Valuation Edge® Analyst Interview Series
Jun Wang, CFA
Senior Fundamental Analyst, Partner, Applied Finance
B.A. Southwest University China, MBA California State University, Fresno
Valuation Edge:
Hello Jun, thank you for taking the time to share your insights with our readers.
Can you start by telling us a little about your role at Applied Finance and what sets Applied Finance apart from other managers?
Jun Wang:
I have been with Applied Finance since 2003 and have been responsible for consumer sectors in terms of managing our turnkey strategies since 2004.
What sets Applied Finance apart is the economic approach we take in understanding corporate performance and estimating intrinsic value when evaluating global equities. Our Economic Margin® properly measures how well a company is doing by looking at the economic profit spread they earn above or below their cost of capital. Our Economic Margin Valuation™ process then combines Economic Margin®, with investment base, investment growth and Economic Profit Horizon™ to properly estimate a company’s intrinsic value.
Since Applied Finance was founded in 1995, we have used Economic Margin Valuation™ to provide 20,000,000+ real-time, out of sample valuations, as we have been conducting 20,000 new valuations weekly for US and International companies for nearly 2 decades. We are unaware of any other such database that encompasses 20+years of live, point in time Intrinsic Value estimates utilizing the same approach.
Valuation Edge:
What is the key differentiator in how Applied Finance values companies?
Jun Wang:
As I mentioned, we evaluate companies by focusing first on understanding their economic profitability, and then we try to estimate companies’ worth by linking their economic profitability with valuation. When we forecast a company’s cashflows for the future, we forecast its future Economic Margins, investment base and investment growth rates. We address the perpetuity assumption in conventional DCF models with a concept called Economic Profit Horizon™ in which a company’s Economic Margin, positive or negative, would decay to 0 at the end of the horizon. We take care of risk calibration for each company with an individualized discount rate reflecting companies’ size and leverage attributes.
One key differentiator that is worth explaining further is our solution to perpetuity. In 1956, Myron Gordon and Eli Shapiro published – “Capital Equipment Analysis: The Required Rate of Profit”. Through that work, they introduced the math behind capitalizing dividends into perpetuity as an approach to estimate the intrinsic value of a company. While the Gordon Growth Model is very mathematically neat, it is very messy empirically, as you must believe that a firm’s point in time performance will persist into perpetuity. Prior to Applied Finance creating the Economic Margin Valuation™ model, however, virtually every valuation framework suffered from some form of perpetuity assumption. To correct this issue, we developed a research process to estimate how long a firm’s economic profits are likely to persist above or below zero, something we call an Economic Profit Horizon™. Smaller, cyclical firms tend to have a shorter economic profit horizon while bigger, more stable firms tend to have a longer horizon. The impact Covid19 has had on companies is just another example of why perpetuity assumptions make no sense.
Valuation Edge:
Speaking of Covid19, the pandemic has obviously hit the consumer sector especially hard and many shops have yet to reopen or operating in a diminished capacity, and online shopping has become more prevalent even pre-pandemic… Is brick and mortar retail dying/dead?
Jun Wang:
No, physical stores are not dead at all. However, just like everything, the fittest survive. While some retailers have died or are struggling, many have thrived with a large physical presence. Costco, Walmart and Target come to mind conveniently. Also, Home Depot and Lowe’s have flourished during the pandemic.
There is no doubt a strong digital capability is critical to sustainable success, especially in today’s environment, but most of those successful retailers have made their physical presence an asset rather than a liability. Those companies have been using stores for fulfillment to reduce shipping costs and most of them have been able to use physical locations for in-store pick-up/drive up, really accommodating consumers’ needs. At the end of the day, in order to succeed, retailers have to have the right products that consumers want and have the means to deliver the products to consumers in whichever way they prefer. COVID-19 did however accelerate digitalization at many retailers as the ”lockdown” and ”stay at home” trend forced retailers to close physical stores and rely solely on e-commerce to survive.
Valuation Edge:
With all the disruptions in the sector and drastic changes in consumer preferences over the last few years, are there any specific trends or shifts that you’ve noticed that investors might be missing in the current environment?
Jun Wang:
In the past few years, we have been talking about how consumers prefer experience over goods which certainly has been true to some degree. COVID-19 reversed that trend. Experiences (travel, concert, events, dining out, etc.) became impossible and people are reallocating “experience budget” to “goods consumption”. Also, consumers have been putting money to work enhancing home living experience now that they spend so much time at home providing a major boon to home improvement stores. Products or goods helping people kill time at home have done well, Peloton, comfort casual apparel sales are up, and toys and games are selling. Pizza companies are also booming.
I don’t feel investors have missed much in terms of identifying winners of the pandemic, I do want to caution investors, however, that the world will return to normal sooner or later, likely starting in spring/summer of 2021. Therefore, I think investors really should be careful with the valuation level of some of the COVID-19 winners. Can their extraordinary growth continue in an after Covid world? At the same time, investors should not jump into COVID-19 losers indiscreetly either. Many companies have added lots of debt to their balance sheet and even after their operations normalize, they likely will be worth less than before, everything else equal. That said, there should be opportunities in “experience providers”, be that airlines, cruise companies, hotels. We just need to conduct our due diligence to find the worthy ones.
Valuation Edge:
Any interesting names that stand to benefit from the recent shifts you mentioned?
Jun Wang:
What surprised many of us is how strong the housing and auto industries have navigated through the crisis, how people are able to make big-ticket purchases despite the deep recession. The explanation is Covid drives people to seek a better living experience and safe traveling/commuting experience, and their jobs are largely unaffected by the pandemic, as the most economically impacted are on the lower end of the economic sphere.
It depends on individual stock’s valuation, but the auto industries may have some interesting opportunities. Many of the auto OEMs and OEM suppliers were rather hated by the investment community entering 2020 as people feared an economic recession would hurt them badly and recovery would be slow. It turned out we had a terribly bad recession that ended quickly, and the auto companies are well-positioned to engineer a rapid rebound.
In particular, auto OEMs and OEM suppliers that have the right technology to meet the accelerating demand for electric vehicles and autonomous driving would likely have sustainable growth potential ahead.
Valuation Edge:
Has Covid 19 altered how Applied Finance values companies or manages their strategies?
Jun Wang:
Not at all! The way we value companies has not changed for 20 plus years. I am heartened to see some of the companies we own in the consumer space, despite taking a hit in February-April, have so quickly adapted to the new reality and strengthened their competitive positioning. Those companies all have something in common – strong balance sheets, able management, and were in leadership positions before Covid. Though their valuation took a hit during the bottom, their relative valuation in their respective industries/sectors remained attractive throughout. The way those companies are able to manage their cost structure to have a lower breakeven point is very impressive and they will be able to further capitalize on those positive changes as the world normalizes.
Valuation Edge:
Consumers have been one of the best performing sectors over the past decade or so, is it becoming more difficult to find quality names trading at a discount to their IV in the sector?
Jun Wang:
The overall market is rather expensive and that is also the case for the consumer sectors. Amazon is a big factor driving Discretionary’s performance though, as Amazon is nearly 40% of Discretionary’s sector weight in the S&P500, and it has appreciated 60% in value year-to-date. Some smaller names look a bit more attractive, but they tend to be in less “trendy” areas.
Valuation Edge:
Any concluding thoughts?
Jun Wang:
It is always an interesting time with the market but 2020 certainly stands out given we have not dealt with a lethal pandemic of this proportion for nearly a century. What we learned is, good companies tend to become stronger amid challenges, and valuation is the time-tested gold standard for outperformance. Valuation is our edge, and we are sticking to it.
Valuation Edge:
Thank you, Jun!
