INVESTING
31 August 2020
RORY SPANGENBERG Director of Global Equities at Northstar Asset Management and portfolio manager of the Northstar Global Flexible Fund
But how, you will ask, does one decide what’s ‘attractive’? In answering this question, most analysts feel they must choose between two approaches customarily thought to be in opposition: ‘value’ and ‘growth’. Indeed, many investment professionals see any mixing of the two terms as a form of intellectual cross-dressing. We view that as fuzzy thinking (in which, it must be confessed, I myself engaged some years ago). In our opinion, the two approaches are joined at the hip: Growth is always a component in the calculation of value, constituting a variable whose importance can range from negligible to enormous and whose impact can be negative as well as positive. - Berkshire Hathaway Chairman’s Letter – 1992
L
ong before factor investing enjoyed the prominence it does today, Warren Buffet eloquently dispelled the notion that the concepts of value and growth, not to mention quality, momentum and low volatility, could somehow be decoupled from one another, only to be resold to investors as a neatly packaged product. Northstar Asset Management’s proprietary research process is focused on identifying companies with a sustainable competitive advantage, which can be bought at a discount to a conservative estimate of intrinsic value, consistent with our mantra: “Long-term exposure to quality assets, where value exceeds price.” We believe an integrated approach, which combines our fundamental assessment of competitive advantage (‘quality, growth’) with a disciplined valuation framework (‘value’), results in a more holistic view of the businesses we invest in, the risks inherent in the investment case we
Why an integrated approach to fundamental value, informed by competitive advantage, offers better risk-adjusted returns
discern for each, while avoiding the peril of falling into a dogmatic trap of your own making. Equally, we believe that an active and forward-looking assessment of the dynamic ‘factors’ determining a company’s prospects and valuation is imminently superior to the backwardlooking and often simplistic criteria utilised in the construction of passive and/or style-driven products. How competitive advantage drives value We believe the practice of disaggregating quality, growth and value, which Buffett refers to as ‘fuzzy thinking’, can result in a significant disconnect between the theoretical value derived by investors and the manner in which corporate value is created in reality. More often than not, this disconnect is compounded by the fact that the majority of investors tend to approach valuation in a very linear fashion, guided by investor relations practices, which are, in turn, informed by the typical three- to fiveyear corporate strategic plan. No surprise then that a large part of the stock market return or shareholder value, often over fairly meaningful time periods, is unexplained by earnings growth, interest rates or any of the other socalled ‘drivers of value’. As professional investors, charged with allocating our client’s savings in a prudent manner, the significance of this residual value component, often dismissed as sentiment, cannot go unexplained. At the same time, the duration mismatch – which exists between how value is theoretically held and how it is derived in practice – creates a time arbitrage opportunity for patient investors.
Source: Northstar Asset Management, MSCI and Bloomberg Northstar Global Quality & Value Model – Top 50 MSCI AC World (Ex-Financials & Real Estate) constituents ranked on proprietary Quality & Value criteria, equally weighted, rebalanced annually.
Our fundamental belief is that a relatively small group of companies benefit from certain strategic competitive advantages, which affords them the ability to stave off competitive forces, in order to generate returns on capital above their cost of capital, for an extended period of time. In a world with perfect information and foresight, investors would accurately determine the timeframe within which returns fade to cost of capital – Miller & Modigliani’s Competitive Advantage Period – which would then be efficiently reflected in share prices. Often, because of the substantial duration mismatch between a company’s competitive advantage period and investor’s shorter analysis timeframe, or due to strategic action by management to lengthen the competitive period, a significant amount of value creation occurs beyond the initially determined competitive advantage period. Determining the competitive advantage period and valuing companies accordingly As students of competitive advantage, our departure point is generally to consider industry structure and the competitive landscape a company finds itself in. Industry concentration, relative market share and barriers to entry can contribute meaningfully to competitive advantage, as well as its duration. Other company-specific forms of competitive advantage may come in the form of a license, a patent or an established brand or distribution network or scale advantage often built up over decades. Taking a view on the source, strength, durability and trend in a company’s competitive advantage, as well as the likely rate of change or delta, directly informs the competitive advantage period and
‘fade’ rate of returns relative to cost of capital, which is then integrated into a discounted cash-flow valuation. Taking a more explicit approach to the intermediate period of a typical three-stage model, with fade and duration directly informed by competitive advantage, results in greater sense of tangible value and sensitivity than would otherwise be the case. In this way, the residual value that often resides beyond the initial assessment of the competitive advantage period is not lost in lessnuanced assessment of terminal value. Helpfully, the implied competitive advantage period can also be ‘backed out’ from the current market valuation and be considered in a conceptual framework, relative to a subjective assessment of the likely competitive advantage period or to the market and industry peers. Lengthening timeframes and avoiding point estimates The nature of competitive advantage is such that it requires time and an informed but subjective view. By lengthening analysis and investment timeframes, we ensure that more of the value ‘lost’ in the residual is brought to the fore, to be explicitly considered. By doing so, we recognise the quest for accuracy in valuation is futile and exchange a point estimate approach to valuation for a scenario approach, incorporating a probability-weighted Bull, Bear and Base case investment thesis and valuation, which more fully accounts for the potential delta in competitive advantage periods. Taking an integrated approach to traditional factors, such as quality, growth and value, has resulted in far greater nuance in our analysis and valuation, while our scenario-driven approach to valuation has meant that inherent risk and sensitivity to fundamental drivers of value are better understood.
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