During his recent interview with The Inside Adviser, Richard Pzena discusses his way of assessing a company’s intrinsic value by estimating its ‘normalized earnings’, which is what the company is expected to earn over the long term. He also discloses how to deal with the risk of investing in value traps. Here’s an excerpt from the interview:
Most investors use a price-to-book (as in, ‘book value,’ or what in Australia would be called price-to-net-tangible-assets, or price/NTA), or a price/earnings (P/E) ratio. But we use a figure that we call ‘normalised earnings,’ which is what we would expect a company to earn across a business cycle – say, at the midpoint of the business cycle. Buying companies that are cheap relative to their ‘normalised’ earnings power is how we define value investing.
It’s what should this business earn given a variety of inputs — its history, the industry structure in which it competes, competitor margins, its individual company strengths and weaknesses, its management and its business plan. We go through a scientific screening process, but ultimately, our estimate of normal earnings is a concept, not a mathematically derived figure. It’s just, ‘what should this business earn over the long term?’ And very often that’s different from what it is currently earning.
Typically, in the companies we’re buying the margins have fallen below their historic norms. That’s important to us – we avoid companies that are doing better than usual, which makes us really sceptical.
On the flipside, one of the questions we always get asked is, ‘how do you avoid value traps? ‘And the answer is, we don’t know. We feel that the very attempt to avoid value traps makes you not a value investor.
Because the truth is, you don’t know which are the ones that are not going to work and which ones that are going to work. The traps that we try to avoid are excess financial leverage, so that the bad outcome is disaster, or businesses that are going through a massive structural change, where you can’t evaluate the downside case.
You can read the entire interview here:
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