For Value Investors, Avoiding Growth Companies Can Hurt Returns

For Value Investors, Avoiding Growth Companies Can Hurt Returns

Although many value investors may avoid growth companies altogether, one asset manager believes such an approach is “fundamentally flawed” according to a recent article in Institutional Investor.

Applied Finance, a value investing firm with $1.25 billion AUM, says traditional metrics (i.e. price-to-book and price-to-earnings multiples) do not offer sufficient information to identify shares that are trading below their intrinsic value. “In fact,” the article says, “companies that are trading on apparently high multiples may actually be undervalued in terms of their overall valuation, thus creating opportunities for large returns.”

Rafael Resendes, co-founder of Applied Finance, told II, “We’re redefining what value is. The term has been tortured and confused with cheapness.” He says his firm uses an unconventional approach to evaluating stocks that includes a valuation-based discipline to R&D, growth potential, competition, and risk. He explains, “One of the things we’ve been doing since 1995 is capitalizing research and development costs. This is something that is just now being viewed as transformation in the value investing universe.”

In a 2000 report, the firm stated, “…a primary goal of value-based metrics is to eliminate the numerous distortions in accounting data to provide comparability across time, firms and industries.” The approach has outperformed the S&P 500 over the past 5-10 years, the firm says, despite their having invested in what were considered growth stocks (including Monster, Apple and Mastercard).

Resendes notes that his firm invests in 50 companies at any given time but does not commit to a particular sector “precisely because of its valuation approach.” Part of the reason that value is still tied to “cheapness,” he says, is that “the academic literature is rigorous, but the financial analysis is very poor” and fails to focus on the fundamental properties of companies. “They’re always using backward-looking data,” he says, adding, “What’s missing is live and out-of-sample data.”