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We Continue to View Large Cap Stocks Favorably



Rafael Resendes, Co-founder of Applied Finance, shares his view on the stock market crash. He warns of panic selling and explains why Facebook, McKesson and Aptiv are attractive value plays.

The crash came out of nowhere: In just a few weeks, stocks have entered bear market territory, investors are facing the biggest setback since the financial crisis. However, Rafael Resendes doesn’t expect a similar scenario like the Great Recession of 2008/09. The Co-founder of the value investment firm Applied Finance warns against panic selling and thereby missing powerful rallies when the outlook brightens up.

“Panic selling and missing the upside returns as markets return to normal set back wealth accumulation by years if not an entire decade”, says the battle-proven investor from the United States.

Every week, Mr. Resendes and his team calculate the intrinsic value of around 20,000 companies globally – and this now for 25 years. Based on their data, they have developed a unique investment approach that goes beyond common valuation metrics and includes key factors such as profitability, competition, growth and capital costs.

In this in-depth interview with The Market/NZZ, Mr. Resendes lays out his investment strategy and shares his view on the stock market. Additionally, he says why stocks like Facebook, McKesson and Aptiv look highly attractive from a value perspective.

Mr. Resendes financial markets are in turmoil. What’s your take on the situation from a value perspective?
Entering 2020, contrary to talking head buzz, US Large Cap stocks were poised to continue their historic bull run. The equity cost of capital priced into stocks was near historic norms, but the equity risk premium was at near record levels given the extreme low yields on 10 year Treasury Bonds. Further, analyst expectations called for 5% sales growth and 10% EPS growth for 2020 and 2021. All told, Large Caps were priced up to 20% below their intrinsic value. However, all that changed with the ongoing evolution of thoughts regarding COVID-19. From being a “China Problem”, to being a “Travel Sector” problem, thoughts regarding COVID-19 have evolved to being a global economic problem. All stocks sold off indiscriminately – momentum, growth, profitability, all factors performed equally poorly indicating a full-blown “risk-off” market.

Where does that leave us now?
Performing a reverse valuation on the market, we find that while analysts expected 10% EPS growth, now the market is pricing EPS declines for 2020 and 2021, before resuming a 10% growth path. This drop in earnings expectations compares to the 15% drop in 2007, followed by a 78% drop in 2008 during the Great Recession. At this stage, we don’t believe COVD-19’s economic path will compare in intensity or duration to the Great Recession. As such, this initial market reset seems extreme. Until more information is available, we continue to view US Large Cap stocks favorably.

So is this a good time to buy?
It is very difficult to time the market, which is why everyone was caught off guard by this sell-off. As such, we advise investors to understand short term market movements are irrelevant to long-term results – unless you miss big upswings after panic selling. Panic selling and missing the upside returns as markets return to normal set back wealth accumulation by years if not an entire decade. The best path to long-term wealth accumulation is to own an economically diversified portfolio of quality, well managed companies trading below their intrinsic value.

The P/E ratio on the S&P 500 is now back at around 16. What does this say about valuations?
The whole world is thinking of value as price to something, whether it’s price to book, price to earnings or price to sales. To us, these metrics are nothing more than an indication of cheapness. For instance, a price to book ratio can be low because a stock is mispriced, or maybe it’s just a bad business that no one wants to pay anything for. A multiple doesn’t tell you enough to understand the true underlying value of a stock. Such approaches are called value strategies, but it’s kind of a misnomer. These indicators should just be called cheapness measures because that’s all they are.

What’s the difference between cheapness and value?
Value denotes monetary or material value, while cheapness is relatively low in cost. For example, if you say Nvidia is worth $350 a share, you have estimated a value for that stock and if it is trading at $250, then it is trading below your estimate of its value. If you say as an investor you will not buy Nvidia because its P/E ratio is too high, there is no expression of value in your assessment, only that relative to its accounting book value the stock is not cheap enough to purchase. The divergence between value and cheapness occurs as value is the intersection of profits, growth, risk, and competition, while cheapness lacks such richness.

What do you exactly mean by that?
In daily terms, being able to buy a new Porsche 911 Turbo for $50,000 that sells for $100,000 is not cheap but is a great value, while paying 20% over sticker for a Mazda is relatively cheap compared to the Porsche but is a poor value. That said, you can construct portfolios that generate alpha on the basis of cheapness metrics. The empirical evidence suggests that historically there’s definitely alpha to be had with such an approach. From Eugene Fama and Kenneth French at Dimensional to AQR Capital Management to Research Affiliates: These are all brilliant people and they certainly have demonstrated that cheapness works, but the last ten years have been a bit difficult for them, to put it mildly.

How come?
What most investors are missing is a consistently derived, empirically valid, broad based point-in-time estimate of intrinsic value. At the end of the day, cheapness investors and strategies suffer from the problem of confusing correlation and causality. Be it price to book, price to earnings, price to sales or price to cash flow: All these metrics are applied with the hope that there is a correlation to stocks trading below their intrinsic value, or to stocks trading above their intrinsic value if you want to avoid them.

So is there no correlation between these metrics and the intrinsic value of a company?
In fairness, there is an approximate 60% correlation between cheapness metrics such as price to book and intrinsic value for the most attractive and unattractive stocks to own. However, after controlling for that correlation intrinsic value continues to work, while cheapness metrics offer little to no ability to explain subsequent stock returns. Consequently, in the hope of inducing stock analysts’ upgrades, firms will often undertake actions that increase their fundamental accounting metrics, but do not create value. Especially the misplaced importance on the role of earnings is tragic, as earnings are only a part of the shareholder wealth creation process.

And what about the boom in passive investing? More and more investors are pouring money into index funds and don’t really care about the price of a single stock.
Moving to passive makes sense if you have no idea how to generate alpha, but it’s a big mistake if you have access to partners with the processes and skill to outperform. Michael Jordan existed in the NBA and similarly there are stellar and lousy active managers. Through our valuation approach, we generated alpha in environments that were favorable to value strategies like the period from 2000 to 2008. But we’ve also generated alpha in the period from the Great Recession to today which has been horrible for value strategies. The key differentiator is that we pursue a valuation strategy and not a value strategy.

What does this mean with respect to your investment process?
It makes it easy for us to identify Google as undervalued, when no multiple-based strategy could own the stock. For us, it’s silly to price Google on a multiple like price to earnings because its P/E ratio has little to do with its intrinsic value. Google’s earnings today are only a small piece of what’s going to determine the overall value of the firm. The focus on management fees and drive the towards passive investing is great marketing. The world’s largest asset managers have become extraordinary asset gathering machines with little chance to outperform the markets given their size, so the best strategy for them is to preach passive, low cost investing and convince the world that Micheal Jordan’s do not exist in asset management. Again, for those that do not have the ability to identify or have access to truly skilled managers, passive is a very reasonable choice.

What exactly are you doing differently?
At Applied Finance, we’ve never fallen to this notion of thinking of valuation as a multiple. A corporate performance metric should provide insights into what a stock is worth. That’s why we created what we call the “economic margin framework” to determine the intrinsic value of a firm. The economic margin framework is more than just a performance metric, as it encompasses a valuation system that explicitly addresses the four main drivers of enterprise value: profitability, competition, growth and cost of capital.

How does this approach work in practice?
You really have to understand how well a firm performs. That’s not easy because earnings are a very poor proxy for the economics of a firm. You can’t take earnings to a store and buy a slice of pizza and go to a movie. You only can do that with cash and earnings might only represent 30 to 60% of cash flow. Also, the investment required to generate these earnings isn’t incorporated well, neither are risk, inflation and off-balance sheet issues. You have issues such as R&D. Take Amazon for example: Jeff Bezos’ strategy wasn’t investing in R&D to get his investment back in the next year. He was investing in R&D to get his investment back over the next twenty, thirty or forty years – just like a company that builds a factory. But accounting rules treat R&D as an expense not as an investment.

What does this mean for the valuation of a firm like Amazon?
In 2017, Amazon had earnings of $3 billion. Let’s take a look at what they consist of: Depreciation and Amortization was $11,5 billion, operating leases were $2 billion, and R&D was about $12 billion. So in terms of the ability of this company’s asset base to generate cash to fuel these investments, Amazon really generated almost $30 billion of cash flow. In other words: The accounting is a tenfold difference from the operations-based cash flow. That’s why a ratio based on the $3 billion of net income has no chance to reflect the fact that Amazon is actually generating ten times more of operations-based cash flow.

Amazon, Apple, Google, Microsoft and Facebook are dominating the U.S. stock market. Which one of the five tech giants stands out from a valuation point of view?
Facebook, it’s the largest social media company and over 2 billion people use its family of products daily, close to 3 billion monthly. Yet, the firm still has room for growth as it is in the early stages of monetizing its Instagram product and is in baby steps for WhatsApp. The upcoming U.S. election brings both opportunities and risks. Potential regulation will continue to pose threats, but some of the new privacy laws will also help entrench current players such as Facebook that already have the compliance resources. As long as users find the product more useful and helpful relative to others, Facebook should see good opportunity as very few companies have the user reach that Facebook has.

What else is important to determine the intrinsic value of a company?
Let’s take a look at the balance sheet of Exxon and Apple. Based on 2017 data, Apple had more assets than Exxon. That’s utterly counterintuitive because everyone thinks of Apple as a balance sheet light company with outsourced manufacturing and a lot of intellectual capital. So accounting really can distort economic reality: For Exxon, accumulated depreciation represents almost the entire amount of the balance sheet: $224 billion vs. $40 billion for Apple. Also, Exxon’s assets are very old because an oil refinery or an oil well lasts twenty to forty years. Adjusting these assets for inflation is another $128 billion. In contrast, Apple’s assets are new and therefore inflation is a minor adjustment. You apply these economic adjustments, and all of a sudden, Exxon’s balance sheet is 50% larger than Apple’s. So if you want to measure return on investment, you have to add this factors to get a complete investment case.

And how do you factor in competition in your valuation models?
Competition is an economic reality, but most ratios only look at a static point in time and assume the world stays constant. For instance, perpetuity assumptions in traditional discounted cash flow models ignore the fact that companies will face competition. That’s highly problematic since up to 70% of the net present value of estimated cash flows typically come from perpetuity assumptions. If you look at companies like Bear Stearns, Toys R Us, Blockbuster or Kodak, nobody thought that these firms would go out of business. Seven or eight years ago, no one would have expected GE to start losing money. We believe competition tends to drive the economic margin to zero for most firms, it’s just a question of whether it happens quickly or slowly. Some firms are able to beat the notion of competition and that’s why they’re fantastic. But there aren’t many Apples, Googles, Facebooks or Disneys floating around.

Where do you spot more potential when it comes to attractive valuations?
A name we like is McKesson. The firm is the largest pharmaceuticals and medical supplies distributor in the U.S., distributing to hospitals, doctors’ offices, retail pharmacies and homecare providers. Its value proposition relies on the necessary services it provides to the overall healthcare value chain. McKesson’s ability to distribute specialty drugs, especially for patients enduring chronic ailments, such as cancer, safely and at the right time, has garnered it a leading stake in the multi-specialty setting. Potential drug price control regulation and ongoing opioid lawsuits continue to pose threats, but McKesson seems to be capable of absorbing potential damage without substantial degradation to its value.

Where else do you see opportunities for investors?
Aptiv presents another promising case. The company designs and manufactures vehicle components, and provides electrical, electronic, and safety technology solutions to the automotive and commercial vehicle markets. The superior technological and operational competency has helped to solidify Aptiv’s increasingly differentiated competitive position, allowing the company to benefit from the increased demand for the mega trends in the auto industry: advanced safety solutions, vehicle connectivity, and high voltage electrification. Aptiv is perfectly positioned to continue to increase revenue significantly above underlying vehicle production around the globe. Separately, the company has made great efforts to strengthen its through-cycle resilience, by having a more balanced mix of customer, regional and end market revenues.

About Rafael Resendes, Applied Finance – Founding Partner

In 1995, together with Daniel Obrycki, Rafael Resendes developed the Economic Margin framework to measure a firm’s economic, rather than as-reported accounting performance, and directly link corporate performance to valuation. Mr. Resendes graduated from The University of California, Berkeley with a Bachelor of Science in Finance and Economic Analysis. Resendes went on to earn his MBA from the University of Chicago. Resendes is also a member of the Phi Beta Kappa Society. Prior to co-founding Applied Finance, Mr. Resendes was a member of the Chicago Board of Trade and served as director of research for HOLT Value Associates. In 2003 Mr. Resendes began serving on the CFA Institute’s Speaker Retainer Program speaking to over 45 Financial Analyst Societies in 12 countries. Resendes has also served as a guest speaker for various equity valuation seminars, National Investor Relations Institute and served as a Professor at DePaul University in Chicago. Just a few days ago, the companion fund to Applied Finance’s Valuation 50 strategy got rated by Morningstar and received Five Stars.



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