deconstructing “value” · introduction. but the last 10 years have been a disaster . 1993....

D E C O N S T R U C T I N G “ V A L U E ”

Rafael ResendesCO-FOUNDER AND CIO

30 APRIL 2020

INTRODUCTION2 5 Y e a r s o f V a l u a t i o n R e s e a r c h

A p p l i e d t o A s s e t M a n a g e m e n t

100% Employee owned

Average partner/employee tenure with an Applied Finance Affiliated company: 17 years

For 25 years, Applied Finance has focused on two questions to construct portfolios:

• What is a firm’s economic, rather than accounting performance?

• What is a firm’s intrinsic value?

Database of over 20,000,000 live, point in time valuations since 1995, forming our Intrinsic Value Factor™

2

INTRODUCTIONV a l u e i s N o t C h e a p n e s s

Let’s start with the basics:

Value: Monetary or material worth

Cheapness: Relatively low in cost

Price to something strategies (e.g. p/b, p/e) reflect cheapness not value.

Conventional wisdom holds cheapness is a reasonable proxy for value.

INTRODUCTION

3

EM: VALUATION

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0

S&P 500 B/P E/P

“ V a l u e ” / C h e a p n e s s I n v e s t i n g h a s w o r k e d …

S&P 500 RETURNS vs “Value”/Cheapness9/30/1998 - 2/29/2020

4

INTRODUCTION

INTRODUCTIONB u t t h e l a s t 1 0 y e a r s h a v e b e e n a d i s a s t e r

1993 Fama/French create the “Value Factor”

Fall 2015 Journal of Portfolio Management, Value is:

Cliff Asness

Over the past 10 years “Value” or Cheapness investing has been a failure.

11.59

13.44

10.5 11 11.5 12 12.5 13 13.5 14

iShares Russell 1000 Value ETF

SPDR S&P 500 ETF

10 YR RETURNS 2010-2019

In addition, our starting point is pure value, meaning price relative to some fundamental, suchas book value, based solely on quantifiable measures

“

5

INTRODUCTIONP r i c e t o S o m e t h i n g M u l t i p l e s

6

• Multiples Conflate Many Different Characteristics

• Generally high return companies trade at high multiples, low return companies trade at low multiples• Generally companies with high future growth prospects trade at high multiples, low growth companies trade at

low multiples

• The “Something” is an unrealistic proxy of company intrinsic value

• Earnings in a year represents a tiny percentage of all future earnings • If EPS is $1.00, growing 5% forever, and risk is 10% - today’s “e” represents 5% of total value

• Book Value for NVDA is $12b; Market Value is $182b• Sales has no direct relation to intrinsic value – distributor vs manufacturer

Price to Something models hope they construct a variable correlated enough to intrinsic value to create portfolio alpha

INTRODUCTION

11.59

13.44

14.29

0 2 4 6 8 10 12 14 16

iShares Russell 1000 Value ETF

SPDR S&P 500 ETF

Valuation 50

10 YR RETURNS 2010-2019

INTRODUCTIONA p p l i e d F i n a n c e V a l u a t i o n i s D i s t i n c t l y D i f f e r e n t F r o m C h e a p n e s s

EM: VALUATION

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002

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211

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/200

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31/2

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007

6/30

/200

711

/30/

2007

4/30

/200

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30/2

008

2/28

/200

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31/2

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1/20

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19

S&P 500 B/P E/P Valuation

S&P 500 RETURNS vs Valuation & “Cheapness”9/30/1998 - 2/29/2020

A p p l i e d F i n a n c e V a l u a t i o n i s D i s t i n c t l y D i f f e r e n t F r o m C h e a p n e s s

INTRODUCTION

A p p l i e d F i n a n c e E c o n o m i c M a r g i n ® V a l u a t i o n

EM: CORPORATE PERFORMANCEA c c o u n t i n g E a r n i n g s A r e A P o o r

I n d i c a t o r o f C o r p o r a t e P e r f o r m a n c e

EM: CORPORATE PERFORMANCE

FTSE World Index : Earnings Growth vs P/E

Earnings Growth

Higher or Lower EPS Growth is Not Insightful into Understanding P/E Ratio’s

P/E

–Cu

rren

t Yea

r

10

EM: CORPORATE PERFORMANCEA c c o u n t i n g E a r n i n g s A r e A P o o r

I n d i c a t o r o f C o r p o r a t e P e r f o r m a n c e

EM: CORPORATE PERFORMANCE

Earnings as a proxy of economic profitability does not account for: o Investment to Generate the Earnings o Cost of Capital o Inflation o Cash Flow

Accounting rules distort economic reality due to: Off Balance Sheet Assets/Liabilities such as:

o Operating Leases o Research & Development

Accounting ratios/multiples are not comparable because each company has a different:o Asset Life o Asset Mix o Asset Age o Capital Structure o Growth Potential

11

EM: CORPORATE PERFORMANCEW h y G A A P R e p o r t e d A s s e t s A r e D e c e p t i v e

Accrual accounting does not accurately capture total amounts of capital that a business uses.

For example, inflation over longer periods can lead to significant discrepancies between Gross PP&E and the total cost to replace the assets in today’s dollars.

Invested Capital for AAPL vs XOM AAPL XOM Delta

Total Assets 375,319 348,691 -26,628

Accumulated Depreciation 41,293 224,555

Inflation Adj 5,445 128,625

Other Adjustments -26,835 -17,591

AFCM Economic Invested Capital 395,222 684,280 289,058

Does it make sense that Apple is more asset intensive than Exxon? NO

Data Date: 2017

12

EM: CORPORATE PERFORMANCEW h y T r a d i t i o n a l M u l t i p l e s F a l l S h o r t

Invested Capital for AAPL vs XOM AMZN

Net Inc 3,033

GAAP ACCOUNTING VS. APPLIED FINANCE CASHFLOW

Data Date: 2017

DD&A 11,478

Leases 2,202

R&D 11,986

Other -248

Adjusted CF 28,452

13

EM: CORPORATE PERFORMANCEE c o n o m i c M a r g i n C a l c u l a t i o n

Operations Based Cash Flow:Net IncomeDepreciation & amortizationAfter Tax Interest ExpenseRental Expense Net Int. Adj.R & D ExpenseNon-Recurring Items

Capital Charge:Return on and Return of Capital that captures company specific economic circumstances.

(Country Specific COC)

Inflation Adjusted Invested Capital:Total AssetsAccumulated DepreciationGross Plant Inflation AdjustmentCapitalized Operating RentalsCapitalized R & DNon-Debt Current Liabilities

±+++++

+++++-

14

EM: CORPORATE PERFORMANCEE c o n o m i c M a r g i n C a l c u l a t i o n

Given 5% WACC, What Must Project Yield To Break Even?

Investment:

PV

Life = 10 yearsN

PMT = ?Salvage:$5,000

FV

$10,000

Annual Economic Charge = $898

* Calculated using the Payment function [PMT (5%, 10, 0, -10,000)]

Capital Charge

15

FV (Salvage Value)N (Life) 0% 50% 100%

7 YR

10 YR

13 YR

$898

$1,114$1,728 $500

$500

$500$728

$1,298

$1,065

EM: CORPORATE PERFORMANCER e m o v i n g T h e N o i s e

FTSE World Index: Economic Margin and MV/IC Correlation

Economic Margin

Economics Not Accounting Explain Market Prices

Filtering Out The Noise Leads To Better Decisions By Directly Linking Performance To Value

Mar

ket V

alue

/ In

vest

ed C

apita

l

Data Source: EquityInsights.com

16

EM: CORPORATE PERFORMANCET r a d i t i o n a l D C F V A L U A T I O N

17

Explicit Forecast Period (5 yrs) of Free Cash Flow• How is forecast benchmarked?• Who is making forecast?• Consistency with others in organization?

After Forecast Period, Incorporates Gordon Growth Terminal Value

• Extreme discount rate sensitivity due to 1 / (r-g) assumptionso Example: r =10; g= 3. Multiple = 14.2o Change r or g by 1% and terminal value changes by 20%

• Ignores competition, through perpetuity assumptions after forecast periodo Profitability never changeso Capital efficiency never changeso Growth never changes

How has it been validated?• How many valuations has each analyst performed• What is the track record for identifying over and under

valued companies• Are the same analysts working today as 20 yeas ago• Is every analyst using the same valuation approach• Is the same valuation model used today as 20 years ago

EM: VALUATIONT e r m i n a l V a l u e P r o b l e m s

MICRON DROPPED FROM HIGH $35 TO $14 IN 2015

Term

inal

Gro

wth

Discount Rate

12.00% 10.00% 8.00%

5.00%$60.45

3.00%$23.99

0.00%$12.79

TRADITIONAL DCF VALUE DISCREPANCY

• Highly sensitive to changes in discount rates or growth rates, leading to drastic variance in values.

• Growth, risk, and competition estimates are subjective and inconsistent from one analyst to another.

18

EM: VALUATIONA v o i d i n g S i l l y P e r p e t u i t y P r o b l e m s :

19

Economic Profit Horizon™Economic Margins > 10% 2007 - 2017

EM: VALUATIONE C O N O M I C P R O F I T H O R I Z O N ™

20

Econ

omic

Mar

gin

®

Economic Profit Horizon™ Years5 10 15 20 25 30 35 40

EM: VALUATION

Intrinsic Value Should Be An Anchor To Exploit Behavioral Bias

21

I n t r i n s i c V a l u e R e p o r t

EM: VALUATION

22

I n t r i n s i c V a l u e R e p o r t

EM: VALUATIONI n t r i n s i c V a l u e R e p o r t

23

EM: VALUATION

CLEAN UP ACCOUNTING DATA

VALUATIONS ON THOUSANDS OF COMPANIES WORLDWIDE

CONSISTENCY

VALUATION DRIVEN™ INVESTING

A p p l i e d F i n a n c e V a l u a t i o n P r o c e s s

Every Stock Objectively Valued

Consistent Cashflow Definition

Consistent Invested Capital Definition

Consistent Risk Adjustments

Consistent Competition Corrections

Applied Finance has over two decades of data to understand:

Company-Specific Valuation Issues

Market Valuation Cycles

Applied Finance has systematically calculated over 20,000,000 real-time individual company intrinsic value estimates.

Applied Finance’s ongoing research database provides the foundation to link valuation research to portfolio construction and ongoing market research to expand our knowledge into how markets reward and punish firms.

24

D E C O N S T R U C T I N G “ V A L U E ”

DECONSTRUCTING “VALUE”

How do attractive “value” and Valuation signals work together and alone

How do attractive “value” signals perform if they differ from valuation signals

How do attractive valuation signals perform if they differ from value signals

Identify when valuation signals exceed “value” signals

Identify when “value” signals exceed valuation signals

T e s t i n g “ V a l u e ” S t r a t e g i e s

Valuation vs Deep Value

Valuation vs Multiples

TEST 1

TEST 2

26


Monthly Factor Quintile Portfolios formed:

D a t a O v e r v i e w

Russell 3000 Universe1998 to 2018

Price Multiple Composite, an equal weighted composite of: (p/e, p/bk, p/s, p/cf)

Variables Studied

Cheap (CHP) = Most attractive Price Multiple Composite companies

Expensive (EXP) = Least attractive Price Multiple Composite companies

Undervalued (UV) = Most attractive Intrinsic Value companies

Overvalued (OV) = Least attractive Intrinsic Value companies

As-reported, time stamped data from The Applied Finance Group

(AFG) database

27

Fama/French 5 Factor Model alpha comparison

Quintiles INTRINSIC VALUE OV Q2 Q3 Q4 UV

PRIC

E M

ULT

IPLE

S EXP

Q2

Q3

Q4

CHP

Applied Finance Intrinsic Value

DECONSTRUCTING “VALUE”C o r r e l a t i o n v s C a u s a l i t y

28

INTRINSIC VALUE QUINTILES

OV Q 2 Q 3 Q 4 UV

EXP

Q 2

Q 3

Q 4

CHP


OV Q 2 Q 3 Q 4 UV

EXP

Q 2

Q 3

Q 4

CHP

PRIC

E M

ULT

IPLE

S Q

UIN

TILE

S

PRIC

E M

ULT

IPLE

S Q

UIN

TILE

S

All CheapAlpha % 2.47

0.00

0.50

1.00

1.50

2.00

2.50

3.00

3.50

4.00

ANN

UAL

IZED

ALP

HA

Cheap BUT OvervaluedAlpha% 0.56

0.00

0.50

1.00

1.50

2.00

2.50

3.00

3.50

4.00

ANN

UAL

IZED

ALP

HA


OV Q 2 Q 3 Q 4 UV

EXP

Q 2

Q 3

Q 4

CHP

PRIC

E M

ULT

IPLE

S Q

UIN

TILE

S

Undervalued AND CheapAlpha % 3.60

0.00

0.50

1.00

1.50

2.00

2.50

3.00

3.50

4.00

ANN

UAL

IZED

ALP

HA

All Cheap Cheap and Undervalued Cheap NOT Undervalued


29


OV Q 2 Q 3 Q 4 UV

EXP

Q 2

Q 3

Q 4

CHP

PRIC

E M

ULT

IPLE

S Q

UIN

TILE

S


OV Q 2 Q 3 Q 4 UV

EXP

Q 2

Q 3

Q 4

CHP

PRIC

E M

ULT

IPLE

S Q

UIN

TILE

S


OV Q 2 Q 3 Q 4 UV

EXP

Q 2

Q 3

Q 4

CHP

PRIC

E M

ULT

IPLE

S Q

UIN

TILE

S

Undervalued AND CheapAlpha % 3.60

0.00

0.50

1.00

1.50

2.00

2.50

3.00

3.50

4.00

ANN

UAL

IZED

ALP

HA

All UndervaluedAlpha % 3.49

0.00

0.50

1.00

1.50

2.00

2.50

3.00

3.50

4.00

ANN

UAL

IZED

ALP

HA

Undervalued BUT ExpensiveAlpha % 3.31

0.00

0.50

1.00

1.50

2.00

2.50

3.00

3.50

4.00

ANN

UAL

IZED

ALP

HA

All Undervalued Undervalued NOT CheapCheap and Undervalued


30

Undervalued, Expensive Cheap, OvervaluedAlpha % 3.31 0.56

0.00

0.50

1.00

1.50

2.00

2.50

3.00

3.50

4.00

ANN

UAL

IZED

ALP

HA

QuintilesINTRINSIC VALUE

OV Q2 Q3 Q4 UV

PRIC

E M

ULT

IPLE

S

EXP

Q2

Q3

Q4

CHP

DECONSTRUCTING “VALUE”C o m p a r i n g S i g n a l D e l t a s

1 Delta:Value: -0.5%

Valuation: 3.5%

Return Spread

Intrinsic Value

All F D C B A

Book

to P

rice

LFY

All 0.0% -3.9% 0.2% 2.3% 5.5% 5.8%

F 0.4% -1.8% 1.0% 0.4% 1.6% 4.3%

D 0.6% -2.6% -0.7% 2.6% 0.7% 5.6%

C 2.2% -7.9% 1.0% 2.8% 5.7% 4.9%

B 3.7% -5.8% -3.4% 1.6% 7.5% 7.5%

A 2.8% -14.0% 2.1% 5.0% 6.5% 4.9%

Cheap Preference -0.5% Valuation Preference 3.5%


1 Delta

31

DECONSTRUCTING “VALUE”C o m p a r i n g S i g n a l D e l t a s

Return Spread

Intrinsic Value

All F D C B A

Book

to P

rice

LFY

All 0.0% -3.9% 0.2% 2.3% 5.5% 5.8%

F 0.4% -1.8% 1.0% 0.4% 1.6% 4.3%

D 0.6% -2.6% -0.7% 2.6% 0.7% 5.6%

C 2.2% -7.9% 1.0% 2.8% 5.7% 4.9%

B 3.7% -5.8% -3.4% 1.6% 7.5% 7.5%

A 2.8% -14.0% 2.1% 5.0% 6.5% 4.9%


3 Delta:Value: -6.7%

Valuation: 3.8%


3 Delta

32

DECONSTRUCTING “VALUE”S a m p l e C o m p a n i e s : V a l u a t i o n P r e f e r e n c e

Return SpreadIntrinsic Value

All F D C B A

Book

to P

rice

LFY

All 0.0% -3.9% 0.2% 2.3% 5.5% 5.8%

F 0.4% -1.8% 1.0% 0.4% 1.6% 4.3%

D 0.6% -2.6% -0.7% 2.6% 0.7% 5.6%

C 2.2% -7.9% 1.0% 2.8% 5.7% 4.9%

B 3.7% -5.8% -3.4% 1.6% 7.5% 7.5%

A 2.8% -14.0% 2.1% 5.0% 6.5% 4.9%


3 Delta

33

STRATEGY INTRODUCTIONV a l u a t i o n D e l t a ™

Quintile Delta >= 3

Russell 3000 Cheap Valuation

Cumulative 406.5% 30.5% 962.9%Annual 7.9% 1.3% 11.8%Return Spread 0.0% -6.7% 3.8%IR (12M) na -16.6% 52.7%Beta 1.00 1.58 1.24MaxDD vs Bench 0.0% -349.8% -25.8%Jensen's Alpha 0.0% -11.3% 2.0%Treynor Ratio 7.9% 0.8% 9.5%Avg/StDev (1M) 17.0% 5.3% 19.0%Sortino (MAR = 0) 24.9% 8.1% 29.2%Turnover na 243.7% 186.1%Average Count 2560.8 172.1 185.4FF 3 Factor Alpha 0.0% -9.9%*** 1.9%Carhart 4 Factor Alpha 0.1% -6.4%** 2.5%FF 5 Factor Alpha -0.3% -5.3% 2.0%AQR 6 Factor Alpha -0.3% -3.0% 2.6%


34


DECONSTRUCTING “VALUE”V A L U A T I O N I S T H E F O U N D A T I O N

35

STRATEGY INTRODUCTIONV a l u a t i o n 5 0 ™ v s P e e r s

37

July 2004 - March 2020 Annualized ReturnsStrategy ReturnsApplied Finance: Valuation 50 7.86%S&P 500 7.53%Oakmark Institutional 6.44%DFA US Large Cap Value 6.20%LSV Asset Mgmt.: Large Cap Value 5.87%Dodge & Cox: Equity 6.56%

0

50

100

150

200

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350

400

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500

6/1/

2004

10/1

/200

42/

1/20

056/

1/20

0510

/1/2

005

2/1/

2006

6/1/

2006

10/1

/200

62/

1/20

076/

1/20

0710

/1/2

007

2/1/

2008

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2008

10/1

/200

82/

1/20

096/

1/20

0910

/1/2

009

2/1/

2010

6/1/

2010

10/1

/201

02/

1/20

116/

1/20

1110

/1/2

011

2/1/

2012

6/1/

2012

10/1

/201

22/

1/20

136/

1/20

1310

/1/2

013

2/1/

2014

6/1/

2014

10/1

/201

42/

1/20

156/

1/20

1510

/1/2

015

2/1/

2016

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2016

10/1

/201

62/

1/20

176/

1/20

1710

/1/2

017

2/1/

2018

6/1/

2018

10/1

/201

82/

1/20

196/

1/20

1910

/1/2

019

2/1/

2020

Applied Finance: Valuation 50 DFA US Large Cap Value Oakmark Institutional LSV Asset Mgmt.: Large Cap Value

Dodge & Cox: Equity Russell 1000 Value S&P 500

Valuation 50: Performance vs PeersJuly 2004 - March 2020

STRATEGY INTRODUCTIONV a l u a t i o n D i v i d e n d ™ v s P e e r s

Valuation Dividend: Performance vs PeersApril 2012 - March 2020

STRATEGY INTRODUCTION

38

0

50

100

150

200

250

300

3/1/

2012

6/1/

2012

9/1/

2012

12/1

/201

2

3/1/

2013

6/1/

2013

9/1/

2013

12/1

/201

3

3/1/

2014

6/1/

2014

9/1/

2014

12/1

/201

4

3/1/

2015

6/1/

2015

9/1/

2015

12/1

/201

5

3/1/

2016

6/1/

2016

9/1/

2016

12/1

/201

6

3/1/

2017

6/1/

2017

9/1/

2017

12/1

/201

7

3/1/

2018

6/1/

2018

9/1/

2018

12/1

/201

8

3/1/

2019

6/1/

2019

9/1/

2019

12/1

/201

9

3/1/

2020

Applied Finance: Valuation Div Brandywine Globa: Diversified LCV BlackRock: Equity Dividend

WisdomTree Asset: WT High Dividend Invesco: Dividend Growth Schafer Cullen: HDV

Russell 1000 Value

April 2012 - March 2020 Annualized ReturnsStrategy ReturnsApplied Finance: Valuation Div 8.02%Russell 1000 Value 7.13%Brandywine Globa: Diversified LCV 7.03%Invesco: Dividend Growth 7.03%BlackRock: Equity Dividend 6.90%Schafer Cullen: HDV 6.62%WisdomTree Asset: WT High Dividend 6.56%

STRATEGY INTRODUCTIONV a l u a t i o n D e l t a ™ v s P e e r s

STRATEGY INTRODUCTION

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Valuation Delta SPY

Valuation Delta: Performance vs PeersOctober 1998- March 2020

Manager vs Benchmark: ReturnOctober 1998 - March 24th, 2020 Annualized ReturnsStrategy ReturnsValuation Delta 12.88%SPY 6.80%

Economic Margin Valuation®, and Cheapness (“value”) Investing

Cheapness measures conflate many potential circumstances • Valuation • Economic Profitability • Changing Circumstances

Cheapness Investing provides noisy correlations to Intrinsic Value

Cheapness Investing , was an innovation, but no longer state of the art

Cheapness Investing results explained away by Economic Margin® Valuation

CLOSING THOUGHTS

Economic Margin Valuation®, and Traditional DCF

Valuation is easy – only requires simple algebraRealistic Valuation is much more difficult, requires:

• Economic not accounting profit• Capital Growth• Company specific risk estimates• Economic Profit Horizon™ estimates

Valuation useful for asset management is even more difficult, requires:• Empirical validation over at least 15 years of out of sample estimates• The same model generating intrinsic value estimates• The same analyst team generating intrinsic value estimates

Traditional DCF and firms utilizing them fail virtually every criteriaNot surprising most active managers destroy wealthApplied Finance’s Economic Margin® Valuation meets each criteriaApplied Finance Strategies create wealth and consistently rank among best in class

CLOSING THOUGHTS

Economic Margin Valuation® Portfolios

Economic Margin Valuation® is superior to Cheapness and Traditional DCF Investing• Empirically validated with over 20 years and 20,000,000 out of sample valuations• Unbiased, consistent intrinsic value estimator across style and size• Complete model incorporating economic profit, growth, risk, competition• Proprietary to Applied Finance

Applied Finance Strategies are top performers*. • Valuation 50® top 2% since 2004• Valuation Dividend® top 2% since 2012• Valuation Delta® in time will become a growth category leader

Access to Applied Finance Strategies is exclusive• Applied Finance Advisors differentiate themselves from competitors• Each strategy has a current AUM cap to avoid overselling to minimize performance slippage

CLOSING THOUGHTS

*PSN and Morningstar, through 2019

Applied Finance

deconstructing “value” · introduction. but the last 10 years have been a disaster . 1993....

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