In value investing, traps are inevitable, said value managers during the 2014 Morningstar Investment Conference in Chicago on Thursday morning. But knowing what traps to avoid can help identify opportunities across markets.
“A value manager’s unlikely to be buying a stock that’s gone from bottom left to top right,” said Harry Hartford, president of Causeway Capital Management. “As a general rule, a value manager’s going to look for something that is perhaps out of favor. Invariably when a stock is out of favor, either the company management has done something to impair the company or the fundamentals aren’t supportive of the company or the companies in that industry. And the real challenge for a value manager as it relates to value traps is to try to avoid those entities that, when you look at them optically, appear cheap, but the investment thesis subsequently proves to be the wrong one. And you’ve made a fundamental error in identifying what’s going on at the company level.”
One value trap is to assume that value is just based on low price, said David Herro, portfolio manager of The Oakmark International Value Fund. Herro says you need to know what you’re getting for that price. You avoid traps by finding companies that have a combination of low price and high quality.
Herro used Japan as an example. Oakmark used to have zero weighting to Japan, when he first started managing the fund. Although it was 60 percent of the index, he felt it was very overpriced. After that, prices fell, quality slowly ticked up and the value gap opened up. The earthquake in Japan in 2011 was a tipping point, where they were overweight Japanese equities. The price went up 80 percent, while the value only grew 10 percent or so. That’s when they trimmed back their exposure. In the last four months, it has been one of the worst markets to be in, and the value gap is once again opening up.
Another mistake is to only consider where a company is domiciled, the managers said. For example, Rob Lovelace, a portfolio manager for American Funds, said many investors are focused on the negative news coming out of European and emerging markets, but many of the companies domiciled there are global companies. Investors should, instead, focus on company fundamentals. But the country of listing does matter, Lovelace said.
Herro said investors should focus on where a company earns and generates cash, rather than where it’s domiciled. For example, 24 percent of German-based BMW’s sales come from China.
The quality of a company is dependent on the return structure that the management team is able to drive from that business and how well they allocate that capital, Herro added. If they earn good returns and are good capital allocators, they will drive that value per share up over time. But if a company has a lot of fixed assets, fixed costs and a lot of debt, it may be too risky, he said. If all their sales are concentrated in one area, that’s another risk. He can live with one of those risks, but not all.
“Ultimately to us, we judge a company by the durability of that cash flow stream, the growth rate of the cash flow stream, the probability that that cash flow stream is going to come through.”