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Value and intrinsic value are not to be confused

Why simply building a portfolio from stocks with a low P/E is a thing of the past.

Every investor hopes to buy an undervalued company and see it double or triple, hence the rise of funds focusing on a value investing strategy.

However, valuation alone should not be the principal reason for investing, according to Denker Capital. It is one factor in the investment decision.

“Our investment philosophy is centred on three things – firstly we want to invest in a business with good economics where there is a moat [competitive advantage], secondly we want to see an experienced and trustworthy management team, and thirdly we want to buy at a discount to intrinsic value,” says Denker SCI Equity Fund portfolio manager Ricco Friedrich. “We don’t talk about traditional value metrics anymore (like low price-to-earnings ratios or high dividend yield) but rather focus on discount to intrinsic value – and this is the last thing we look at, not the first thing.” Intrinsic value is the discounted value of the excess cash flows of the life of the company.

Friedrich says companies rarely have all three things, usually only in a boom or correction. “You can choose the two you want, but we won’t invest if it is just cheap because the ability to value that company is so low and the chances of being wrong are very high,” he says.

A company with good economics generally has a higher return on invested capital and a number of opportunities to take R1 of cash flow and reinvest it at a high return on capital. It is the management team that drives these decisions, so if a management team continuously takes R1 of capital and turns it into 4c, the company will eventually run out of capital, Friedrich says.

A company with a strong moat, decent growth prospects and good management team will usually trade at a higher price/earnings (P/E) multiple, while a business with poor economics and prospects will trade at a lower P/E multiple. Simply buying on a low P/E is fishing in a pond full companies with below average economics and the odds are stacked against you as a large proportion of the companies are likely to end up as poor investments.

By focusing simply on low accounting valuation metrics (such as price-to-book and P/E ratios) an investor may be ignoring a great quality business with the ability to grow faster than its peers. The intrinsic value captures these key value drivers, says Friedrich.

“We back this up with a study that shows that over 18 years, the total return to shareholders (capital growth plus dividends) for a high-return-on-invested-capital (ROIC) business is much higher than one with a low ROIC,” he says, adding that this is usually accompanied by stable management teams who are able to execute on long term strategies.

Value is in the eye of the beholder, says Claude van Cuyck, who also manages the SA Equity portfolio. “We talk a lot about the intrinsic value of a business, and embedded in that is one’s view of the growth potential relative to the underlying business economics, and the firm’s ability to generate return on capital above its cost of capital consistently over time.”

He adds: “Performance is never in a straight line, but our aim is to generate long term real returns. If you are investing in the right companies with the right management teams and they are investing capital wisely on your behalf, they are going to continue to compound your wealth.”

Denker believes that while the relationship between price and value is the key to investment success, it is not the first or only thing it looks for in an investment. “The last check is to ensure that we are not overpaying for a business, based on a realistic set of expectations of the company’s profitability and growth prospects.”

Brought to you by Denker Capital.

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