How Most Value Managers are Getting it All Wrong

In a recent episode of the Bloomberg Odd Lots podcast, hosts Joe Weisenthal and Tracy Alloway talk to Rafe Resendes, portfolio manager and co-founder of the Applied Finance Group, about the value strategy and how the underlying concept needs some tweaking.

Here are some key takeaways from the interview:

“So much of value is intangible,” according to Resendes, who says it is not captured by the price-to-book metric, which is a “cheapness measure that doesn’t necessarily relate to the worth of a stock.” He says his firm’s focus is on “cheapness versus intrinsic value.”
Resendes says his team applies a “litany of adjustments” when examining the financials of potential value targets, including the capitalization of both research & development costs and operating leases (instead of viewing them as expenses) and the adding back of interest expense. “We also adjust the balance sheet for inflation,” he said, an important modification particularly for industrial firms that have a lot of plant and equipment.
These accounting tweaks, Resendes explains, run contrary to the existing worldview that “investing is bad,” based on data showing that those companies that invest heavily tend to underperform. But he argues that this is a short-sighted and “flawed approach” since, historically, the best returning companies in the world have invested heavily in themselves and their futures.
The intrinsic value of a business, says Resendes, is a function of the “true economic value” of the firm as measured in profitability potential as well as the level of reinvestment and its risk profile (with respect to size and leverage).
The “dichotomy of value versus growth is really a false way to look at it,” says Resendes, adding that “every firm is growing, whether it’s in a positive or a negative direction. True value becomes the intersection of economic profitability, growth, competition and risk.”
The value component “has lost a lot of its identity,” according to Resendes, and “needs to be reclaimed.”
Resendes says that 2020 taught him the importance of sticking to an investing discipline: “It’s very painful when you see the world is trading against you and you’re underperforming. But you need to hold on to the central truths you believe in.”