By William Fries, CFA

Since the stock market peaked in early 2000, “value” has outperformed “growth” by a wide margin. Mutual funds with a value philosophy have outperformed the market generally and have done a better job of protecting wealth than funds or portfolios identified with a growth label.

This role of capital preservation is relished by most value managers. It is interesting, though, that since the market lows, the value camp has given up some of its performance advantage. One could argue that this should not be happening because, with the market downturn, there should be plenty of values from which to build and enhance value portfolios.

This highlights one of the challenges facing portfolio managers: When does a stock go from growth to value and vice versa? There is a strong probability that the stocks that worked for investors over the past several years will not work as well over the next couple of years. Recent experience may be giving us a hint of this. What was once considered a growth company and stock may have fallen to a point at which it is now a value stock. The biggest winners of the 1990s were labeled growth stocks. It is likely that some of these stocks have now become value stocks, based on low price-to-book value ratios, even though current price-to-earnings ratios may be high due to poor current profitability. This may well be where the best values are today.

It will be challenging to separate the winners from the losers. Finding true value is not as simple as relating a couple of numbers like earnings per share in the last 12 months or book value per share to the current price.

The whole company
You can’t synthesize everything about a company into just a couple of numbers. When you are buying a stock, you are, in effect, buying the prospects of the whole company. While it may only be a small fraction of the company, the purchase is probably important to the investor.

The price of a stock in relation to its current earnings may be a good measure of a stock’s current popularity, but it tells you nothing about what’s going to happen next. However, the richness of the multiple does have a good bit to do with a company’s record, its financial model and implications about future earnings expectations.

The value proposition of a company includes these features of value just as it does ratios related to price. In other words, value is complex and price ratios do not capture all there is to consider about comparative value among companies and their stocks. A comprehensive value proposition should consider other issues, some of which may be qualitative. These include corporate culture, the business model and competitive position in the marketplace.

Corporate culture provides the context within which business decisions are made.

Value consideration of corporate culture—Corporate culture provides the context within which business decisions are made. The nature of a corporate culture starts at the top. The drive and discipline of employees to succeed will probably not exist if it is not imbedded in corporate leadership. Even something as simple as the look and feel of a corporate campus may have a bearing on management’s effectiveness and the corporate culture.

Executive leadership’s attitude about employees and their compensation is always an issue. Stock option plans, reasonable incentives and bonus plans are important, as is how dilutive the plan is to existing shareholders. This is all about corporate governance and equity.

Because of recent corporate scandals, most American companies are giving renewed attention to the role of directors. There will always be some conflict, but basically the prosperity of the firm is the common objective of all stakeholders, with the oversight of an active and knowledgeable board of directors. The majority of the board should be truly independent so that if management is about to make an error in judgment, somebody on the board would protest.

South Trust provides an example of a company with a corporate culture that has good value. The bank has grown into one of the largest banks in the Southeast, reporting 12 percent to 13 percent compounded annual EPS growth rates over the past one, five, 10 and 25 years. The company’s efficiency ratio (operating expenses/revenues) is low, and we have seen impressive consistency over the year. The number has trended lower over the years, supporting earnings growth that is faster than revenue growth. The bank’s current efficiency ratio in the mid-50s is not so low that further improvement is unlikely.

Value consideration in a business model—How a business is designed, the revenue (cash generation) and funding of growth are crucial to sustaining it. The core issue here centers on how revenues (cash) are generated, how profit margins are sustained and what the capital returns are on equity. A company that compounds retained earnings at 25 percent is more valuable than one that compounds at 10 percent. Other value contexts are the amount of financial leverage, including the levels of debt on the balance sheet, and a relation of the debt level to other industries and other companies in similar industries. Self-funding of ongoing capital needs is usually a strength. Companies that generate free cash flow are more secure and have flexibility to capitalize on opportunities. However, it is possible to have too much cash because low returns on cash constrain the reinvestment rate of retained earnings.

Price ratios do not capture all there is to consider about comparative value among companies and their stocks.

The absence of debt in and of itself does not necessarily make an investment safe—safer maybe, but not safe. Technology companies are often funded by venture capitalists and rarely are burdened with debt. Cyclical companies with the same growth and profitability characteristics as consistent revenue generators will generally not be awarded the same valuation attributes. This is just common sense; if you do not have to worry about earnings periodically disappearing or declining materially, you should be willing to pay more. Here again, thoughtful investors know this; so, at times, they will prefer the more cyclical stock, when its promise of recovery is more compelling than the steady company’s trend-line prospects.

Value in competitive leadership—Market leadership includes factors like having a recognizable brand name or product leadership that is represented by “best of breed” products within a specific industry. Market share is particularly valuable when it displays a disproportionately high percentage of marketplace dominance.

Pricing power is another important item in the context of market leadership and value. One of the reasons there seems to be a bias against companies that are considered original equipment manufacturers is that their customers are very powerful. A smaller company selling a computer part to Dell Computer Corp., for example, which controls such a large segment of the market, is subject to Dell having the power to demand lower prices from the supplier.

A good example of a company with pricing power would be Genzyme, a profitable biotechnology firm. The company’s main product (Ceredase/Cerezyme) is a treatment for the rare, but fatal, genetic disorder, Gaucher’s Disease. There is no other therapy or product that does the same thing.

William Fries, CFA, manages the Thornburg Value Fund and Thornburg Global Value Funds. You may reach him at bfries@thorn burg.com.

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