Markets in dislocation are never mindful of valuations, but we always are!

CIO Insights 3Q2011

We propose that the renewed sell-off in equity prices around the world has led to a widening in the margin of safety (price-to-value gap) available to the Fund, further increasing its attractiveness. But how can we illustrate this supposed undervaluation in an objective and unpretentious way? To recall, we use a strict discounted free cash flow (DCF) methodology in determining the intrinsic value of a firm. This work requires judgment calls about a multitude of factors involving many future unknowns. Thus, we deliberately avoid the disclosure of DCF-output as it would carry with it an unintended “advertising effect” to show off the Fund’s calculative, inherently subjective margin of safety. But what we can do instead is to offer an accessible perspective on the potentially anomalous equity prices present within the Fund’s portfolio by consulting three conventional valuation metrics and to compare the results when applied to a broad market index.

One of those indicators is price-to-sales (P/S). Relating a firm’s equity price to its revenues admittedly is a very crude measure of “value”; it wholly ignores cost structures of industries and profit margins of companies. But its advantage in contrast to the more popular earnings and cash flow ratios is that it is much less prone to distortions due to accounting effects and natural business-related fluctuations. The weighted average P/S for the Fund at the end of the quarter amounted to 0.59x against 0.91x for the FTSE All World Index. Since our deep value approach is balance-sheet- centric rather than profit-and-loss-driven, we will be the first to acknowledge that the profitability level of the companies represented in the index may very well be somewhat higher than of those in the Fund. Having said that, this reason alone is far from being able to explain such a noteworthy disparity.

Another one is price-to-book (P/B). Although having an entire set of its own problems as an indicator of value, the [accounting] book value of a company is probably quite fair and meaningful during or after an economic slump like the one we have been experiencing in 2008–2009 and now again in 2011. That is, goodwill write-downs, asset impairments and restructuring charges have already been recorded widely and liberally; book value should therefore reflect a more tempered estimate of the average company’s net worth than may be the case in booming times when such deductions are less likely to have been taken. The weighted average P/B for the Fund at the end of the quarter was 1.02x versus 1.49x for the FTSE All World Index. Since the Fund traditionally exhibits a heavy tilt towards businesses with high fixed cost characteristics, we are habitually cautious when assessing the soundness of underlying book value. In this light, the notable difference in the P/B ratio between the Fund and the index in our opinion is a rather robust sign of probable undervaluation.

Lastly and perhaps most significantly, let’s observe the dividend yield (DY), i.e., dividend payout expressed as a percentage of price. We have written and talked many times about the virtues of dividends. At the end of the quarter, the Fund’s weighted average current DY amounted to 3.6%, while that of the FTSE All World Index was 3%. A 60bp yield advantage may not appear to be stellar at first glance, but it must be put into perspective. First, assuming this positive spread will hold going forward it would have a powerful compounding effect over time. Second, we must consider that one-sixth of our portfolio companies don’t pay a dividend at present, approximately half of which we think will eventually instate or reinstate a regular payout. And third, we judge the latent aggregate dividend growth potential within the portfolio to be better than the one within the index.

This exercise hopefully serves as a rough reference point from which to gauge the substantial margin of safety we believe is embedded in the Fund’s portfolio. For while the markets may continue to get jolted, what should matter most is whether the Fund manages to increase its margin of safety in the process. From what we can see so far we are confident that this is indeed the case.

Sincerely,