Finding great companies and great investments

The objective of investing is to take advantage of the gap between expectations and reality. The stock price of companies that are currently underappreciated by the market will trade at a discount to what it is truly worth, but over time, as everyone comes to appreciate the true value of the company, we can expect the stock price to increase. If you can accurately judge the true value of a company before it is fully appreciated by others, then you are well on your way to generating strong returns.

The difficulty however is in judging the true value of companies, especially in today’s world where intangible assets are more important than ever. We wrote about this here. Intangible assets include things like software, research and development and culture (arguably the most important). In the past, it was sufficient for investors to focus on the value of tangible assets – like property, manufacturing plants and equipment – because the economy at the time was primarily built on tangible assets. For investors, analysing tangible assets is a relatively easy process using accounting metrics. Furthermore, investors can also refer to secondary markets to gauge the market value of comparable tangible assets. Intangible assets however are not reflected in accounting metrics nor is there a secondary market to which investors can refer.

In the early 20th century, the stock market was still immature and investment decisions were based on rumours and lacked sophistication and the analysis that occurs in today’s market. A new class of investors identified the shortcomings of the common approach and developed a new process. One that was methodical and quantitative with reference to accounting data. This strategy was a success! Their process enabled them to judge a company’s value better than the herd, who relied on “gut feel” and rumours. Their approach was also effective in an era where tangible assets dominated the economy. This new approach was dubbed “value investing” and the most famous student was Warren Buffett.

In the same way that a new investment strategy emerged in the early 20th century, we think that a different approach is needed today. One that can better value intangible assets and account for the disruption taking place without ignoring the progress made by “value investors” in the 20th century. Our approach is to identify high quality companies with strong competitive advantages, but we also attempt to acquire them at a price such that they become great investments for investors. This requires judging a company’s value today, using tools not limited to historical accounting metrics. We consider the normalised value of a company, based on current earnings as well as the potential of the company. Valuing the potential of a company is difficult but there are some key variables to consider. They are the investment rate, the incremental return on that investment and the duration. All else equal, a company that can deploy large sums of capital at a high rate of return for a long period of time is best placed to create value for shareholders, and they are the types of companies that we seek.

This note has been prepared by ELM Responsible Investments (‘ELMRI’) ABN 70 607 177 711 AFSL 520428, for Australian wholesale clients for the purposes of section 761G of the Corporations Act 2001 (Cth).

The information is not intended for general distribution or publication and must be retained in a confidential manner. Information contained herein consists of confidential proprietary information constituting the sole property of ELMRI and its investment activities; its use is restricted accordingly.

This note is for general informational purposes only and does not purport to be comprehensive or to give advice. The views expressed are the views of the writer at the time of preparation and presenting and all forecasts, assumptions, opinions, data and other information are not warranted as to accuracy or completeness and are subject to change without notice. This is not an offer document and does not constitute an offer or invitation of investment recommendation to distribute or purchase securities, shares, units or other interests to enter into an investment agreement. No person should rely on the content and/or act on the basis of any material contained in this note. Any potential investor should consider their own circumstances and seek professional advice.

ELMRI funds, its directors, employees, representatives and associates may have an interest in the named securities.

Past performance is for illustrative purposes only and is not indicative of future performance.