Recent events have made it even more important to improve standards of due diligence. This also applies to value investing, where basic company valuation attributes like “high free cash flow yield” or “price-earnings (P/E) ratios at all-time lows” should not constitute a value investment case by themselves. Investors have to dig deeper to understand the business drivers, just as they would for a growth investment, rather than depending on these basic attributes to build an investment case. By doing this, in our view they can avoid falling into “value traps” in an environment of economic deterioration.
- Value investors need to look at several characteristics to identify whether an investment is a value trap or trapped value. Some of them may include pricing trends (falling or rising), growth rates, concentration (client or product), a strategy built around expense reduction, and payouts funded by debt.
- Investors can then further analyse whether the company has sufficient levers available to unlock value: pockets of higher growth, product innovation, reinvestment of cost savings, management’s strategic growth plan, to name a few.
- Investors should conduct deep due diligence to identify whether a company is permanently impaired or under-managed, or whether it can move resources around to accelerate growth and profits or build a new business.
- Value investors use evidence-based investing to avoid pitfalls: fundamentals and trends instead of just valuations; and whether a business is growing or not—as value is harder to create in a slowing or unprofitable business.
- One investment characteristic—margin of safety—is often cited as a reason to invest. This is not good enough without growth or progress, as the company will struggle to sustainably increase intrinsic value over time.
“Growth” and “value” are not different investment strategies, in my view. Without growth, value creation—growth of returns on capital that are greater than the cost of capital—is harder to do. Value investors want to see signs of growth, or a clear progress; they just don’t want to overpay for it. For further discussion, I invite you to read “Value Trap or Trapped Value?” by John Reynolds, Portfolio Manager of Templeton Global Equity Group.
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