12 Apr “You’ll Never Lose Your Job Losing Your Client’s Money On IBM.”: Value to Quality Ratio
An important metric that we coined and employed in communicating with our clients on the health and intrinsic value of the fund portfolio, beyond the current NAV price, is the metric the “Value-to-Quality” (“VQ”) ratio. It has guided our investment thinking to uncover underappreciated investment opportunities. While the principles of value investing – to buy undervalued assets at a margin of safety – appears simple, its complexity lurks beneath in the actual practice. This is because investors tend to commit the investment errors of:
(1) solely focusing on buying statistically cheap stocks while sacrificing or misevaluating “quality”. For instance, screening for high net cash, or high net current asset, as a percentage of market value of the company might be the first step for many “Graham-style net-net value investors” to determine the discount in valuation of certain stocks. However, in Asia, their financial numbers often are revealed to be “propped up” artificially to lure in funds from investors, while the studiously-assessed asset value has already been “tunnelled out” or expropriated in money-go-round tunnelling opportunities via unusual related-party transactions. Seemingly cheaply valued stocks often turn out to be either value traps, or worse, unravel into fraudulent blackholes; and
(2) overpaying for popular “quality” stocks whose growth underwhelms expectations. As recounted by Peter Lynch in his book One Up on Wall Street: “You’ll never lose your job losing your client’s money on IBM. If IBM goes bad and you bought it, the clients and the bosses will ask: ‘What’s wrong with that damn IBM lately?’ But if La Quinta Motor Inns goes bad, they’ll ask: ‘What’s wrong with you?’ That’s why security-conscious portfolio managers don’t buy Wal-Mart when the stock sells for $4, and it’s a dinky little store in a dinky little town in Arkansas, but soon to expand. They buy Wal-Mart when there’s an outlet in every large population center in America, fifty analysts following the company, and the Chairman of Wal-Mart is featured in People magazine as the eccentric billionaire who drives a pickup truck to work. By then, the stock sells for $40.”
A seemingly valued stock trading at an enterprise value-to-operating earnings (EV/EBIT) ratio of 5x (Company A) is not informative on a stand-alone basis of its cheapness in value if the company generates ROE of 2%; similarly, a stock trading at EV/EBIT of 15x (Company B) is not necessarily expensive if the company generates ROE of 30% and is growing healthily. However, growth can be destructive, as growth can outstrip the capabilities and competencies of a company and its management team, and can stress quality and financial controls, eventually destroying or diluting one’s culture. This is especially so for companies generating low ROEs, who want to grow at a rate faster than their ROE by pursuing supposed new value-creating projects, as they need to tap the external capital markets using debt or equity. Is this good news or bad news for minority shareholders? Building upon Nobel Laureate George Akerlof’s classic research in 1970 on The Market for Lemons, due to the presence of asymmetric information with entrepreneurs knowing more about the private value of their firm than investors, the adverse selection problem is created: if consumers cannot tell the quality of a product, and are willing to pay only an average price for it, then this price is more attractive for sellers who have bad products (“lemons”) than to sellers who have good products. Thus, selling equity is more attractive to owners of bad firms (lemons). This implies that investors should be suspicious if they are offered equity.
The ills and lapses that come with growth is a key reason why many Asian businesses, or over 80% of the 24,000 listed firms in Asia, fail to scale up beyond the billion-dollar market capitalisation mark, and remain statistically cheap value traps whose share price and volume are also often manipulated by syndicates and insiders. Therefore, a VQ ratio matters in overcoming the two investment errors, and separating the winners from losers in the pari-mutuel race between Value and Quality. In the first example of Company A trading at EV/ EBIT 5x with ROE of 2%, the VQ ratio is 2.5x while Company B trading at EV/EBIT 15x and ROE of 30% has a VQ ratio of 0.5x. A simplified description is that investors are paying a value of $0.50 per dollar worth of “quality” in Company B as compared to $2.50 for Company A. We usually do not invest in companies with VQ ratio above 1x.