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THE FAIR-VALUE FOLLY: THE DANGER OF VALUATION-CENTRIC PORTFOLIO CONSTRUCTION
ARCHIVED - 08-Jan-2015
Franz Weis
CIO - PORTFOLIO MANAGER - MANAGING DIRECTOR
It must be human nature: everyone loves to discover a great bargain! Whether we pass by a shop closing down, try to spot limited offers on eBay, or of course during end-of-season sales, we often find ourselves switching into hunting mode: the focus sharpens, the pulse quickens, we rush to identify an attractive deal before anyone else does, doing our best to stimulate the economy in the process.
This approach may work for most types of products. However, if you plan to wait to find a Hermes tie or a Rolex watch on sale, you may be in for a long wait. Certain items are rarely found at bargain prices. It simply does not make sense to look at the price as the first and most important criterion. Probably not many consumers enter Galeries Lafayette, Harrods or Macy’s looking for the cheapest handbag: most will already have in mind a certain brand. Likewise, who would screen Auto Trader or similar second-hand car magazines simply for the cheapest car? It is very possible that during end-of-season sales the consumers hunting for bargains actually end up buying and spending more than they would in a well-considered and targeted purchase. Only looking at the purchase price of a product is pretty short-sighted. When investing, companies take into consideration the total cost of ownership and re-sale value. Likewise in private life: a Porsche may cost more than a cheap-and-cheerful car when you buy it, but at least you can sell it at a reasonable (or even a collector’s) price later on and you do not need to pay someone to take it off you at scrap value.
Bargain hunting is not only typical consumer behaviour; it is often considered best practice in financial markets: everyone competes to outsmart the rest, trying to buy securities cheaper than anyone else and below fair value. However, this preponderant focus on price, often at the expense of other considerations such as quality or risk, may lead to unpleasant consequences like a corporate profit warning or even a financial crisis such as we experienced in 2008/2009. Nevertheless, discussions about the attractiveness of particular stocks often start with, or even remain limited to, their valuation.
Valuation matters, but cannot be the only factor to be considered
When picking stocks and constructing a portfolio, valuation does matter: yet, it cannot be the only factor to take into consideration. The beauty of a valuation method such as the widely used price-earnings multiple is its simplicity: both the share price and consensus earnings estimates are readily available. We at Comgest, on the other hand, argue that valuation should not even be the most important factor in investors’ minds; particularly for investors with a longer-term horizon, earnings become the increasingly dominant factor as the holding period lengthens. After all, by investing in a company, one buys a future stream of income (dividends), whereby the size and growth of future dividends strongly rely on the underlying earnings development1.
This paper was originally written in 2015 and was updated in 2020. The views expressed are valid at the time of publication only and may not reflect current thinking.
1This paper uses earnings growth as the key measure of a company’s successful development merely for the sake of simplicity. A more complete discussion of the aspects of ‘quality growth’ such as RoCE and the generation of free-cash flow may be found in the following Comgest white papers: “Deconstructing the Comgest Quality Growth Approach” (April 2015) and “Cash Is King and There’s No Heir to the Throne” (January 2015), which are available upon request.