Romain Ruffenach analyzes stocks — and manages a portfolio — for a European equities fund at SMA Gestion: Bati Actions Investissement 1. He started with that firm in 2013 — in the previous 5 years he worked at KPMG in the TMT sector. Romain studied at Audencia Nantes and Max Fisher College of Business and he holds a Masters in Corporate Finance. He sent me a message on LinkedIn that he’d noticed a few intriguing publicly traded companies in Japan, some of which he considered as possible value stock material. I had an opportunity to ask him questions about his work and what he was seeing — here’s how it went:
When you use the term “value,” Romain, what do you mean, exactly?
Romain Ruffenach: A simple definition of value is to buy a company at a market price below the intrinsic value. The simple concept is whether you buy socks or stocks you are looking for merchandise on discount. It is not just an investment style but a concept of everyday life. The greater the difference is between price and intrinsic value the greater my margin of safety is.
To quote Buffett “Price is what you pay; value is what you get”. So when you regard yourself as a value investor, you consider that the financial markets are not always efficient: they give you sometimes good merchandise at bargain prices. Obviously, the difficulty here is to put a fair price tag on the intrinsic value of a company by estimating the main drivers of value creation, which translate into profitability (return on capital employed), organic growth, tax rates and the required rate of return. All companies are not easy to value.
Companies with competitive advantages like scale effect or switching costs just to name a few enjoy better visibility than weak companies. A better visibility gives you higher confidence on the company but also higher accuracy in terms of valuation. Moreover, companies with high portion of debt reduce your confidence on the equity side valuation. If a company has an enterprise value of 10 billion $ with 8 billion $ of debt a mistake in your initial estimation of 10% on the enterprise value could mark down your equity investment by 50%.
What would you say is the difference between value and growth?
Ruffenach : The asset management industry tends to oppose value and growth. I am not in favor of such an opposition.
A value fund would be a fund which is investing in low P/B, low EV/EBITDA or high FCF yield companies and giving little importance to competitive advantages and prospects for the company (example : retail industry in the US).
On the other side, a growth fund would be a fund invested in companies with good prospects giving little importance to a reasonable intrinsic value (example: Amazon in the US). I think it comes from a misunderstanding of the concept of value.
Except for a few cases, the valuation of a company depends on the discounted value of the cash that can be taken out of a business during its remaining life. In order to put a price tag on the value of a company you need to estimate mainly four parameters: profitability, growth, tax rate and the required rate of return.
In fact, growth is a key component in the calculation of value. The two approaches are joined at the hip. I do not think that buying companies with the single argument of low P/B or low EV/EBITDA should be qualified value investing. In my view, value is not just buying companies with low growth and value does not mean cheap.
For illustration, motor vehicles companies are used to be cheap on P/E multiples and would be a bargain ground for value investors. But earnings of motor vehicles do not take into account a lot of financial twist.
For example, R&D expenses are sometimes capitalized and spread over a period of time. Earnings multiple do not include several tailwinds of the industry like high need in working capital, increasing capital expenditures due to regulatory constraints, risk of operational failure (think about the Diesel Gate or Takata airbags), partially owned subsidiaries in China, bubbling automobile loans.
You mentioned that you’ve been identifying value stock opportunities in Japan — where do you find the information?
Ruffenach : Firstly I do not have any personal interest in Japan. I do not consider Japanese economy or culture to be better fitted for a long term investor. But I think that from a geographic point of view some markets are euphoric (think about some lofty valuations in the US) and others are sometimes mispriced. In Japan, there has been a long period of weak financial market performances due to aging population (the average age of customers among Japanese brokers is around 70) and unusual financial culture (share buybacks formerly virtually banned until 2001).
When you have decades of under performance, people tend to throw in the towel and go on. I think this was particularly notable in Japan from 1990 to 2013 and it is still the case even if mispriced securities tend to be less common over time in this market. I have three ways to identify stock opportunities in Japan. The first one is by studying competitors of European companies. When you look at Inditex in Spain, you have to look at H&M (Sweden) or Fast Retailing (Japan) which owns Uniqlo retail stores. And to appreciate Kuka (Germany), you need to know Fanuc, one of the largest makers of industrial robots in the world. The second one pertains to information you get from third parties. This could be blogs on value investing or networking.
And, finally, I use a stock screener. I regard screening as a tool to leverage quantitative techniques to measure the quality of the business. Regardless of the source of the competitive advantages, the existence of a moat can be certified (a posteriori) by strong profitability and growth during an extended period of time. The main metrics I use are based on profitability (ROCE, cash conversion), growth, leverage (gearing, coverage), capital allocation and valuation. It is very similar to the screener suggested by Joel Greenblatt in “the little book that beats the market” whose main objective is to sort companies by quality and by price.
But even if I love the marketing concept I do not think there is a magic formula to invest in stocks only thanks to a screener or to a broader extent, by a robot. The screener is just the quantitative part helping me detecting potential good candidates. You have to perform bottom-up analysis in order to understand if a moat exists thanks to competitive advantages and if there is durability in the moat. This moat will provide insurance to your valuation on the long term. Without moat your company with high profitability and low valuation could be a value trap (think about brick and mortar in the US). The screen is also useful as a checklist tool as I will not study companies with too low profitability or too much debt.
You have thousands of quoted companies in the world, why bother with low profitability and leveraged businesses?
Identifying value stocks is fundamental analysis — do you ever take into consideration the use of technical analysis, that is, chart reading?
Ruffenach : I like to see myself like a business owner. Stock market is a great place to do business because it offers you a lot of opportunities. Number of business available are very large (more than dozens of thousands in the world) and accessible for everybody except for some stocks like in Japan trading by lots and thus requiring a certain amount of money.
Equity markets are just a useful tool to buy good business sometimes at bargain prices. But I will work the same way if I was working for a private equity institution. Do you consider KKR or Blackstone using pattern charts to buy a company? When your takeover target is not listed you do not have any charts to scrutinize.
When I study a company I always try not to read the chart in order not to be influenced. An increasing stock price could falsely tell you that the company is great (Enron from 1990 to 2000) or that the stock is no longer cheap due to its strong run (Microsoft from 2009 to 2014). In the same way a decreasing stock could falsely tell you the company is a lame duck (American Express from 1990 to 2009) or a value play because the stock looks cheap (Lehman Brothers from 1990 to 2008).
I am not an adept of technical analysis but I accept it as a complementary tool as it reflects the moods of the market stakeholders (named as Mr. Market according to Graham allegory). A decreasing stock price could be an anticipation of material problems to come (a company losing its major customer or a cyclical industry turning around).
And some technical supports could suggest management and big institutions are willing to buy significant stocks considering the company to be a bargain. More than technical analysis it is interesting to know what are the hypotheses incorporated in the stock price to know the mood of Mr. Market. As Mr. Buffett said, Mr. Market is a drunken psycho so you like to buy him business when he gets very depressed and sell him when he is very enthusiastic.