July 2, 2021
Happy Independence Day USA
During my research these past few months, it occurred to me that perhaps investors are still equating “value” investing with low price to book and low price to earnings multiples. I never invest in value without quality. A low valuation on earnings can most often suggest that the quality of those earnings is not worth paying up for.
There have been a few articles in the financial times highlighting how non-residential investment into intangible investment (research and development, intellectual property, brand) has grown at significantly higher levels than tangible investment (plant and equipment) since the year 2000.
Additionally, a study produced by accounting professor, Baruch Lev, and highlighted in an opinion piece on June 2, 2021 in the Financial Times entitled: “Don’t be fooled by corporate losses” discusses how accounting rules make innovative company earnings appear deceptively low. The reason is that most investment in intangible assets is expensed immediately, instead of amortizing over a period of years. Hence, earnings are artificially reduced. The conclusion drawn was that the more innovative the enterprise, the higher its accounting losses.
When my research assistant (thanks F.P.) and I looked for more research on the topic, we determined that there was not much information or discussion available. This led me to believe that there may be numerous companies producing quality earnings that may not being fully recognized by their stock prices.
Given the trends in technology and the speed of innovation from the year 2000 to present, it seems to me that there is currently a secular change occurring (intangible investment should continue to grow in comparison to tangible investment), and the research has not fully appreciated this. Old models die hard!
This led me to start looking for companies that were putting a high percent of their revenue back into research and development (innovating).
However, it is not enough to innovate, you must be growing cash flows and return on capital every year. If a company is losing earnings momentum and margins are tightening, sticking with the same playbook can causes losses to pile up quickly and a reversal of fortune is afoot. Morgan Stanley has a research piece entitled, The Impact of Intangibles on Base Rates, from June 23, 2021 by Michael Mauboussin and Dan Callahan on exactly this caveat. As an example, think how blackberry ignored the shift to touch screen phones, did not adapt, and the ultimate consequences.
To counter these problems in selecting quality companies, I combine other important metrics to hopefully find quality earnings growth continue into the future.
The types of companies we want to invest in for long time horizons are those that produce high free cash flow, have plenty of interest coverage, and have products or services with pricing power (high margins and high returns on cash employed).
Many of these companies on a traditional P/E (price to earnings) basis would look expensive; thus, it keeps the “value” investor away. However, if companies such as these are showing resilient free cash flow growth over time, these companies are worthy of trading at a premium to the rest of the market. Additionally, we may find quality earnings for reasonable prices.
We will be adding highly innovative companies to our portfolios where earnings are likely depressed from on GAAP accounting measures, but that meet our criteria for companies with consistent growth, and by our estimation, trade at reasonable prices.
Our Approach to Investing (3 Pillars):
Diversification Across Asset Classes, within Asset Classes, and Across Time.
Determine Appropriate Level of Market Risk.
Select Quality Companies that will Grow Earnings over the long term.
Why we diversify (Respect the unknown):
There is so much noise around economic data presently, when judging the economic cycle, I place far less weight on these inputs today than I would have historically. Because the world became myopically focused on Covid, and policies were put in place to mitigate the risks around the disease, many historically predictable economic relationships have likely been altered significantly. This means to me that economists, strategists, companies, and government agencies are going to continually be taken by surprise around outcomes. Consumer demand, inventories, productivity, incentives for work and education have likely become more difficult to predict because traditional backwards looking models may not (I suspect will not) work anymore.
I make no claim on my ability to predict the future of such relationships. However, I believe strongly that my respect for the UKNOWN is greater than most. Hence, my ability to address uncertainty starts on a higher plane because of the acceptance of this reality. I will stay open minded when it comes to change because I fully expect significant changes to occur over time. We find ways to adapt to changing relationships.
How do we address the unknowable?
Faith in Democracy and dynamic societies that can adapt quickly to change. Therefore, (I believe) economies with robust legal protections of individuals tend to adapt and grow over time.
If we believe we will grow over time, but we do not know which sectors will benefit most, we diversify by respecting those sectors and asset classes that have grown historically, and those areas essential to society.
We believe there will be creative destruction as there has always been, previous winners will fail, and new companies will emerge. This is a primary reason we utilize ETFs that give us access to asset classes. The winners in these indices will get bigger and the losers will get smaller and eventually drop out. We want to own the winners we do not yet recognize.
We value liquidity in our client’s portfolios which allow us to reduce risk or take advantage of new opportunities as circumstances warrant. We tend to use low-cost Exchange Traded Funds where we understand the assets within the fund, and we understand how to exit a fund expeditiously when necessary. We do not tie up our client’s capital (or pay for) the certainty of annuities or the expensive fees of private equity (this does not mean these products are not useful, but it is rare that we need them in our quest to meet our client’s goals).
We increase portfolio risk when we believe market opportunities are abundant and the public is fearful, and we reduce risk when the opposite is true. There are many degrees in between. We utilize our macro experience as evidence presents itself to change. Some might call this market timing, but I believe it is different. We assess risk as we have done historically through probabilistic models and consensus deviation from those probabilities. Our hope is during market upswings we will participate fully, and we will reduce risk as opportunities become less clear and investors more comfortable.
We believe in paying as little as possible in fees and tax to achieve return goals. A penny saved is a penny earned.
We believe a full and complete assessment of client needs, goals, and emotions is essential in assuming risk levels in client portfolios.
We believe fixed income (income streams with some certainty) should be used when we are compensated sufficiently for assuming credit risk. Investing in quality earnings is always the priority to achieve goals. It is better to reduce principal over time from a growing portfolio than to invest in overpriced bonds or “value” dividend payers with poor earnings quality.
Ultimately, we expect our 3 pillars of investing will:
Increase our possibilities of achieving higher growth than the S+P 500 over the long term.
Reduce concentration risk and volatility over the long term.
Achieve the goal of growth of client portfolios subject to their risk tolerance and available opportunities.
There is no guarantee we will achieve these goals, but we will indefatigably pursue these goals deploying all our experience.
Thank you, Joseph Cardello, Principal August Wealth Advisors, LLC
The Loft, 101 Franklin Street, Suite A, Westport, CT 06880
Direct (916) 461-9451
toll free (800) 985-9477
jcardello@augustwealthadvisors.com
Investment advice offered through Stratos Wealth Advisors, LLC, a Registered Investment Advisor DBA August Wealth Advisors. The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. All performance referenced is historical and is no guarantee of future results. The economic forecasts set forth in this material may not develop as predicted and there can be no guarantee that strategies promoted will be successful. Investments involve risk and unless otherwise stated, are not guaranteed. Be sure to first consult with a qualified financial adviser and/or tax professional before implementing any strategy discussed here.