bit cool. None more so than Benjamin Graham’s best-known pupil, the great Warren Buffett, who refused to get involved with technology stocks just because they were hot. When he appeared on mainstream American TV to explain that he didn’t understand tech stocks, he seemed like nice old Uncle Warren – humour him, but he’s irrelevant. Within months, Mr Buffett’s reputation had scaled even greater heights and value investing was off the endangered-species list.

Which, of course, prompts the thought, are we about to see a replay? Come the vaccination, come the revival of the old world. Certainly, the Bearbull Income Fund, which leans heavily on value, felt the benefit. In November, it had its best month-on-month return in the 22 years it has been running – up 11 per cent. Although let’s put that into context – the FTSE All-Share index, the fund’s benchmark, also produced its best monthly return in that period and it rose 12.4 per cent.

Yet if there is to be a revival in the craft of value investing, it helps to understand what’s happening when an analyst puts a value on a company; in particular, on its equity. It also helps to know how to adapt value investing, a practice that focuses on a company’s tangible assets, to a world in which intellectual property is regularly more valuable than factories and offices.

To start, let’s go back 60 years to a seminal piece of thinking by two American academics, Merton Miller and Franco Modigliani (nowadays, simply known as ‘M&M’). Their paper, Dividend Policy, Growth and the Valuation of Shares, introduced a break-through notion – that the value of a company comprises the present value of the sum of its projects, both those and up and running and those that might be built.

Like all brilliant insights, this was both a statement of the obvious and an innovative way of thinking. First, it is demonstrably true. Take a nice, neat example – clothing retailer Next (NXT) is the sum of its stores, all or 500 or so of them, its online operation, which claims 6m active customers, and the infrastructure that binds the operation together. Each store can be seen as a stand-alone project, a separate profit centre. In that sense, the group is, indeed, the sum of its projects, where the cost centres – the warehouses, distribution and back office – also play an integral part. Thus, when an analyst opens a spreadsheet to update forecasts, in effect the group-wide numbers for the current year are being updated to reflect changes rippling through all those little projects.

M&M’s paper also assumed the projects that, say, Next already has in place will run and run. Sure, there will be changes as stores are refurbished, sometimes expanded or – more likely – closed. Simultaneously, the infrastructure serving the high-street and online operations will evolve. But the projects in place can be viewed as the source of a stream of profit that will flow for years. In that sense, their net profits for a typical year are an annuity whose value is derived by capitalising those profits at an appropriate interest rate.

The second part of M&M’s valuation framework comprises the projects that a company might build. Clearly, with all the expertise Next has assembled over the past 35 years of – mostly outstanding – trading, it knows how to exploit opportunities. And an investor buying its shares makes the assumption, first, that growth will materialise by building new projects and, second, that the profit potential from growth isn’t fully priced into the stock; logically, an investor has to reach that conclusion otherwise the stock wouldn’t be cheap.

The challenge is to put a value today on those projects that could – although won’t necessarily – be created. The exercise is more of a contrivance than valuing what is already in place, but it can be done and, for what it’s worth, has long been a core part of Bearbull’s share assessments.

To explain, let’s switch to the software and IT services supplier Sage (SGE). That is a decent company on which to apply the M&M approach because, like most IT companies, it is light on tangible assets, on which old-style value investing focused, and is heavier on intangible assets, which comprise 88 per cent of the £2.5bn fixed assets in its latest balance sheet. Also, it does significant amounts of spending on research and development (R&D), which is relevant.

To get an approximation of ‘installed’ value – the value of all those projects in place – we would go either to the income account or the cash-flow statement, it should not make much difference. Table 1 shows figures derived from Sage’s income statement, which are based on the weighted average of Sage’s results for the past five years (the more recent the year, the higher the weighting).

Table 1: Sage – Installed value
 £m
Pre-tax profit375.6
Plus: interest39.6
Taxes saved-8.8
Taxes charged-82.6
Nopat*323.8
Capitalised at6.6%
Value4,919.0
less: debt-990.0
plus: surplus cash812.0
Installed value4,741.0
Value per share (p)434.0
*Net operating profit after taxes
Source: FactSet, company accounts

The valuation revolves around the slightly manufactured, but important, line labelled ‘Nopat’. This stands for ‘net operating profit after tax’ and captures the benefit to shareholders of the taxes saved by the tax-deductibility of interest payments. So Nopat becomes the annuity generated by all the in-situ projects and its value is capitalised at an estimation of Sage’s cost of capital weighted for the proportion of debt and equity. From the resulting value (£324m annuity grossed up at 6.6 per cent), Sage’s gross debt is deducted (since we are interested in the residual amount left over for shareholders) and surplus cash is added in (gross cash in the balance sheet minus the amount needed for day-to-day operations).

What remains – 434p a share – intuitively feels like a sensible valuation in relation to Sage’s 573p share price. It leaves room for the gap to be closed by an estimate of the value that management might create, but not so wide as to require heroic assumptions for growth.

To find the figure that fills the gap – what I label ‘franchise’ value because it owes its creation to the franchise that management has built over many years – the focus switches to cash flow. Here, the maths becomes a bit complicated, but the principles are simple. A company is rewarded for the amount of capital spending it does that is geared towards growth; for the rate at which that spending may grow in the future; and for the rate of return on the cap-ex. In the same calculation, it is penalised the closer that the rate of return on cap-ex gets to the cost of equity; and, if the return falls below the cost of equity, then value is actually destroyed; it is also penalised the faster the rate of return drops to the cost of equity, as competition theory says it should.

These steps are logical, but quantifying them involves some guesswork. Defining growth-orientated capital spending as the amount in excess of depreciation and amortisation is logical, especially if those years when cap-ex is less than depreciation count as zero, not a negative. Estimating the future return on ‘growth’ cap-ex as a group’s latest return on equity is also sensible since it is cautious and can expose the wasteful spending that the bosses of low-return businesses often do. However, estimating the growth rate of future spending or the rate at which excess returns will fade to the cost of equity can only be guesswork. Yet these figures are important since the maths used – essentially a tweaked version of the constant-rate dividend discount model – is very sensitive to changes in their numbers.

Suffice to say that, as Table 2 shows, a central estimate of Sage’s franchise value comes out at 63p a share. Arguably, that’s a lot of value being squeezed from just 1.5p per share of growth-orientated spending. In the familiar terms of multiples, the spending is capitalised at 42 times. Familiar, however, may not be relevant and chiefly that franchise value reflects Sage’s likely high return on equity. That said, it leaves the total estimate of Sage’s value of almost £5 per share still 15 per cent short of its share price, which, arguably, is the only valuation that matters.

Table 2: Sage – Franchise value
 £m
Capital spending (incl intangibles)44.8
of which, 'growth' cap-ex18.6
Growth cap-ex per share *1.5p
Return on growth cap-ex16.4%
Franchise value (per share)63p
*Weighted average of past five years 
Source: FactSet, co accounts, IC estimates

But it doesn’t end there. Bruce Greenwald, a professor at New York’s Columbia Business School, has updated the value investment manual for the 21st century in his book, Value Investing: from Graham to Buffett and beyond, which is a must-read for serious equity investors. His modernised tool box emphasises the value companies create via their spending on research and development (R&D) and marketing. Since such spending builds barriers to entry against would-be competitors, it counts as an intangible asset.

As to quantifying those intangibles, putting a value on R&D is easier because companies show it in their accounts. Professor Greenwald suggests capitalising the latest five years’ R&D, although depreciating it at 20 per cent a year. Apply that rule to the £973m Sage has spent since 2016 and there is an additional asset worth 58p per share. Doing a similar exercise with marketing and sales is more vague because these costs are not separated out. Assume, however, that 10 per cent of sales and marketing costs are, in effect, devoted to building barriers to entry and treating the past five years’ spending in the same way as R&D then there is an intangible worth 33p per share. Add these amounts to the values estimated via the income statement and cash flow and we have 588p per share, adjacent to the share price.

Sure, these amounts are highly tentative and extremely sensitive to inputs, some of which are subjective. In the valuation game it was ever thus. A valuation is only ever a suggestion. The question is, is it sensible? If value investing does return to favour we should get lots more opportunities to put it to the test.