Beyond Bulls & Bears


Value and Growth: The Indivisible Dichotomy

Franklin Mutual Series’ Director of Research Grace Hoefig sits down with us to explain how value investing involves more than just computing ratios, and why the answer to the age-old question “growth or value” should be “yes.”

Q: Let’s start with the 50,000-foot view. How does Mutual Series think about value investing?

Grace Hoefig: Interesting question. But I would ask: Would you be willing to buy something for half of what it’s worth?

Buying something for less than what it’s worth is value investing at its essence. At Mutual Series, we buy stocks at a discount to what they are worth, taking an objective view of the economic value of the company’s assets and growth prospects. We look beyond statistical cheapness and rote ratio calculations and conduct a more rigorous analysis of business and asset value driven by our understanding of industries, their competitive dynamics and the long-term cash generating ability of an enterprise.

For each company we evaluate, we establish what’s called a fair value. A fair value is what we believe the company is actually worth, not what the stock price is necessarily trading at. Ideally, we want to buy a stock that is trading at a discount to fair value. It also helps if the company’s management is aware of the gap between the two and will work with us to close it.

Q: Can  you break this down? It sounds like you’re looking at a company’s financials. That’s not exactly a new strategy.

Grace Hoefig: The analysis that we conduct is much more than that. Holistic, in-depth knowledge of the company and the environment in which it operates is necessary for assessing the accuracy of figures on the financial statements and properly valuing a company. We don’t just take a company’s financial statements at face value. That’s a mistake. Financial statements are a historical record of where a company has been, but you have to fully understand the nuances of the business and the context in which the company operates to anticipate how the company’s financial situation could change. It’s all about anticipating catalysts and growth prospects in order to close the gap between the company’s stock price and its fair value.

Q: What types of things might need to be adjusted in order to get a more realistic idea of a company’s actual financial picture?

Grace Hoefig: The accounting value of an asset, which is the value listed on the balance sheet, can differ from the underlying economic value of the asset. Economic value is what matters. Economic value reflects an asset’s potential contribution to cash flow growth and the company’s competitive positioning in the marketplace in addition to its monetary value. Economic value isn’t listed on a company’s financial statements. Ratios such as price-to-book (P/B) and price-to-earnings (P/E) do not automatically include economic value. This is why simplistic ratios, such as price-to-book value or price-to-earnings ratios, fall short when it comes to identifying value stocks.

Q: Why aren’t P/B and P/E ratios enough to identify a value stock? Lots of individuals seem to view value investing this way. What else do you think these investors are missing?

Grace Hoefig: The price-to-book method for identifying value stocks can leave out economic value, but also two other components which are key in determining a company’s actual worth—the economic value of intangible assets and an assessment of its growth prospects. Some intangible assets, such as the research done in a pharmaceutical firm, are not included on the balance sheet at all! Similarly, a company’s price-to-earnings ratio can be a crude metric as well, as it may reflect expensed costs incurred during the generation of intangible assets, which depresses current earnings per share despite these investments being value creating over the long term.

Q: You mentioned earlier that part of your team’s process is identifying catalysts. What does that mean?

Grace Hoefig: A catalyst is an event that unlocks shareholder value. Identifying these events is another aspect of our research and investment process. In addition to examining the economic value of assets, we look for companies that have what we believe is a high probability of undergoing future changes that will lead to closing that gap between the stock price and our estimate of fair value. In addition, we can monitor the progress toward completion of a catalyst to make sure our investment thesis remains on track.

Q: You previously mentioned understanding a company’s growth as a part of your analysis. How does growth fit into Mutual Series’ value mindset?

Grace Hoefig: Growth and value are not mutually exclusive concepts. As disciplined value investors, we undertake an in-depth look at a company’s growth prospects; we think a keen analysis of growth prospects is necessary to assess a company’s fair value. Sales growth, margin growth and free cash flow growth are all part of this equation. The age-old question of whether to invest in growth stocks or value stocks ignores that the two concepts cannot be divorced from one another. Statistical cheapness does not guarantee attractive returns. While a cheap stock can benefit from price reversion to the mean, the real fuel for increasing prices, and avoiding value traps, is cash flow growth.

Q: Some of the Mutual Series portfolios invest in technology stocks. That’s unexpected for a value team. Is that a result of your “yes to growth and value” approach?

Grace Hoefig: Yes. That’s a prime example of how our differentiated approach plays itself out in our portfolios. We are unconstrained in terms of how we identify value, and we look for opportunities across the market. We focus our efforts on determining a company’s fair value. When we uncover an entity that is selling at a significant discount, regardless of what its ratios might be or what index it has been assigned to, we consider it a value stock. We also look at the future growth potential of the company’s cash flows that it can use to either invest in new opportunities or return money to shareholders. Our broader take on value investing opens up our investable universe.

Q: You joined Mutual Series early in your career, took a break, then rejoined again a few years ago. In your opinion, has anything with the team’s investment strategy or the markets changed from your prior experience to now?

Grace Hoefig: Oh, sure. Value investing used to be all about statistical cheapness. Buy something that’s cheap, and mean reversion will lead to a profit. As we’ve just discussed, there’s so much more to it now. The market has become increasingly more complex in the recent decades, and we believe we must evolve with it, discovering new ways to think and consistently add value to portfolios.

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What Are the Risks?

All investments involve risks, including possible loss of principal. The value of investments can go down as well as up, and investors may not get back the full amount invested. Stock prices fluctuate, sometimes rapidly and dramatically, due to factors affecting individual companies, particular industries or sectors or general market conditions. Value securities may not increase in price as anticipated or may decline further in value.

Actively managed strategies could experience losses if the investment manager’s judgment about markets, interest rates or the attractiveness, relative values, liquidity or potential appreciation of particular investments made for a portfolio, proves to be incorrect. There can be no guarantee that an investment manager’s investment techniques or decisions will produce the desired results.

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