The relevance of deep value investing in the modern economy

CIO Insights 2Q2020

Driven by ever looser monetary conditions around the world, liquidity continues to find its way into the usual “new-economy” favorites such as high-tech; social media; fintech; and biotech. At the same time, the so-called “old-economy,” i.e., asset-intensive sectors encompassing machinery and capital goods; manufacturing; logistics and transportation; energy; electricity; telecommunications; and basic financial services continue to be shunned. Indeed, it seems that many investors have given up on these areas, putting essentially all their bets on the digital and virtual world.

The prevailing situation logically begs the question whether the old economy has become incrementally irrelevant. Our unambiguous answer is “no,” for logical reasons. The basic human needs of food, shelter and clothing can neither be digitalized nor virtualized. Logistics and transportation cannot be provided without physical means such as ships, planes, trains, trucks and cars. Telecommunications are mainly enabled by fiberglass pipes, copper wires and transmission towers, linked intercontinentally via giant subsea cables. Energy and electricity, including “green power,” ultimately come from natural resources and have to be procured, produced and distributed by an intricate web of heavy infrastructure. And, as the fallout from the recent lock down measures has shown, even modern finance can impossibly exist without the availability of traditional banking and insurance services.

Why, then, is this dichotomy of perception between the old and the new economy, which has accentuated itself in extreme valuation discrepancies over the last dozen years, so persistent and resilient? Although the reasons are manifold and debatable, the ultimate process of mainstream investment allocation follows a path of least resistance. That is, incremental liquidity is flowing into areas that promise the quickest returns and most obvious future growth prospects. As long as the current monetary regime persists (i.e., negligible interest rates and unlimited central bank funding), the same pattern will hold. Critical to realize here is that this path of least resistance does not concern itself with value. The market merely represents a conduit of liquidity allocation rather than a valuation mechanism. Moreover, mathematics and financial theory by themselves are not designed to provide us with the answer how to value “growth” correctly, either.

After all, as policy interest rates hover around zero, computationally the valuation of “growth” approximates an infinite number. Accordingly, the financial markets lack an inherent or self-imposed control mechanism with respect to what makes or doesn’t make sense in valuing stocks. The capacity and responsibility of doing so is the job of the individual actor who participates in the market out of free will. He or she must use sound reasoning and diligence to reach economically rational conclusions. 

That’s where deep value how we practice it comes into play. To reiterate what we have explained on previous occasions, the “hurdle rate” (the discounting mechanism whereby all future cash flows are expressed in present value terms) we apply to value businesses will ultimately hit a structurally low limit. In other words, we consciously set a minimum threshold when discounting future cash flow streams. The result is that we are willing and able to pay less for eventual future growth potential as promised by the well-known glamour equities. Meanwhile, the less flashy capital stock forming the backbone of the economy can be acquired cheaply thanks to the inherent cyclicality and uncertainty which renders the valuation process a more challenging task. Accordingly, our investment allocation continues to find a home mainly in these underappreciated and inexpensive areas. We patiently wait until the day when interest rate conditions gradually adjust towards a more economically justifiable level. This will be the time when our way of investing will redeem itself and find renewed favour with the broader investment community.

The caveat is that we do not know when it will happen. All our loyal clientele and we can recognize is that this iron patience and discipline is being rewarded over time.

Sincerely,