Equities: Targeting value
ROBERT HARRIS 10-May-2022
The beginning of the year has not been easy for investors. The Federal Reserve began a new rate-hike cycle. Treasury yields have moved abruptly higher while inflation readings have far surpassed expectations, and not in a good way. Add in some geopolitical turmoil and it was an environment that saw most equities decline, with the exception of commodities, energy, gold and utilities. In this market, more expensive stocks—especially those fast-growing tech stocks with enormous potential but without current earnings—seem poised to continue underperforming cyclical sectors, such as energy, materials, and financials, which are central to many traditional value-oriented strategies.
The Federal Reserve has been out jawboning its intent to tame inflation so it’s unlikely that the rising rate backdrop is going to change any time soon. In fact, expectations for higher interest rates have increased over the past several months, and now the market is pricing in several more aggressive rate hikes ahead, according to fed funds futures. In times when inflation rises, companies with pricing power may be better able to improve margins versus those companies with potential future earnings (i.e. more speculative growth stocks). All this makes a compelling argument for “value” as an investment style. Thus, it should not be surprising to learn that over the past several quarters the small-cap value style box has been the best performing domestic equity category, according to the Russell family of indices.
So if an investor (or advisor) agrees that value strategies may be well-positioned today and worthy of new capital allocations, it becomes a question of tactics and philosophy. Rather than arbitrarily allocating to any value strategy, we believe there’s a specific metric that tends to work well across various market environments.
Focus on ROIC
Investors have an abundance of choices when it comes to value investing. Many of these approaches use metrics such as Price/Earnings, Price/Book, Price/Sales, and PE/ Growth-Rate as the basis for investment decisions. Those are all fine and can provide important clues, yet such valuation metrics cannot be used in a vacuum. After all, these are often driven by near-term focus, both on the part of investors and company management, with limited attention paid to longer-term value creation for shareholders. We contend that the one business analysis metric that has proven most useful in determining stock performance over the long-term is Return on Invested Capital (ROIC)—and more importantly—anticipated changes in forward-looking ROIC.
An investment approach predicated on improving ROIC just might be the essential measure of the intrinsic value-creating capability of a company. This metric helps identify businesses undergoing important structural changes, which are often accompanied by new leadership, changes in the competitive landscape, the uncovering of underappreciated assets, or other circumstances that can lead to significant improvements in a company’s ROIC. Companies on the cusp of such an inflection point may be able to improve financial performance irrespective of what is happening in the general economy, within the sector, or among the company’s competitors.
It is, however, important to distinguish between companies with already high ROIC and those with improving ROIC. In fact, our experience suggests that it is the degree of change in a company’s ROIC that is the key predictor of long-term stock price outperformance. After all, many companies with strong and consistent ROIC have already been recognized and are highly valued by the market.
We find that the converse is also true. Many companies that have lower ROIC are poorly valued by the market. The market tends to be slow in recognizing and rewarding structural changes occurring at companies until the financial statements clearly provide proof points of ROIC improvement. Additionally, once a company turns the corner from one of these inflection points, the magnitude and duration of the ROIC improvement may be sustainable in many cases.
In the challenging equities market of early 2022, investors were inclined to sell first and ask questions later. This, too, creates an environment ripe for stock pickers. We believe that targeting and acquiring companies with improving ROIC, which we feel is the essential metric of value, may be a path to building an attractive value-oriented portfolio.