03 February 2023

    We have a long history in active value investing, delivering excess alpha over the 27-year life of our process.  Our proven philosophy assesses a company’s worth based on its sustainable earnings generation, growth potential, and quality, to identify undervalued businesses that can deliver higher risk-adjusted returns.

    Our approach

    Tyndall values companies based on their sustainable earnings capacity. We seek to determine the intrinsic value by capitalising the sustainable or mid-cycle earnings of every stock under coverage. Using these valuations in conjunction with our forecast dividends and franking credits, we can then calculate an expected return for each company under coverage. This provides us with strong signals as to where the best opportunities are in the market.

    Our team of analysts spend their days examining company financial statements and researching industry dynamics with a company, its competitors, its suppliers, and customers, to gauge an all-round view of the outlook for the industry and a company’s position. From this, our analysts form a very strong view as to the likely sustainable or ‘mid-cycle’ earnings of that company. We then apply an appropriate capitalisation rate (or multiple) to those sustainable earnings to determine a share price forecast, from which we derive an internal rate of return for each stock under coverage.

    We refer to our approach to value investing as being an intrinsic value style.

    True value

    Our intrinsic value investment approach is highly consistent with that practiced and taught by Benjamin Graham, who is commonly known as the father of value Investing.

    Benjamin Graham’s seminal work, Security Analysis (co-authored with David Dodd and first published in 1934), sets out his process and views on value. In summary, Graham believed that there are three sources of value: assets, earnings and growth. Graham would seek to buy companies at a significant discount from his assessed value, i.e., he would seek a ‘margin of safety’.

    The three sources of value

    The first source of value comes from a company’s tangible assets. Recognising the flaws in accounting methodology, Graham wouldn’t rely purely on balance sheet measures. He ideally sought to buy companies at a discount to the value of net current assets. Of course, investing during the Great Depression presented such opportunities. In modern markets, such valuation anomalies are extremely rare.

    Beyond this, Graham would consider the net current assets plus the value of property, plant and equipment. In a business considered to be a going concern, the appropriate valuation of these hard assets is replacement cost. In a liquidation scenario, these assets should be valued at scrap or disposal value.

    Unfortunately, in modern markets opportunities to buy companies at a discount to hard assets are very rare. That said, these values are certainly a consideration in downside protection for more uncertain investment situations.

    The second source of value that Graham observed was the potential cash or earnings generation of a company and an appropriate capitalisation of that income stream. He referred to this as the ‘earnings power value’. Recognising the difficulty of forecasting, Graham would rely on historic reported earnings.

    Graham was also aware that many companies have earnings that fluctuate with the business cycle. Consistent with our approach, Graham would:

    • make an allowance for where a company was at in its business cycle and adjust earnings to the level it would earn on average through a cycle;
    • adjust a company’s earnings for non-recurring revenues or expenses.

    The third source of value that Graham recognised was growth. Graham considered this the most uncertain part of the valuation. Therefore, there were limited situations in which Graham would factor growth into his valuation. Essentially Graham would only include an element of growth in his valuation in situations where the company had an extremely strong competitive advantage. Where this is not the case, Graham’s assertion was that any investment for growth would only achieve a return in line with the cost of capital and therefore would not provide incremental value.

    We differ modestly from Graham in our approach to valuing growth. We do recognise that only companies with barriers to entry and sustainable competitive advantages can deliver value-adding growth in the long term. For this reason, it is only for companies with these characteristics that we allow an extended franchise period and above-average growth. Even for such companies, we limit this period of excess growth to a maximum of eight years. This recognises that even for the highest quality stocks, excessive growth and elevated returns on capital are not often a permanent state but are more commonly of limited duration.

    Academic value

    As a direct result of the success that famous value investors such as Graham and his students including Warren Buffett enjoyed, efforts were made to understand and systematise this value approach. This effort gave rise to the use of ratio-based valuation measures as proxies for an assessment of value. Such ratios include price-to-book and price-to-earnings, and were only the first step in the stock selection process developed by Graham.

    Using these ratios, academics have consistently found that portfolios comprised of stocks with low price-to-book and low price-to-earnings metrics etc. outperform broader share market indices. As a result of these findings, a cohort of value managers now exist that pursue only this style of value investing. We refer to this style as academic value.

    Graham and Dodd (1934) recommended not relying on simple fundamental metrics, but instead gaining a more complete understanding of the underlying security’s intrinsic value. The reversion to reliance on price multiples began to gain traction in the 1980s. The introduction of computers and the resulting development of financial databases acted as the catalyst. 

    In addition, Kok, Ribando and Sloan (2017) from Berkeley argued that simple ratios are not good substitutes for value-investing strategies that use a comprehensive approach to identifying under-priced stocks. They noted the following:

    • The price-to-book ratio systemically identifies securities with overstated book values that are subsequently written off.
    • The trailing price-to-earnings ratio systemically identifies securities for temporarily high earnings that ultimately fall.
    • The forward price-to-earnings ratio systemically identifies stocks where sell-side analysts have more optimistic forecasts of future earnings.

    In our view, while there is some useful information in such ratios, in isolation and without further investigation they are of limited use. They say nothing of a company’s future prospects, its growth potential or the threats to its existence. As a result of this lack of insight, this purely academic approach to value investing is sometimes also referred to as naïve value.

    Superior risk-adjusted returns

    We believe that our intrinsic value approach is consistent with that of Benjamin Graham, the father of value investing. We believe that using our valuation framework, coupled with portfolio risk controls, ensure we can deliver the value premium with lower volatility than is possible via strict adherence to the academic value style. 

    03 February 2023

    Tim Johnston

    Deputy Head of Australian Equities
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