How a Small Manager Won a Huge Pension

Last October GPIF hired value manager Applied Finance just as the style was coming back.

Illustration by II

Illustration by II

Applied Finance is one of the smallest managers in the Government Pension Investment Fund’s lineup.

Employing a strategy that is a little different from many of its peers, the value investor secured a mandate from GPIF — the world’s largest pension — in October, following a due diligence process that started that summer. Value has been underperforming since the global financial crisis, but started to come back in 2021. The style’s outperformance versus growth last year was the greatest since 2000 as rising rates hurt expensive sectors such as technology.

“The care and intensity of the due diligence from GPIF made perfect sense as it is driven by a sense of strong responsibility that eventually it is the Japanese people that will benefit or be hurt from the success or failure of a chosen strategy,” said Rafael Resendes, co-founder and managing director of the firm.

Applied Finance, which has $2.25 billion in assets under management and administration, goes beyond using traditional multiples to capture what it calls the “intrinsic value” of a company. Applied Finance measures the underlying “economic vitality” of a company, which can be compared across time, firms, and industries.

The firm’s economic margin strategy is rooted in a corporate finance discipline, linking income statements and balance sheets to determine a company’s capital structure, longevity of assets, investments, and cost of capital.

“Economic margin measures a company’s profitability by answering whether a company generates cash flow in excess of what investors require to achieve an appropriate return on their investment,” according to the firm.

Applied Finance challenges the notion of some definitions of value: cheapness rooted in statistical properties of stock prices rather than the fundamental properties of a company.

“Finance has moved away so far from the concept of doing a company specific valuation. Current finance is focused on statistical properties of returns. There’s no factor that measures whether a stock is over or undervalued,” said Resendes. “We’re happy to trade against the people that buy on the basis of cheapness or buy on the basis of growth, because they’re missing what really tends to drive returns, which is identifying over and undervalued stocks.”

The strategy continues to beat major indices. Over the past five years, the firm’s Valuation 50 returned an annualized net 9.81 percent against the S&P 500 which returned 9.42 percent and the Russell 1000 which gained 6.67 percent. In the decade ending December 2022, it returned 13.84 percent against the S&P’s 12.56 percent and the Russell index which was at 10.29 percent.

Highlighting some of today’s most expensive stocks, Resendes noted that tech giants such as Alphabet and Apple were trading significantly lower than their intrinsic value more than a decade ago.

Since the firm purchased Alphabet in 2010 for $13.46, the stock has soared 640 percent to $99.87 as of the close on January 31. For Apple, which was purchased in 2011 at $12.45 a share, the rise was even higher: more than a 1,050 percent increase to $144.29.

“Nobody actually knows if their model works because they don’t have any live data to test their answers against,” Resendes asserted. “Our model has been tested through the tech bubble. During the tech bubble, we said Cisco was worth $14 a share when it was trading at $80. People thought we were crazy.”

Sure enough, in a year and a half the stock tumbled to $16 a share, along with several other high-flying tech stocks of that era, Resendes said.

The corporate finance perspective taken by his firm is rooted in a simple logic: a company’s financial actions have predictable wealth creation consequences, which will eventually determine the true price of a stock.

“If the way you view the world is cheap and expensive, and don’t understand true intrinsic value, you’re just basically putting yourselves at the whims of the gods in terms of what bucket of stocks is doing well,” he said.