Think growth and value can’t coexist? Think again.
Traditional value investors pick stocks that are trading below their fundamentals based on a wide variety of measures. As a result and by definition, many dismiss growth companies altogether. But one manager believes that ignoring growth stocks out of hand is “fundamentally flawed.”
Value investor Applied Finance, with $1.25 billion in assets under management, argues that traditional metrics — such as low price-to-book and price-to-earnings multiples — don't provide investors with a comprehensive framework and are inadequate in identifying stocks that are trading below their intrinsic value; in fact, companies that are trading on apparently high multiples may actually be undervalued in terms of their overall valuation, thus creating opportunities for large returns.
“We’re redefining what value is. The term has been tortured and confused with cheapness,” said Rafael Resendes, co-founder of Applied Finance, who initially started the firm as a consultancy for corporations.
The argument comes as investors have debated for years the reasons behind the long underperformance of value strategies, even though these stocks have recently staged a comeback. In fact, academics and practitioners have regularly debated the definition of value investing itself. Warren Buffett, the most famous value investor, has evolved from looking for so-called Cigar Butts to higher quality stocks. Bill Miller, the former portfolio manager of Legg Mason Value Trust and now CIO of Miller Value Partners, famously owned high-flying technology stocks in his value portfolio.
Launched in 1995 from a basement in Chicago, Applied Finance's unconventional approach includes performing weekly valuations on 20,000 stocks and selecting companies not based on the “cheapness” factor employed by many value diehards, but through a valuation-based discipline comprised of R&D, growth potential, competition, and risk.
“One of the things we’ve been doing since 1995 is capitalizing on research and development costs,” said Resendes. “This is something that is just now being viewed as transformational in the value investing universe.”
Applied Finance focuses on a company’s allocation to R&D, but weighs them differently between companies. For example, a dollar allocated to R&D for Alphabet (Google's parent), will be worth more than a dollar of that for IBM, owing to the difference in growth potential, explained Resendes. The firm then makes projections based on the return of those investments —generated cash flows — before figuring out a company’s economic profit horizon. “It’s understanding the economics of a firm, not just its accounting.” Economic profit in this context is defined as, “the cash remaining after a firm has provided investors the minimum return they require for providing the company capital.”
The firm’s models then extract how much a company will reinvest in the future by looking at its history, the competition facing a particular company, and the risks associated with the investment — that is, how much the firm is willing to pay until a company performs well marketwise or vice versa. This matters especially for value stocks since investments are made for the long haul. “...a primary goal of value-based metrics is to eliminate the numerous distortions in accounting data to provide comparability across time, firms, and industries,” stated Applied Finance in a 2000 report.
According to Applied Finance, the strategy has generated returns that have outperformed the S&P 500 over the past five to ten years, despite having invested in what were considered growth stocks. Some of these companies include Monster, Mastercard, Apple, and Nvidia. One of its best bets was buying Nvidia for $13 per share in 2011 and selling it for $525 apiece this past August.
The firm, which invests in 50 companies at any given time, doesn’t commit to a particular sector precisely because of its valuation approach, Resendes said.
The question is why value is still tied primarily to “cheapness.” Part of the reason, according to Resendes, has to do with financial academia and research widely used by investors. “The academic literature is rigorous but financial analysis is very poor.”
The findings, he explained, fail to focus on valuation and are concentrated in statistical properties of stock prices rather than the fundamental properties of a company. “They’re always using backward-looking data,” said Resendes. “What’s missing is live and out-of-sample data.” Other academics have recently echoed similar sentiments, expressing that the old ways have “outlived their usefulness.”
Applied Finance’s position comes less than a week after the Federal Reserve signaled raising interest rates sooner than investors had expected —twice by 2023 — sending tech stocks soaring and value stocks such as cyclicals — finance, industrials, energy and commodities — to retreat (though some of these stocks have since rallied from last week’s decline).
The shift in the Fed's stance and thus the performance of certain stocks may, of course, be overstated. Research by Acadian Asset Management last week challenged the simplified narrative on the relationship between rates and value, arguing that it depends on the confluence of many factors, and, more importantly, the need for a nuanced approach — a call that value investors like Resendes are increasingly pushing for.