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.