MASTERCLASS: Value Investing

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  • 55 mins 45 secs
Value isn't dead, and we could be in the beginning stages of a value super cycle, according to these two experts. They discuss the impact of inflation and rates, how to incorporate ESG, the importance of metrics, and how to spot and avoid a value trap.
  • Alessandro Valentini, CFA® - Fundamental Portfolio Manager - Causeway Capital Management
  • Diane Jaffee, CFA® - Senior Portfolio Manager - TCW

Jenna Dagenhart: Hello, and welcome to this Asset TV value investing masterclass, joining us today to talk about how to spot red flags and avoid value traps, ways to incorporate ESG into sectors, including energy, and whether we could be in the begin think stages of a super value cycle. We have Alessandro Valentini, Fundamental Portfolio Manager at Causeway Capital Management and Diane Jaffee, Senior Portfolio Manager at TCW. Well, Diane, Alessandro, it's great to have you both with us, and Diane kicking us off, how do you define value?

Diane Jaffee: We define value as price to book, price to cashflow. Cashflow yields are super important. Dividends, high dividend yields are very good as long as the underlying company is growing, and of course, price to book. Those are some of the traditional measures of value. We also look at price to sales, that is also important for certain areas of the market.

Jenna Dagenhart: Alessandro, how is your definition and practice of value investing evolved?

Alessandro Valentini: Sure. I think the biggest evolution in the practice of value investing has really been moving away from the concept of simple arithmetic value. Because multiples are low, it doesn't mean a company, an opportunity has value. Valuation is an essential piece of the puzzle, but it has to be looking in a context of why an opportunity is emerging. And I believe the value often can be put in one of two buckets, a cyclical value bucket and a restructuring value bucket. The cyclical value bucket it's self-explanatory. These are good companies with good management, good returns, characteristics that are exposed to the wrong part of the cycle. It's often the economic cycle, but it could also be other cycles like semiconductors, et cetera. These companies sell off aggressively as the market mood changes, but then rerate when commerce periods prevail, and often they take advantage of the crisis to make themselves better.

Alessandro Valentini: For example, last year, after the COVID crisis escalated, this bucket was really overflowing. And then you have the restructuring value bucket, and that's a little bit more complicated. These are companies that have gone astray, they have the potential to be great but bad management decisions, and often around capital location, has led the business in the wrong direction. This kind of opportunities is where fundamental in-depth research, like the one we perform at Causeway, really shine. You need to know the business, you need to know the management and often you need to be ready to nudge management in the right direction to ensure the full potential of the company is realized.

Diane Jaffee: We agree with Alessandro and Causeway, that the names and the valuation factors have to be put into context. I remember there was a dividend yield portfolio management team at a firm I worked with long ago and they literally a had evaluation screen where they would buy stocks that had a dividend yield of greater than 5% let's say, and then sell them when the dividend declined to less than 4%. And that just is penny-wise and pound-foolish. You want to make sure that the cash flow generated is appropriate for that company to pay out that dividend and you have to look at multiples to make sure that they're sustainable. So we agree with Alessandro that you need to look at metrics, but you have to put it in context with the company.

Jenna Dagenhart: Alessandro, I see you nodding your head.

Alessandro Valentini: Yeah. I mean, I think the concept of reversal to the mean that was very popular in terms of thinking about value maybe a couple of decades ago, it's not as strong right now in terms of the realization of value as an investment approach, and you really need to see changes even within the environment of a company or within a company to get the value realized. Just hoping and looking at reversal to the mean as a reason to own a company, I really don't think it's enough anymore.

Diane Jaffee: And you can even put it in context with sectors. For example, utilities were one of the worst performing economic sectors last year, does that mean that they're going to be the best economic performing sector this year? Clearly not. So you have to put the companies and the sectors themselves into evaluation context and a company context.

Jenna Dagenhart: Yeah. To follow up on Alessandro's point, hoping doesn't get you too far in life or investing. Now Diane, what factors are most associated with value?

Diane Jaffee: Yes. So of course we focus on dividend yields, our investors like the comfort of dividend cushions, but we also want growth. So we call our investment philosophy, the search for value, poised for growth. So while we are excited by juicy dividend yields, we are also looking for companies that have real products, real markets, real customers, that they can continue to have an increasing payout ratio. So yes, most factors associated with value include cash flow and book value and dividend yield. The way we think of the world though, is we do statistical analysis on each of those, the five factors that we look at, to see which factor or factors is most associated with that company and the industry it's in. And that way it allows us to pursue value in other economic sectors that traditional reversion to the mean managers might not be able to.

Alessandro Valentini: Yeah. I mean, I agree all hardily with Diane in terms of the sustainability of the dividend needs to be backed by good business, a business that is growing and generating the cashflow. Because dividend itself, which is important for us, doesn't give you the whole picture. You need the sustainability in order to find attractive investments.

Jenna Dagenhart: So Alessandro, what makes the approach to value investing at Causeway different than the traditional approach?

Alessandro Valentini: Sure. Our approach is unique because what you see at Causeway is really, we blend the rigorous fundamental value approach in stock selection with a proprietary quant approach to risk analysis. The fundamental analyst identified the value opportunities in the market, they form an opinion on the intrinsic value of a company, and they do it through in-depth research. Then the quant part of the team uses a proprietary model that identifies the risk of the security in question, vis-a-vis, the portfolio, not in isolation. We then the two and we rank all the opportunities that we are seeing on a risk adjusted return.

Alessandro Valentini: So sometimes we're very happy to take risk as long as we're getting paid for it and we have that excess return. And this is really the ranking that we use as a roadmap to build and manage a portfolio. And this is unique because it not only takes risk management and integrates it in the portfolio construction from the beginning but allows us to identify what are the risk factor, similar to what Diane was saying earlier, the companies under consideration are exposed to. And that helps to inform the fundamental analyst on what might be the reason for an attractive evaluation. Is a company cheap because it exposed to an out of favor factor or because of idiosyncratic reasons within the company? Answering that is really helpful to understand why these opportunities are being presented to us to invest.

Jenna Dagenhart: Diane, TCW has a relative value perspective of value. What do you mean by that?

Diane Jaffee: Such a good question, Jenna. So, what we like to do is be able to participate in value in all parts of the cycle. And so, what we do in terms of relative value, is we look for companies that are selling equal to or less than the broad-based market in each of those five valuation factors I mentioned. A dividend yield that would be equal to or higher than the broad base market, but a price to book, price to sales, price to cash flow, and a price to earnings ratio that's equal to or less than the broad-based market would get a check mark from us in terms of valuation. And so, this relative value approach has allowed us to invest in multiple industries and sectors within the framework of the broader US market, but yet it keeps us very true to that value discipline.

Jenna Dagenhart: There's a lot of speculation going on right now with regard to interest rates. Alessandro, lower rates are perceived as a headwind for value. How do you think about rates and inflation in the context of value investing now and, in the years, to come?

Alessandro Valentini: Sure. Lower rates and the excess liquidity to the market has accumulated all over the last decade plus. It's really been a headwind for value as an investment style. When discount rates are zero or close to zero and money and capital almost has no cost, any cash flow, even if very uncertain, far in the future has some present value because you're really discounting the cash flow at 0%. So, you have growth companies with aggressive promises for cash flow tomorrow, or at some point in the future have ordered higher multiples by the market. But as the situation normalizes the analytical spirit, and I really think about value investing as being fundamental, analytical investing. That's the analytical spirit that should prevail. And this is I think the situation we are getting in right now; you have inflationary pressures and the realization that the liquidity pumped in the market over the last decade, it's creating unintended narrative consequences, and it's leading to several central banks starting to withdraw that liquidity.

Alessandro Valentini: And we've heard it from the FED, we've heard it from the Central Bank in England. And as you withdraw that liquidity and even increase rates, as we've seen in some EM economies, that should be positive because finally money has a cost, and the discount of cash flow is not done anymore at 0%. Now we are not expected interest rates to move higher very rapidly or to move to very high levels but if inflation confirmed itself to be stickier, we expect that rates will be up marginally and that should help with the price discovery for businesses that we are seeing right now, they generate very good cash flows and they're valued very, very attractively.

Diane Jaffee: I also think we have to focus in on where absolute interest rates are right now, and the fact that we are at extremely low absolute levels, there's a lot of history that you can do data mining on. And it basically shows anytime interest rates have increased, even several hundred basis points at less than 3% or so, the stock market is actually increased on average 17%, almost 70% of the time, because it's an indicator of where the economy is going, and we don't quite yet know what the neutral rate is. Some people think it's going to be 2% or historically it's been much higher, but we're way below that neutral rate. And that is a very positive framework for markets to do very well in.

Jenna Dagenhart: That's really interesting, Diane, I didn't know that. Now, Alessandro, how is value different in a global context versus a US context? Where are the opportunities different and where are they similar?

Alessandro Valentini: Sure. And we are in a privileged position being global investors. We look at opportunities across all sectors, across all countries, so we can really go where the mispricing is. And the usual thought is that the US is a very efficient market and I agree with that. It is true, it's more efficient than many other foreign markets still. So, you see mispriced opportunities harder to find, but especially I think the window where these opportunities present themselves, it's actually shorter. That doesn't mean that there are not great opportunities for value in the US, and as I mentioned earlier, both the cyclical bucket last year was pretty full of opportunities in the US. But also, the restructuring buckets, company that can get better, that can earn a higher multiple because they do a better job. But outside of the US, you have less efficiency, and these opportunities are more available, and the mispricing often lasts longer.

Alessandro Valentini: And the extreme case in that is emerging markets where you have leading companies, great companies with leading positions, great management, good returns, strong balance sheets. And from time to time, they trade for very, very low multiples because the concern is about the country. It's about the political cycle in the country. Is about what happening to the currency as there is an impact on the company but really the main concern is on the country rather than the company. And when you see that this is driven less by the fundamentals of the company, and you really have a great opportunity, as long as you understand what's going on at the macro level, to buy these companies for very, very attractive evaluations. But I would say at the end of the day, a value at the end of the US and in international market should share the same characteristics. You need an attractive margin of safety. You need a compelling valuation. And thirdly, you need a reason for the evaluation discrepancy to disappear. And that's really what we focus, whether it's ideas in the US, it's ideas in Europe or it's ideas in Asia or emerging markets.

Jenna Dagenhart: And Diane, given the run growth has had since 2016, at least until recently, what do you say when others say value is a dead strategy?

Diane Jaffee: I totally disagree because these companies are filled with people like Alessandro and like you and like me and your audience, and they don't want to be in a dead or buggy whip kind of company. They really want to; they'll restructure or they're going to develop new products and markets for themselves to live and grow. And we've seen this time and time again, maybe you need new management to come in, or maybe you have a great creative person and who can help focus you on new markets and new directions.

Diane Jaffee: For a long time, Target was considered a buggy whip company, and then they really took their cashflow and said, no, we're going to become targe again. And you can see that has really served them well throughout the pandemic and even ever since. So, I think that you have to be a good bottom up analyst, really focus on what's happening at the individual company level, and if you can see that catalyst for change, that's where we come in with that search for value, poise for growth, and that can create a wonderfully great value company that will have growth going forward.

Alessandro Valentini: Yeah, I absolutely agree. Finding companies that are going through a tough patch, but have good management, they have good cap, they have improving capital location and can rethink of themselves. They don't always need to reinvent themselves. They can just do what they do better and find new life that really leads to great opportunities. And value companies that become growth companies and you really benefit from identifying those companies. And I would also say that when people talk about value being dead, I really associate value with good fundamental analysis.

Alessandro Valentini: I'm not saying that growth investing is not good fundamental analysis, but other styles like Momentum, it's less based on good fundamental analysis. And unless people agree that fundamental analysis of companies doesn't matter anymore, which I don't think it's a statement anybody would agree with, value still has a big place in the investment universe. Now, lower rates, as we talked about, has reduced that importance because cash is free, but as rates normalize, I really think that the value of fundamental investment, it's undeniable, and that's why I really don't believe, as you said, those people that say the values of that strategy.

Jenna Dagenhart: And Diane, cap weighted indices have benefited from the Momentum factor. Do you expect this to continue?

Diane Jaffee: Well, it's really been impressive how Momentum has worked with such full force and vigor. And a lot of that has had to do with passive investing. So if you are a passive index fund and someone gives you $100 and immediately you're going to put $4 and 50 cents or whatever Apple's weight is currently into that stock and then allocate the rest according to their placement in terms of market capitalization in the index. And that just feeds on itself as a feeding frenzy, and it's all well and good while those things continue. But we're getting to the point where technology is almost 25% of the S and P 500, or 30 to 40% of a growth index. And while technology is super important for the US economy, and I would say the world economy as well, there are going to be pitfalls along the way.

Diane Jaffee: And so we think that active management where you can say, okay, this may not have be the largest size doc in that index, but there's something really positive and fundamental changing here, that's a better allocation of resources for new money flows to come in. So they always say that it's an escalator on the way up, but an elevator on the way down. I don't have anything bad to say about US technology companies or some of the forefront leaders that are in the index funds, but I would just say on the margin, if there was even a little bit of a change, it could create a waterfall effect on the way down. And I don't think that investor realize the risk maybe that is associated with passive funds that are calculated.

Jenna Dagenhart: Alessandro, how does a value investor analyze management differently than a growth or Momentum investor?

Alessandro Valentini: I mean, a good management is a good management, and a lot of the characteristics are similar. You want to focus on management that know the business, that's pretty obvious, that understand the industry and they have good capital location. And that generates value, whether you're looking at our company, it's a growth company or a value company. But as I mentioned earlier, often these value opportunities are hidden in restructuring industries and companies. And that's when you start really looking at the management, especially if it's a new management or the resume. How much expertise do they have with turnarounds in the past? There are turnarounds experts and there are managements that have done turnarounds and then have made a company great. You want to see the management having done that before, that gives you a lot of confidence that they can do it again. And then have they done it in another industry? What are the similarities between the two industries?

Alessandro Valentini: And these issues matter a lot more with these restructuring companies, these companies and what I called earlier the restructuring bucket. And for cyclical value opportunities, then is really the knowledge of the business and the industry that matters. A new manager that has never seen a cycle, might make mistakes a veteran might not make and that's really important. And you want to trust this management when you see a company going through a cycle and at the same time management of growth companies, they don't need to worry as much about the cyclical restructuring aspect, but if you're a value investor and you look for opportunities into these two buckets, you really want to see an alignment of management capabilities. Well, what the company needs to do to see the valuation discrepancy disappear.

Diane Jaffee: We do think there are some metrics you can look at, like return on equity, return on invest capital, or return on assets to see how good the management team has been a shepherd of these stocks and companies in the past. But what we also really emphasize is making sure we meet with managements. Ever since the pandemic started, that we knew that was super important for the portfolio and for our clients to get them the best returns. And so literally since March of 2020, we've met with over 1,000 management teams virtually via Zoom or on conference calls, and that has been very, very helpful in helping discern which management teams are really focused and which ones are or not.

Alessandro Valentini: Yeah, I agree. I would say that pandemic and work from home and Zoom meetings have not stopped. If anything has probably increased the amount of contact that we have with this management and their availability. The time that they spend on an airplane, it's time right now they can talk to us. As things normalize, I think this will continue. And for us too, meeting management is an essential part of the process. We would never invest in a company if we haven't had a chance to talk in detail with management, and it's not just the CEO and the CFO, it's going down the lines of reporting. You want to understand covering myself in all the pharmaceutical companies, what the people in R and D are doing? What's the head of oncology doing? Where's the capital allocated to get those returns higher, as Diane mentioned.

Jenna Dagenhart: Yeah. And you said a lot of these opportunities are quite hidden. How do you go about identifying them, especially with management? Anything else you'd add?

Diane Jaffee: Well, for us, our team has worked together for 19 years, and we have sector specialists and that's really wildly important because sector specialists, whether the companies in the portfolio or being considered for the portfolio, or for us maybe too expensive to be in the portfolio, sector specialists really have a good understanding of the opportunities and pitfalls that there could be in screening for value. And so, we think that longevity of the investment management team and the portfolio process gives something that is invaluable to our clients. And so, screening is important, but you have to be in, we ascribe to the Columbia Business School policy, that sector specialists are the best. And I know Alessandro was a graduate with an MBA from there, but we really ascribe to that policy that sector specialists are really key to identifying opportunities for investment.

Alessandro Valentini: Yeah. Absolutely. I think expertise, in-depth understanding of the company is essential. Experience is essential. And when you think about our process at Causeway, we have portfolio managers and we have analysts, but portfolio managers spend the vast majority of their time doing analysis on companies. What I did 15 years ago when I joined the company, is spent time on models, spent time talking to management, spend time building investment thesis. And I am very happy still where I spend most of my time now because that's what we're passionate about, and with that passion comes expertise and come see really the ability of understanding these issues. Screens are great. We run screens, but I would say that ideas are really generated by expertise.

Jenna Dagenhart: And given the valuations in technology, Diane and the Facebook, Amazon, Apple, Netflix, Alphabet, Microsoft stocks, how can value managers participate in these traditional growth areas?

Diane Jaffee: One of our core principles in terms of investing is that we'll never be void of any major economic sector. In fact, we self-imposed bands or channels around our sector weights that were never less than 50% of the broad-based market sector weight, and never more than two times the broad sector weight. And that gives us a lot of room to invest. And then what we do from a bottom-up basis, is we look at those five valuation factors we're so fond of, price to cash flow, price to sales, price to earnings, price to book, equal to or less than the broad base market or dividend yield that's greater. And that relative value allows us to invest in stocks that are maybe in a group that overall valuations are super high. 1998 and '99 is a great example, where literally lots of value managers were void of technology back then, or they threw in their hat at the very last minute, like in 1999.

Diane Jaffee: But we had technology all the way through just as we do for this cycle. And we were able to buy, we were underweight, but we were able to buy great companies that had a relative valuation measure that was still very attractive in those expensive sectors. That can happen in energy, in the late 1990s and in again in early 2008, energy stocks were just running like crazy. Believe it or not, we had to be underweighted because valuations were so high, but we always had exposure. And while exposure to all the major economic sectors can definitely hurt you in one particular quarter or one year when [inaudible 00:24:44] stocks or technology or even utilities, or like the king and the hill, having exposure to all the major economic sectors really, really helps with your tracking error over time and making sure that you don't want to lose sight of that great energy company when WTI was negative 37 or whatever it was in April of 2020.

Alessandro Valentini: Yeah. Our approach is slightly different. We are okay not having exposure to some areas of the market, if you redefine new attractive opportunities in those areas. But at the same time, when we look at it on a fundamental bottom-up basis, even some of the technology companies, there is still room for misunderstanding in the market. You look at companies that make a lot of investments in that price’s earnings, because they're making investments that they either going to stop and then the earnings is going to come back, the customer's going to come back or they're going to actually be realized and be successful endeavors. So as long as you know the ability of management to allocate the capital right, you can find opportunities even in areas maybe that have a little bit more growth that have that misunderstanding of the market in terms of what the real earnings power is. And that allows us to access some of these growth areas that traditionally value investors have had a tougher time to invest in.

Jenna Dagenhart: So Diane, have valued managers had to change their processes in order to survive in a growth cycle?

Diane Jaffee: I think you have to be very, very careful about that. I know consultants and investors are wary of investment philosophies or processes that change dramatically over time. So, I think that's something to sort of make a mental note of, is this the doctrine that you're using today the same as it was 10 years ago or 20 years ago, and yet the world is changing. And so that's why we love the relative value approach, because that allows us to have technology or other sectors, believe it or not biotechnology in healthcare surprising given where the valuations are today, were very much growth sectors. And so I think having relative valuation measures in place allows us to go through those cycles without changing our investment philosophy and process.

Alessandro Valentini: Yeah. I would agree. Style drift, it's extraordinarily dangerous for managers because you build an identity, you build a process around a particular style, and when you start to question that that becomes very dangerous for the results for really our clients and the money, they entrust with us. So, what we do when we go through our growth cycle, we just stick to our process. Again, our process is one that prioritizes risk adjusted returns, and when we don't find a lot of opportunities, maybe the returns are a little lower, like they were maybe pre pandemic, and the risk is a lot lower in the portfolio, and you can really manage through the process, you can manage through the cycles in that way, through the process without having to compromise the belief that we are value investors. And as Diane said, I'm an [inaudible 00:27:58] of Columbia Business School and I've learned there the importance of value investing, and I think everybody at Causeway shares that view with me.

Jenna Dagenhart: And Alessandro, your coverage expertise includes both financials and healthcare. How does hunting for value differ in the two areas?

Alessandro Valentini: That it's very, very different. I mean, I think the banks financials in general, but banks are quintessential value investments. When you think about the valuation, you find opportunities within banks and financials in both baskets. Companies that are in the wrong part of the cycle and companies that need to change completely what they do. And for banks and financials, and insurance companies, capital location, which is always important, but becomes central in these instances, you want to own businesses that have invested the capital thoughtfully while the cycle was good and I understand where the higher return is now, or as they go through a downturn in the cycle. In healthcare, companies that have made missteps or mistakes, those become more interesting opportunities. Some companies made a bad acquisition, some company has poor R and D and they're not able to deliver on the pipeline and then the valuation becomes really attractive.

Alessandro Valentini: And these restructurings usually take longer; an R and D pipeline is not fixed in a quarter. So, you need to have patients, understand when the results are going to come and who the right people there are. And in addition to that, you also have somewhat cyclical opportunities in healthcare. At the end of the day, R and D itself is cyclical. You've looked at the early 90s and that was a period of time where a lot of drugs were being developed and they were launched, and R and D are very high productivity. And then as this drug lost patent expiration, the productivity came down and company has to reinvent the way they do R and D. So, I would say over the last 20 years, you've seen at least two longer cycles in terms of R and D. And you can take advantage of that as you invest in pharmaceutical companies within healthcare.

Diane Jaffee: The way we like to look at it is yes, do the bottom-up fundamental analysis. But because we can do statistical analysis on these five valuation factors, we can see which factor has the most correlation, the most relevance for that particular company and the industry it's in. So, for example, for financials, you might just qualitatively say it's priced to book and quantitatively it would be proven as well, but there are some financial companies that are asset light and price to book would not be a relevant factor for them. Or if you look at healthcare, for example, you might look at price to cash flow or price to earnings ratio, but maybe they have a huge R and D pipeline and you want to measure it based on their book value of the potential R and D and the total addressable market that that new drug can have, in which case you'd make a model to look at that value of those assets going to forward.

Diane Jaffee: So we like to do everything from the bottoms up, but also take a statistical point of view to make sure that we're not missing anything. If you have an analyst that's been doing something for 20 years, she might just instinctively say, a retailer should be best priced on price to sales. But if you do the statistical analysis alongside of that, then all of a sudden price to book comes up, or some other factor comes up. Then you can dig a little deeper and say, oh, they have a huge amount of real estate on their books, maybe there's a way to monetize that. So, I like to match the qualitative and the quantitative when looking at different companies within different sectors.

Jenna Dagenhart: Alessandro, anything you'd add about matching those two?

Alessandro Valentini: We agree. The valuation approach is very important and not every company can be looked at in the same way. You want consistency, but not every company can be looked at in the same way. And I agree that matching your knowledge of the company with the metrics that you're looking at and making sure that your folks are on the right metrics is very important. We always look at return metrics to understand the capital location, but in terms of how you think about the valuation, you need to have some flexibility.

Jenna Dagenhart: Yeah. Flexibility. And you also mentioned patients earlier, why is that so important Alessandro?

Alessandro Valentini: Especially when you think about restructuring stories, they often take longer than you think. It's rare the case that I can think of where a restructuring story works from the first quarter where management set foot into the new offices and they just start delivering. Problems at companies often run deeper, acquisitions that have changed the identity of a company that need to be fixed take longer, and that's why you need to be patient. You need to make sure you understand that management is doing the right thing, but you also need to understand the timing, and you need to really be thoughtful in terms of when you want to make that investment.

Alessandro Valentini: And that's why we use quantitative tools that our quant team provides us with that help us understand when the earnings momentum is, when you really think, not the price momentum, but really the ability to generate those earnings, that cash flow. When is it changing? What is happening to that at a company? And that helps us a little bit with not being too early in terms of investments. But I would say that especially restructuring stories, the timing is very important because companies can restructure successfully for a long period of time before they get to where the market really recognizes that restructuring.

Jenna Dagenhart: And Diane, given the emphasis most value indexes have on utilities, industrials, materials, and energy, how can you incorporate ESG principles into a value portfolio?

Diane Jaffee: Oh, ESG is embedded in everything that we do from the screening process, making sure that there aren't any unquantifiable liabilities that are ESG oriented, that would automatically warner elimination from the further consideration, to the second part of our process, where we're really looking at the fundamental catalyst and talking to management, and to the third part of the process, where guess what, if they don't meet their ESG milestones and targets, then that name can be eliminated. So this is where I think active management can really serve clients really well in terms of ESG. We can see that in a utility that historically had 50% call, but got new management coming in and is changing their production capabilities so that they can use alternative energy, we can see that ahead of different ESG indices that might need to wait till after the fact. An active manager can see that in a utility company, or what about an energy company that's based in California, thinks the way Californians do, really embraces climate change and looking to lower their customer's carbon footprint.

Diane Jaffee: I think that you can find energy transition companies within the energy space that will help keep climate change from the magnitudes that this current run rate has us on. And in materials, we absolutely, we emphasize safety of employees, making sure that when they're mining that that it's their first consideration and that the ecological ramifications are also being best served for those environments. And so that's where we think value management can really shine, is unearthing literally ESG companies in different sectors that historically haven't really focused a lot of attention on those ideas. This is something we've been big proponents of, used to be called socially responsible investing, we started adhering to UNPRI with our European clients back in 2005 and have been tracking ESG since 2015. And this is something that's spread into the bone for the TCW relative value strategies.

Alessandro Valentini: Yeah. ESG has become an essential part of the investment process and we've adopted it going back years at Causeway. We've actually developed a set of tools that allows us to score each company really that we meet with, not just companies that we're taking into consideration. On an ESG framework, we have developed, we've hired people out of academia in the past to develop this framework. And within the quant team, we've developed scores for E, for S, for G focusing on different issues clearly, and allowing us to look at each company that we would think about and that we will consider on these three dimensions. And I would totally agree with what Diane said, and when you think especially on energy, the simplistic approach of ESG is that well, energy companies are ESG centers, we don't want to be involved but that's not the case.

Alessandro Valentini: You have companies doing the right thing in terms of transforming their business. And when you think about a lot of the energy companies, for example, right now in Europe, they're benefiting from the cash flow coming from our oil price. You rewind 10 years, they would take that cash flow, distribute some shareholders, and then put the rest back into the ground to get more barrels of oil. What, like the Totals and the like companies are doing, they're taking the cash flow that right now it's very high because where oil prices are, they're returning more to shareholders in a way that it's very shareholder friendly and they're redeploying the rest to accelerate the transformation, that transition into being a renewable company, into being a company that will not depend on fossil fuel, a company that not only can survive, but can thrive for the next 30 years.

Alessandro Valentini: And when you make the ESG consideration, you need to think about that evolution of the company, not just where the static ESG position is. And that's why making this consideration it's so important, and including an ESG approach, it's so important in terms of finding the right opportunities as bottom-up value managers.

Diane Jaffee: So we take a best of breed approach on our team, and that is, if a company has a high ESG score, as well as the valuation, as well as the company specific [cattle's 00:38:25] that we like to see, then that name can go into the portfolio. But we are also looking for companies that maybe have a lower ESG score today but have a game plan for how they can improve that score over time. And we think that this actually, this best of breed, two-pronged approach to ESG, is going to help our clients have better rates of return while engaging with companies to make sure they stay on this path.

Diane Jaffee: So that in the future moneys of high absolute ESG requirements will go to these companies because they have changed their stripes. So we think that using this two prong approach has to have a high ESG score already, or very concrete milestones for attaining a higher ESG score allows us to engage with the companies, engage with management teams, remind them how important it is, and if they stray from that roadmap, then that aim could be sold for us.

Jenna Dagenhart: What you don't own is just as important as what you do. And yeah, I mean, building on your points about energy, energy does seem like the least likely sector to be ESG friendly. Diane, Alessandro, anything you'd add about the bottom-up analysis one can do to find ESG compatible energy stocks?

Diane Jaffee: So for us, it's really important that energy companies be part of the energy transition. Of course, we're going to need energy today, but can they set up a turbine that maybe uses hydrogen, that would be super exciting. It could be dangerous unless they get it exactly right but that's wildly important for the next steps. Or it could be a company that has developed a battery that can hold alternative energy storage much longer than we have in the past. And I don't know if many viewers realize that Exxon was the genesis of the lithium-ion battery. People forget that there could be a lot of research being developed at some of these companies that could be used for a lifetime of a cleaner environment and a lower carbon footprint.

Alessandro Valentini: Yeah. I think it's just as important to see where a company is going in terms of ESG as it is to look at where a company is right now in terms of ESG. And that is really to be dynamic. You can identify energy companies that are doing the right thing as it was mentioned, redeploying the cash flow in the right opportunities to develop a renewable business, to transform themselves. And that's when you look at it, yes. On a first look, energy might not look ESG friendly, but the transformation is clear in that direction. Not every company is doing it, so you need to have the bottom-up analysis and understand the companies that do it well, but you can find plenty of opportunities in terms of companies that are doing the right things. And when you look 10 years down the road and you can pretty clearly see that the ESG score is not going to be the same and the perception is not going to be as ESG unfriendly, but rather one of the big, important players in the environmental evolution that we're seeing today.

Jenna Dagenhart: So what are the greatest pockets of opportunities right now, Alessandro, in terms of value distortion?

Alessandro Valentini: Sure. For us, cyclical is still an area where there's still a lot of value. Compared to a year ago it's a lot more nuanced, a year ago as I mentioned, both buckets were full and getting fuller of opportunities, maybe even 18 months ago. Right now, we are finding still a lot of opportunities in companies that have not quite recovered from the COVID shock. What I think it's really incredible is that these opportunities are not all concentrated in one sector or one industry, but they really are across the market. And I look at our portfolio right now, it's as diversified as it has almost ever been because you find companies that have that ability to rerate and to improve as we get on the right side of COVID through vaccination, et cetera, in areas like classic industrials, like Rolls Royce, airplane engine manufacturer, but then you also have Spanish airport operators, which are transportation. But then also tech stocks, you think about some of the tech companies involved in the bookings of transportation, et cetera, you think about retailers, WHSmith, they run concessions in airports, et cetera.

Alessandro Valentini: So there's a lot of opportunities there in terms of the COVID recovery. And then ironically, you find opportunities almost on the other side of the market. I mentioned pharmaceuticals area, we're going through what I think about as a political cycle in the US, and concerns around legislation for pharmaceutical pricing. It's clearly a big debate right now and has put a lid on the valuation that some of these pharma companies can achieve. We are constructive, we think something will happen, but it's something that pharmaceutical companies in our portfolio, and that's why the bottom-up analysis is so important, can take and they're well positioned to weather in terms of our reform.

Alessandro Valentini: And in the meantime, you get companies that generate an enormous amount of cash flow, that have good capital location and have really good R and D that will fuel growth in the future. And you'll find in them for multiples that compared to the market and compared to history, they're almost at 10, 15-year lows. And that's why this is a great environment. The opportunities are everywhere, and we are still finding these opportunities even after the good performance of the market, as we've seen.

Diane Jaffee: We agree. And that if you look at the architecture billings index or PMI orders, this signal strength, not just for this quarter, which is surprisingly better than expectations or next quarter, but into next year, that we should be seeing a lot of strength in terms of earnings growth for the cyclically oriented companies that can be in a variety of industries. I would be remiss if I didn't mention there are some consumer stocks that fall into this bucket, as well as some financial companies, and we want to be looking everywhere we can to find value poised for growth. So, we think there is a lot of opportunity left in this marketplace. If you look at earnings investors, follow earnings growth, and even if nothing goes wrong with technology, and there are great companies, as we've seen demonstrated in this earning season, that you can just see mathematically that some of these more cyclically oriented companies, their earnings stream is actually going to be better than technology has even in a good technology environment.

Jenna Dagenhart: And as we've been discussing, metrics matter when it comes to value investing. Alessandro, what are you and your colleagues at Causeway focus on in terms of metrics to determine both the valuation and the quality of companies?

Alessandro Valentini: Absolutely. And we touched upon it earlier. I mean, we do now follow one size fit all approach. We respect evaluation metrics. We let the individual analyst decide what is the right metric that matters in terms of evaluation for a particular company. But what we require is consistency within an industry. If you're looking at very similar companies and you're looking at two different valuation approaches, that is going to elicit a lot of questions. And in terms of the process, every idea that we generate needs to be presented in front of the entire investment team here. So that question is going to come up in the hour and a half, two-hour presentation when you talk about a company. And then the real important other part, when we think of evaluation metric, is triangulation. We love to look at pharmaceutical companies similar to what Diane said, on an NAV, on a DCF basis, what is the cash flow generated by these drugs and what are the drugs that are important?

Alessandro Valentini: But if we just propose the price target based on the valuation, without triangulating it to a price to cash flow, to a price to earnings, we will be remiss, and we wouldn't be doing the right thing. And that's important because when you look at one valuation metric and a company looks cheap, that doesn't necessarily mean it's cheap, and that's why the triangulation is important. And then in terms of quality, what we focus on is cashflow and returns. Cashflow generation is the ultimate measure of success of a company. So we look very closely at free cash flow yield, cash flow metrics that a company can deliver, and then return on invested capital. Return on capital employed, whatever metric or return we think is most appropriate, because that really gives you the indication of how good a management is in terms of allocating the capital. And they are the stewards of the capital that is provided by our clients. So, we want to see those metrics show that they can allocate capital correctly, and they don't destroy value by allocating capital.

Diane Jaffee: We agree that it's important to focus on valuation. And if we do our jobs correctly, what our companies should be showing is earning surprise. That would be a very good testament to that we've done our jobs correctly as bottom-up managers of our client's assets, that we have unearthed that catalyst, whether it's cost cutting and restructuring new products, new markets, or new or strong management, if we've got our job right, then our clients should be seeing the companies and their portfolios start showing earning surprise. And that will garner even more investor attention and the price will follow.

Jenna Dagenhart: And going back to the point about what you own is just as important as what you don't own. Alessandro, how do you spawn and avoid a value trap?

Alessandro Valentini: I'm still looking for the magic formula that will help me avoid them all, and I haven't found that yet. I think you need to look for red flags in an investment. I think the first and most obvious one is a change in story by management. And it goes back to what we were saying about talking with management. Management, they have the right and as they restructure a company, they can't adjust mid-flight in terms of the strategy, but when the story changes dramatically, this is something that you need to spend time on. You need to look at evidence of moving targets, of exceptionals that were not guided for the management, maybe didn't explain. Any other sign like this always becomes a warning sign when you're looking at a company. Another topic I will cover here is leverage. Financial leverage.

Alessandro Valentini: Financial leverage usually limits the action that a new management can take. Restructure a company, it's already hard. If you start with little financial flexibility, it's still doable, but it becomes even harder. And then lastly, it's very hard to turn a tide in terms of valuation if the company or the industry cannot show that they are growing. They need to show that they're not in terminal decline. Great cash and capital management can get you out of the predicament but it's always harder. And having growth always helps in terms of getting the cashflow generation and getting out of a situation through restructuring. So, I would say really these are the three red flags or warning signs that I look for in an investment that my start suggests that an investment looks more like a value trap than a value opportunity.

Diane Jaffee: For us I think that symbol of a red flag is super important. The market is the ultimate judge at the end of the day, whether you've done a good job in terms of investing your client's money. And so, we have special reports that are live on all our analysts machines that look at the price action for the particular name and the portfolio for that day, that week, month to date and importantly, a rolling 30 day basis. And whenever there is a spread of 10 to 15%, literally a red flag pops up and says, hey, the market is telling us we are wrong. What did we miss? Something was either unveiled that we should have seen or couldn't have seen.

Diane Jaffee: So we bring in another senior analyst or myself on that particular name, and within one week or less, we have to come back to the team and say, there is an action item on this name that has a red flag, and it's either to add more or 60% of the time that name is either reduced or sold completely because the market action has revealed something that we should have known or couldn't have known and is telling us that we were wrong on that particular stock.

Alessandro Valentini: Yeah, I think reviewing your investment thesis is essential, and that's why every company that we own, we have written research that shows what the investment thesis is and all the analysts and the portfolio managers required on a quarterly basis to review that investment thesis, review the price target and confirm the price target and the investment thesis on a quarterly basis if they want the particular company to be included in this menu of risk adjuster return companies that we would own. So, absolutely, I agree with Diane that reviewing your investment thesis and checking your investment thesis continuously, it's extremely important to avoid value traps.

Jenna Dagenhart: And Diane, why do you expect the current value cycle to continue?

Diane Jaffee: So this is a big statement, Jenna. We think we are in the beginning stages of an early super value cycle. And everybody takes a big breath when I say that, and the reason is clear because the last calendar year that value outperformed growth or the SP500 was 2016 in the United States. So, it's been a while, but there have been other periods of time when growth has been wildly out of favor and then value comes in super strong. That occurred in the 1970s. It occurred in the 1980s and 1990s. And even the most recent super value cycle was at the end of 2001, and it continued for nearly six and a half years into 2007. It was a super value cycle, and believe it or not, during that time period, energy stocks became Momentum stocks.

Diane Jaffee: So there had been multiple periods of value being in a super cycle before, we think the reason that we are in the early stages of a super cycle now is because of the earnings trajectory that we can measure and see and literally touch in terms of going forward in the next few quarters into the next year that their earnings trajectory is actually going to be better than the non-cyclical parts of the market and investors follow earnings growth, that's the whole point, you get more higher valuations if your earnings grow.

Diane Jaffee: So it's never a straight line. We had a big whoosh of value outperforming growth since the March quarter of 2020. We definitely took a step back, as Alessandro mentioned when interest rates went down, starting in May through the summer. But now that we're seeing this quarter’s earnings come through, we can see that value tends to be outperforming right now. And we think with the leading indicators that we have, like architectural billings index, the API index, or PMI orders, that we can see this trajectory for earnings growth, for the value names to continue into next year, at least.

Jenna Dagenhart: It's tough to follow up after that Alessandro, but what's your outlook for value moving forward?

Alessandro Valentini: I mean, very bright. I think, Diane and I on the same page on this one. I think that at the end of the day, value investing is the realization of fundamental investing. And we are in an environment right now where fundamental investment matters, big themes like excess liquidity have dominated the discourse for so long, it has been very favor for growth. But as Diane mentioned, I think we are seeing right now the fundamental bottom-up drivers of individual companies and the market cannot ignore that. And it's interesting because again, thanks to our quant tools, we can look at the correlation between different factors and recently for the first time, as we've seen value perform, that correlation between value Momentum is positive, which is huge. That just tells you that there is momentum and the value performance it's improving. And it's improving because the fundamentals are improving and because the market cares about those fundamentals. And when the market is focusing on the fundamentals, that's really the sweet spot for value. So, I think the future for value is very bright going forward.

Jenna Dagenhart: Well, Alessandro, Diane, great to have you both with us.

Alessandro Valentini: Thank you so much.

Diane Jaffee: Thank you, Jenna.

Jenna Dagenhart: And thank you for watching this value investing masterclass. Once again, I was joined by Alessandro Valentini Fundamental Portfolio Manager at Causeway Capital Management and Diane Jaffee, Senior Portfolio Manager at TCW. I'm Jenna Dagenhart with Asset TV.


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