“Buying cheap stocks is great, but buying good companies cheaply is even better” - Joel Greenblatt

Value investing has so much intuitive appeal. Who doesn’t like a bargain? However, in recent years much has been written about the death of value investing. Value investing is sometimes mistaken for a style that just buys cheap stocks. However, this superficial method says nothing about business quality. The problem with just buying cheap stocks is that they can remain cheap for good reasons.

Valuations and quality attributes of a company are joined at the hip and is best expressed in the following equation:

Price to book multiple  = (return on equity - growth rate) / (discount rate - growth rate)

In the equation, price to book (PB) multiple is a proxy for valuation and return on equity (ROE) is a proxy for quality. Hence, if a company’s quality is lower it means a company’s valuation should also be lower and vice versa (if all else is equal). It’s not surprising that the collective wisdom of the market roughly captures this relationship. This market efficiency is highlighted by the correlation between ROE and PB multiple for the Australian banking sector through time and across stocks.

Time-series of Commonwealth Bank’s PB multiple and ROE

Source: FactSet


Cross-section of Aussie bank’s PB multiple and ROE

Source: FactSet


If the cheapest bank has the lowest ROE and the most expensive bank has the highest ROE, do you think they are mispriced (undervalued or overvalued)? Or is the market simply efficient in pricing the quality of the business?

‘True’ value investing is not about buying cheap stocks for cheap sake but is about identifying mispriced securities when valuation and quality are disconnected. In other words, buy good companies at a cheap price. For example, a defining moment in Warren Buffett’s career was when he bought American Express (a ‘compounding machine’ as he would later call it) after its share price collapsed from the Salad Oil Scandal in the early 1960s.

Joseph Piotroski (2000) later popularised the idea of buying good quality companies when valuations are cheap. His research paper attempted to sort out company valuations disconnected from their fundamentals. His findings highlight that higher quality companies within the value basket delivered 7.5% p.a. higher returns than the entire value basket alone. Piotroski’s research helped lay the foundation for the quantitative world in creating factor exposures for the quality attributes of companies.

Finding valuations that are disconnected from fundamentals is rare because markets are roughly efficient over time. But it becomes easier during market corrections because indiscriminate selling creates more opportunities. At Vertium, we call these opportunities “bathwater babies”, where the market has thrown out the baby with the bathwater. Post the COVID crash, our research highlights two stocks (Lendlease and Cochlear) where their current valuations are substantially dislocated from their business quality.

Lendlease (LLC)

LLC’s core business is property development, hence it’s no surprise that its valuation multiple falls when economic growth slows. During these periods, it makes no sense to value a business on earnings multiple because short-term profits evaporate.

Fortunately, there are multiple ways to adjust valuation multiples when earnings are temporarily depressed. One could use the earnings generated before the slowdown. For example, the historic 10-year average earnings could be used similar to the method adopted by the Shiller CAPE ratio. Alternatively, we like to use the PB multiple. If the long-term ROE of the business has not changed and the PB multiple is temporarily depressed, then a disconnect between valuation and quality is potentially identified.

LLC can currently be bought close to its book value. At current prices LLC represents a classic value stock where the market is not willing to pay for much goodwill or future growth of the business. However, LLC offers more than just being cheap, there is a large disconnect between its current valuation and its fundamentals. LLC’s PB multiple is temporarily depressed but the business is likely to be stronger in the future given its large development workbook (a proxy for its future earnings and ROE).

The disconnect between valuation and quality is even more apparent when examining the ratio of LLC’s market cap to its development workbook over time. This ratio is currently the lowest in history highlighting that LLC is cheaper now (compared to future profits) than during the Euro crisis in 2012.


Source: FactSet, Lendlease, Vertium

Cochlear (COH)

COH would not be the first stock you think about when investing for value. Its leading global position allows the company to earn an extraordinarily high ROE (5-year average of 44%). Most investors would call it a compounding machine given its long track record of delivering earnings growth. Given its pedigree the stock has seldom exhibited a cheap headline valuation multiple. Many believe that traditional price to book multiple is obsolete for growth companies such as COH because intellectual property does not show up on a balance sheet in the same way as tangible assets.

However, when earnings are temporarily depressed the old chestnut, PB multiple, becomes extremely useful. Given the COVID crisis, the lack of elective surgeries has resulted in a very large earnings hole for COH. Its share price has de-rated to such an extent that its current PB multiple is as cheap as it was in 2012, the year that its business was affected by a product recall.


Source: FactSet

COH’s business bounced back from that temporary setback in 2012, but the key question now is whether it can recover from the COVID crisis. In other words, will its depressed valuation reconnect with its long-term profit generation capability? If its long-term ROE is not impaired, then earnings should mean revert. Hence, over time COH’s PE multiple should compress and its PB multiple should expand with an improving ROE.

Our research indicates that COH should recover well post the COVID crisis. There is evidence that Cochlear surgeries have mean reverted to pre-COVID levels where lockdowns were lifted, such as in China. If the reason for the earnings collapse is due to no elective surgeries, then by the same logic earnings should recover when elective surgeries resume. Furthermore, in the near term there’s scope for COH’s earnings to recover strongly given that Advance Bionics (a key competitor) issued a product recall just before the COVID pandemic lockdowns. In the long term, COH’s runway of growth will be enhanced if management can successfully commercialise a totally implantable cochlear implant from their R&D program.

Summary

Rather than systematically buying value (regardless of quality), ‘true’ value investing involves looking for disconnects between valuations and quality. While value investors will naturally have a tough time in a bull market, there are many market dislocations on offer due to the COVID crisis. Both Lendlease and Cochlear have been thrown out with the bathwater and over time their current depressed valuations will eventually reconnect with their strong business fundamentals.

In our view, Greenblatt’s quote at the start of this article is only partially correct. We suggest that this quote should be changed to:

“Buying cheap stocks is SOMETIMES great, but buying good companies cheaply is ALWAYS great.

Reference:

Piotroski, J., Value Investing: The Use of Historical Financial Statement Information to Separate Winners from Losers, Journal of Accounting Research, 2000, Volume 38, pp. 1-41 

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Jim

A refreshing angle was taken with this article. Appreciate the insight.

Jimmy Pham

Jason great article. Thanks heaps!

Peter Ralph

CBA is yet to report in a period impacted by coronavirus. Beware, the ROE will no longer be pushing 11% when it significantly increases its bad and doubtful debts provisions in the next set of results.

Shawn Burns

Well argued Jason

Matt Christensen

Aware you know all the below Jason and may disagree with parts. Making the counter argument to applying a P/B or ROE approach in the circumstances COH faces. • Stock count expanded by 13.6% from cap-raising. Dilutionary to EPS by 12%. (Based on final $1.1 Billion raised). • Original request was for $850 million (expand count by 10.50%, dilute by 9.50%) • That 9.50% planned dilution covered; i) Underwriting & JLM fees of $22 million; ii) Payment of $92 million dividend otherwise at risk, iii) $420 million Legal liability now payable (at current 66.7 forex), and iv) extra $63 million legal liability if priced at 58c forex. v) $238 million for unresolved contingent liability (at 58c forex; reduces by $31 mil at current 66.7). vi) $80 million Ordinary Capital Expenditure for the remainder of 2020CY. vii) Total demands on originally planned $850 million = $915 million. • Leaving -$65 million not directly covered by attributable items from original Capital-Raise settings. • Meaning, the real new contribution to the balance sheet (from an $850 million raise) would include increasing Debt-Drawn (despite some presumed lender reluctance inspiring the raise), and to Capitalise $80 million Capex, and enjoy only $15 million Book Value expansion overall (i.e. ~ 2% uplift). • All this, for originally planned 9.50% dilution. Coming with, zero non-ordinary/growth capital, and still not fully provisioned on legal liabilities unless COH won appeal on the final $238 million court-challenge. • Accordingly, it is understandable why COH upsized the deal!! • Adjusting for the extra $250 million raised (via the classy upsize of SPP, and upsized placement), and for the forex gains of $94 million (assuming neither the firm/contingent liability was hedged at 58c) this expands Book Value by a further $344 million, uplifting by $359 million (or 44% uplift in Book Value). • Clearly this new Marginal Capital (the final $344 million not linked to any action, bar lowering leverage) will do little to expand the profitability of Cochlear. It will certainly see substantial diminishing returns on the average future ROE’ Cochlear can deliver. All it does short-term is lower lender-angst, financial leverage, and hold sufficient capital to cover the total cost of doing business (incl. of liabilities long-deferred). • This also implies that if COH was holding this extra Capital (say from 2017/2018 to cover these liabilities by choosing to fully recognise them earlier), this would have materially lowered 5-year ROE achieved. • Note: Morningstar, Skaffold and my own counts are all 1%-4% below your 44% ROE figure, but fully agree 40%-43% impressive past ROE (albeit on a balance sheet that was clearly under-capitalised). • To summarise; I view Price to Book valuations made over COH, without heavy-heavy-heavy adjustments a futile exercise that will produce misleading figures/outputs. • Realise the 2021 to 2022 Earnings years have low visibility, but taking comfort in artificially large Equity, and the extreme lowering of the Price to Book ratio likely gives zero real guidance towards “value”. Suggest COH at $194, being priced materially above its own average Price to Sales ratio is the more prescient near-term heuristic/ratio. • Think we agree that COH’s “value” or otherwise hinges most heavily on where its 2022 Sales and Earnings end up…..

Jason Teh

Hi Matt, thank you for your detailed comments. The book value I'm using has already been adjusted for the equity raising. Given that book equity is heavily influenced by the equity raising an alternative measure one could use is enterprise vale to funds employed, which will be less volatile. Whether one uses EV/FE or P/B, its about trying to match it up with its ROA or ROE respectively to identify a disconnect. Yes, we both agree that future earnings need to mean revert to prove that a disconnect between fundamentals and valuation exist today.