Finding Value in Optically Expensive Stocks: A Deep Dive

During their recent episode, Taylor, Carlisle, and Matt Sweeney discussed Finding Value in Optically Expensive Stocks: A Deep Dive, here’s an excerpt from the episode:

Matthew: Concentrated value. It’s a short version of that. It’s typically around 15 stocks. I think I’ve been as high as 20 and as few as 12. Typically, taking a three-to-five-year view on a business with an intelligent business person’s perspective on how the business is going to change over time. The underlying belief is underneath all of that is if a business is creating cash flow, you’re going to do okay as long as you don’t overpay going in.

Jake: That was one of the things, and I don’t want to rehash the complete discussion because I think people should go listen to it. But your podcast that you did with Bill– One of the observations that you made there was about how much of the market participants now are driven by really just numbers today. You were observing that– Please tell me if I have this wrong. Your businesses that you have in your portfolio, you vision what they might look like in three to five years, and why those numbers would look attractive to that other 80% who’s maybe just only focused on some of the most next quarter type of things. So, maybe just unpack that a little bit for us.

Matthew: Yeah. So, one of the things that has been discussed ad nauseam in the value investing world for the last, I don’t know, a couple of years, I guess, is the question of whether or not value investing is, “broken.” David Einhorn has been a leading proponent of that theory. I think he has a great way of coming at it, as do other people. The way I’ve thought about it, it relates to a piece I read from JP Morgan back in 2019.

The piece basically said that, by their estimate, 80% of equity market participants these days, or in 2019, it’s probably higher now, but 80% of market participants were relying entirely on quantitative inputs for their decision making. So, that’s indexes, ETF’s, any kind of quant investment platform, the AQRs of the world. Tobias, you might have a view here as well. [Jake chuckles] So, my thought was basically, in today’s world, if 80% of the world is just looking at the numbers, maybe we should be looking somewhere else. If something looks quantitatively cheap– [crosstMatthew: Yeah, that’s a huge part of it. Sure. I spent a lot of time in small cap where I have less of that. The basic idea being that if something looks quantitatively cheap and 80% of the world is just looking at the quantitative numbers, what is not in those numbers, what is cheap, that is not there, because there are definitely exceptions. But from a high level, it’s not hard to imagine that if it looks cheap and 80% of the world has looked at it and it’s still cheap, that means 80% of the world has passed. And if 80% of the world has passed, well then who’s the incremental buyer?

Because on a long enough timeline, the only thing that matters, of course, is fundamental business performance. But in the real world, opportunity cost is a real cost. So, we can’t just rely on things that are going to execute without anybody ever buying them. You want to know that there’s going to be a buyer. So, I just chewing on that idea a little bit and the implications of that came around to the view of what if we could find businesses that the quantitative screeners cannot identify, or cannot identify as attractive right now.

So, let’s just imagine that some quant fund out there has a value factor. Well, let’s not look at value factor. Let’s look at things that are optically expensive, and then have a view on the actual business and the people running it, and the competitive nature of the industry, and how things are going to evolve over time and how the numbers are going to change over time.

Just a theoretical example. You could take a stock that today maybe looks like it’s trading at 100 times earnings. Well, nobody would argue that based just on the numbers. That’s cheap. But then do some work on the business and understand the people. Maybe the reason it’s trading at 100 times earnings is because margins are temporarily depressed because of any number of reasons. It could be because they are spending more money on R&D.

It’s not really important what it is for this conversation, but figure out why the screeners would be missing it and figure out what’s going to happen. If it is a temporary problem, a temporary blip, then something that looks like 100 earnings today might really only be like 10 or 12 times earnings, looking out three years when the business is running more efficiently.

The quants, in theory, if they’re really paying attention to that value factor, they’re going to pass on it today. But then a couple of years from now, when they say, “Oh, wait, it’s actually only 10 times earnings.” They’re going to buy it. That’s your incremental buyer there. You have the added benefit, of course, is that the business is presumably executing. At least in this example, they’ve either grown top line and widened margins, or taking cost out and widened margins. But just from a fundamental business perspective, a business with wider margins is more valuable than a business with less wide margins. So, you get both sides there, the fundamental business performance as well as the incremental buyer.alk]

Jake: And 50% of that purely just what market cap is, like one number?

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