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At a prior job I was at a large Connecticut-based hedge fund,
working for a prominent hedge fund manager with a stellar long-term
track record. One morning, my boss was reviewing analyst ideas when a
new member of his team came running in with a fresh investment idea.
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"You gotta look at this stock! It is 55% cheaper than anything else in
its peer group," said the analyst. "The P/E is only eight times this
year's earnings, and everything else in the sector is over 16 times!"
My boss didn't seem too impressed. "That P/E ratio you mention...how do
you get that?"
Mr. Cheap Stock looked confused. "I looked at First Call, got the
current-year earnings estimate and divided that into the closing price
of the stock."
The boss squinted a little more. "If you all can do the same math, what
is your edge? You are hoping this stock somehow wakes up one day,
realizes it doesn't get the same respect as its peers, and starts to go
up. I know that company. The CFO is a drunk, the head of marketing is
having an affair with the only analyst pushing the stock, and their
last three product launches have been delayed. They haven't gained
market share since I started this firm. A buddy of mine plays poker
with the head of the comp committee of the board, and he wants to quit
because the CEO has the board in his pocket. Math isn't an investment
edge. Come in with another stupid idea like this, and you're fired."
That encounter sticks in my mind to this day for two reasons. First, it
served as a reminder about how the valuation metrics used by most of
the sell side are inadequate in really tying fundamentals to stock
price movements. Second, it taught me the ultimate importance of
defining in clear terms your investment edge in a stock. The
methodology used by most of Wall Street is some combination of
earnings/cash flow and the current value of the company. This might be
price/earnings ratios or EBITDA/market value. These metrics have been
around for 40-plus years.
A lot has changed since the early days. Companies became savvier about
manipulating these measures of value. They play endless games with
financial results to maximize what they think the Street finds most
important.
Also, indexing has become far more prevalent, with 7% to 10% of every
dollar invested in the market put to work with no thought as to
valuation. This number was less than 1% back when P/E was first
established as the primary valuation benchmark.
In addition, financial reporting has become more expansive, with more
data about incremental investments, executive compensation and sources
and uses of cash now required of all U.S. companies. Despite these
changes, thoughts about how to value U.S. equity securities have not
moved as far.
Let's move on to an investment edge. There are numerous definitions
that wander around the Street related to this term, but we think an
edge is basically asymmetric information. That phrase might concern
some, as it sounds too much like insider trading. How, after all, can
anyone have incremental information about a company that hasn't come
out in a conference call, company meeting or industry conference?
To me, the issue of what creates an edge is more about investment
process than any given observation about a company's prospects. In
other words, how an investor goes about looking for undervalued
securities is the key driver of outperformance. There are four kinds of
investors that currently dominate the public equity investment
landscape:
—Value investors, who look for out-of-favor stocks and seek to
determine the intrinsic value of the operation. They tend to look at
broken or dysfunctional enterprises and then analyze what catalysts
might close the gap between current price and intrinsic value.
—Growth investors, who seek out companies with a competitive edge
that will drive value beyond the current stock price. These buyers look
for strong companies whose competitive position is misunderstood or
whose current financial results understate their true long-term
potential.
—Event-driven traders, who want investment ideas that are about
to experience a transformative event. Whether they know it or not,
these market participants are really a hybrid of growth and value. They
are looking for the event that will drive stock price movement that
either highlights a promising value idea or proves to the market that a
growth stock has a longer period of success in front of it than the
market realizes.
—Style-agnostic "story" investors, who just want good ideas.
These market players are style-neutral and most often hedge funds,
since long-only players are usually too beholden to the growth or value
"style boxes" that consultants use to pigeon-hole money managers. They
look for stock ideas where their investment viewpoint is materially
different from the Street consensus. As with event-driven traders, they
only care that their investments close the gap between perception and
intrinsic reality.
Now let's combine these two lessons of stock valuation and investment
edge. In our view, there is a serious disconnect between the
brute-force and antiquated approach of P/E and EBITDA/market value.
When General Motors was trading between $50 and $90 per share just a
few years ago, it was touted as a value stock because it was earning
more than $5 a share. More recently, the investment banks have been
trading well, with Goldman Sachs, Lehman Brothers and Bear Stearns Cos.
all trading to new highs. They also sport low-double-digit multiples.
Same story? Hardly! But using P/E multiples would lead you to that
conclusion.
To illustrate this point, let's review some current stock
recommendations from our analysts. Our financial services analyst, Mark
Morgan, has a buy on Keycorp and a sell on Comerica. Needless to say,
he sees very different stories behind these two names, even though P/E
analysis would lead you to think they're similar. KEY and CMA both
trade at 12 to 13 times current-year earnings. Looking at growth rates,
these two companies again look quite similar. According to First Call,
both companies should be able to grow earnings by 8% every year for the
next five years.
Looks like P/E analysis has left us hanging. By these metrics, we
should probably be interested in buying both. If we believe the Fed
will be done raising rates soon, then bank stocks should rally, and a
rising tide will presumably lift all boats. Our take on these stocks is
different. Keycorp is close to a textbook turnaround story, growing
profitably and dedicating significant cash to a stock repurchase.
Comerica, on the other hand, has a worrisome amount of business
concentration in the domestic auto sector.
At Rochdale, we quantify these business-model variables by estimating
future return on capital, growth in capital and a time horizon driven
by competitive advantage for the company in question. We expect KEY to
be able to sustain returns on capital far better than CMA. CMA is
simply too tied to the fortunes of auto workers, small auto suppliers
and larger automotive operations, all of which rely too heavily on the
domestic auto sector. We are not sanguine on the domestic automakers
and believe that most will ultimately have to seek bankruptcy
protection to unwind their sizable legacy costs. It is the airline
sector in repeat.
Technology is also a fertile area to make the comparison between P/E
analysis and more robust return on invested capital (ROIC) metrics. In
my experience, no group of sell-side analysts is more capricious and
arbitrary in their use of P/E multiples than tech folks. Take two cult
stocks: Apple Computer and Research in Motion. Both have lofty P/Es,
heavy-duty expected growth rates and legions of fans on both the buy
and sell side.
Yet our analyst, Daan Coster, has a buy on AAPL and a sell on RIMM. He
sees far more opportunity for Apple to grow its currently small market
share in computers than he sees for RIMM to hold its strong market
share of handheld e-mail devices against a slew of attractive new
competitors.
In summary, we think the world will be moving to a more sophisticated
approach to valuation over time. P/E ratios simply reveal too little
about the fundamentals of a company to continue being useful for stock
selection. In contrast, looking at companies through a ROIC lens allows
investors to incorporate more features of a company's business model
and allows for greater quantification of an information edge.
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