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June DG Newsletter & Intrinsic Value Investing

publication date: Jun 1, 2020
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author/source: Brian Nelson, CFA

"But how, you will ask, does one decide what [stocks are] "attractive"? Most analysts feel they must choose between two approaches customarily thought to be in opposition: "value" and "growth,"...We view that as fuzzy thinking...Growth is always a component of value [and] the very term "value investing" is redundant."
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          -- Warren Buffett, Berkshire Hathaway annual report, 1992
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By Brian Nelson, CFA
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Hi everyone! 
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We remain unequivocally bullish on the markets and intrinsic value investing. We believe value today rests within companies that have strong net cash positions (all cash less short- and long-term debt) and solid expected future free cash flows (operating cash flows less all capital spending). The types of companies that fit our definition of value today are generally (and counter-intuitively) large-cap growth and big-cap tech, entities that not only display the characteristics of cash-based sources of intrinsic value, but also have long runways for growth and have recurring, asset-light revenue models backed by solid economic "moats" (duration of economic profit) and very attractive economic castles (magnitude of economic profit). 
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While these companies can coincidentally have low ratios in the form of P/B, P/S, EV/EBITDA, P/E, and the like, we reiterate that companies that have such low price-observed metrics without strong net cash positions on the balance sheet, solid expected growth in free cash flow, and "moaty" recurring and asset-light business models may more closely fit the quintessential definition of a value trap (or a stock that just appears undervalued) than a truly undervalued stock on an intrinsic value basis. This distinction, which in part we sought to address in the book Value Trap, is why statistical or traditional quant value (based on the P/B ratio, for example) has been performing terribly for the past decade plus. Most of traditional quant is investing repeatedly in value traps and suffering mightily for it, awaiting a turnaround on little theoretical basis beyond the gamblers' fallacy ("luck").  
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In short, today, we continue to be huge fans of the buckets of large-cap growth and big-cap tech, not because of the arbitrary style definitions, but rather because these are the types of companies with cash-based intrinsic value characteristics that offer tremendous resiliency in a time of great uncertainty. Over time, cash-based intrinsic value characteristics might move around the style spectrum depending on the characteristics of the companies within such arbitrary buckets, but now and for the foreseeable future, asset-light and cash-rich large-cap growth and big-cap tech is where the components of intrinsic value reside. Warren Buffett couldn't have said it better when he said that growth is but a part of estimating the intrinsic value of a company (its worth on a per-share basis) and that separating growth from value just doesn't make any sense.
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What I am referring to is the basic construct of enterprise valuation. To derive a fair value estimate of a company, the two most important and transparent drivers are the company's net cash position on the balance sheet and its future expected free cash flows. The intrinsic value investor then looks for the stock price of these cash-rich entities to trade below an informed intrinsic value estimate. The Valuentum investor then goes a step further and overlays relative valuation measures to strengthen the intrinsic value assessment, while waiting for technicals and momentum to reveal whether the market also believes the stock is underpriced. We think a falling share price means the market thinks the company's intrinsic value is lower than the current price, while we think a rising share price means the market thinks the company's intrinsic value is higher than the current price.  
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It becomes very clear by this contextual logic and framework that demanding stocks with strong cash-based intrinsic value characteristics that are trading at a discount to an informed fair value estimate on improving share-price momentum is simply par for the course. Our dividend analysis even takes this process a step further, as we overlay our cash-based intrinsic value work by assessing whether companies also have the financial capacity to keep paying the dividend based on the health of the balance sheet and future free cash flows. For almost a decade now, we've had tremendous success with our processes, as evidenced by the outcomes of both the Best Ideas Newsletter portfolio and Dividend Growth Newsletter portfolio (our favorite ideas are always in the newsletter portfolios), and we encourage all to read our latest update on how we performed during the COVID-19 crisis, "Important Recap of Valuentum's Research and Market Events," May 20.
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In short, today, the conversation of 'value' comes down to the following:
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"Graham and Dodd" investing = value traps
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Traditional quant value (low P/B, low P/E, etc) = value traps
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Strong net cash, strong expected future free cash flow = cash-based sources of value
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Stocks with net cash and strong expected future free cash flows trading at a discount to a reasonable estimate of intrinsic value = intrinsic value investing (or true value investing)
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I wanted to add into this brief note how much I appreciate your interest and loyalty. It's not lost on me at all. I think you saw how well our team performed during the COVID-19 crisis in calling the top, "dollar cost averaging" the bottom, and in highlighting outperforming ideas, while pounding the table on the importance of putting investors' first (and where we stand with respect to indexing and moral hazard advice), "Video: A Call for More Policy Action in a Post COVID-19 World," May 19. Without you, we simply could not be in a position to push this industry forward, ask the tough questions about "best interest" advice, work to expose conflicts of interests that become readily apparent from our perspective, and have the difficult conversations. 
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There are no risk-less investments when it comes to the stock market, of course, but as I close this note, I also wanted to reiterate my long-term bullish opinion on the markets and further emphasize that this "win-win" scenario we seem to find ourselves in today appears to be one-of-a-kind in history. To learn more about what I am talking about, please read the following, if you haven't already: "Stay Optimistic. Stay Bullish. I Am." With all that said, the June edition of the Dividend Growth Newsletter can be downloaded here (pdf). We're available for any questions. Stay safe, and God bless!
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Kind regards,
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Brian Nelson, CFA
President, Investment Research
Valuentum Securities, Inc.
brian@valuentum.com
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Tickerized for stocks in the SCHG.
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Brian Nelson owns shares in SPY and SCHG. Some of the other securities written about in this article may be included in Valuentum's simulated newsletter portfolios. Contact Valuentum for more information about its editorial policies. 

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