How a deep value investor seeks growth

CIO Insights 4Q2012

An eternal debate in fundamental investing centers on whether “growth” or “value” provides better return opportunities over time. For us, this question is a definitional issue rather than a debate. Most investors on both the sell-side (advisory/brokerage) and the buyside (discretionary asset management) looking for growth put their focus on estimated sales potential for a new product or market or extrapolate past progression in revenue and earnings trends into the future. We as deep value investors, on the other hand, try to find growth in less obvious, more unconventional ways. It may be helpful for interested Fund holders to briefly review those.

One example of how we look for growth is consolidation and market share gain by companies operating in mature sectors and industries such as traditional media (broadcasting, publishing, education and advertising services), commercial services (e.g., transportation, logistics and wholesaling), chemicals and packaging. The trick here is to identify the “survivors/consolidators” who over time manage to dominate a specific market or product niche by exerting pricing power and/or cost leadership, while avoiding the weak players who are eventually destined to go out of business.

A second path to growth we pursue is by normalizing temporarily depressed cash flow and earnings generation in high-cost-structure businesses. Such situations are available in capital intensive, long-lead time products/ services such as machinery, infrastructure engineering and construction as well as in heavily regulated public services such as utilities (electricity, gas, heating, water) and telecommunications. The P&L statements of these companies are prone to be very volatile due to the lump-sum nature of customer orders and/or the extraordinarily high fixed costs inherent in the business. Here we count on incumbents’ advantages such as high barriers to entry for potential competitors, high switching costs for existing customers, low substitution threat and a pragmatic regulatory framework that will ultimately enable them to earn a satisfactory long-term return on invested capital.

Third, growth can be pursued by looking at companies whose current earnings and margins are understated. This may occur in cases where profitability is deferred into the future, for example by undertaking a big capital expenditure program, heavy R&D funding or costs incurred for improving production processes and pursuing other operating efficiencies.

And fourth, we are interested in businesses with a bloated cost structure who have the potential to streamline their operations so as to achieve a higher base-case profit margin. Here we have to be most careful, as the likelihood for prolonged underperformance remains high unless the company’s board of directors exhibits the willingness and determination to effect changes in executive management, to dispose of structurally challenged business units or to take other far-reaching decisions.

These four alternative paths to growth have one trait in common: the current or recent trend in business results has been weak, and change for the better is not plainly visible yet. By targeting these investment opportunities one must necessarily believe in the concept of mean reversion. Consequently, for potential investors where this is not the case, the Fund may not constitute a suitable investment vehicle as most of the decisions we take are based on this very assumption.

Sincerely,