Strategies to identify company value.
There are many ways to value a company. Some swear by price-to-earnings, while others prefer price-to-book, price-to-sales or any number of other ratios. Patrick Blais, managing director and senior portfolio manager at Manulife Asset Management Limited, applies a unique, differentiated approach. His primary valuation tool is tangible cash flow – because, as he explains, that’s “the real cash flow that truly makes it into shareholders’ pockets.” This approach to cash flow can be very different from other types of cash flow calculations. For example, his model excludes cash earmarked for debt repayments, tied up in accounts receivable, or covering stock options costs, real capital expenditure levels and deferred taxes.
Blais’s common-sense approach, which he employs on the Manulife Fundamental Equity Fund¹ and Manulife Fundamental Balanced Class, is surprisingly rare in the professional investing world. Blais attributes this in part to the fact that teasing out tangible cash flow requires a specialized skill set. Analysts have to sift through a company’s financial statements to locate all sources and uses of cash, and they have to replicate this process for multiple companies across multiple sectors and geographies. With the right team in place, however, Blais believes a focus on tangible cash flow has the potential to generate excellent results for investors.
“We’re really able to identify the companies that are resilient, that aren’t dependent on other sources to generate that value,” he says. “We think of [tangible cash flow] as the real value creator in a company, and we think that it takes away a lot of the emotion, the opinions, the distortions that you’ll see in the market.”
Company management is often tasked with growing earnings, but, Blais says, management can grow earnings by simply throwing money at it. The question is, Is that a profitable strategy? Is it creating value? Earnings can also be distorted by changing accounting rules. That said, he’s not keen to see the intense focus on earnings disappear, because it can help investors like him.
“Those earnings stories – to us, it’s just noise, and that noise creates opportunities,” he says. While other investors are on the hunt for growth metrics, Blais and his team might be uncovering a business with highly tangible cash flow in an unglamorous sector but with solid margins, sustainable profits and relatively low risk.
Take, for example, the “unexciting” world of label making. It’s not something most investors think about, but labels are very important to producers. A label can differentiate a product on the shelf, and once a consumer is familiar with the label it becomes more valuable to the producer. This provides some pricing power to the label maker; clients may be more inclined to accept small price increases as the awareness of that label grows.
“Those are the types of companies we look for,” Blais says. “If you focus on facts, if you focus on that cash flow, if you focus on those metrics, what I’ve learned is you’ll make fewer mistakes, you’ll find more winners, and over time you’ll just build a better portfolio for clients.”
Searching for resilience
Blais measures a company’s quality, sustainability and valuation before making the decision to invest. He defines quality as having a solid competitive advantage or “competitive moat.” Sustainability means allocating cash flow appropriately into sustainable lines of business or returning it to investors in the form of dividends or share buybacks. Assessing valuation includes looking at both the upside potential and the downside risk. As Blais points out, “If you generate a lot of tangible free cash flow, we find that the downside has a floor. It’s limited.”
Putting it all together, he says this approach helps to identify companies that potentially have stronger downside protection during down cycles. In the Canadian energy sector, for example, a number of companies reported what at first glance looked like strong cash flow towards the end of 2015 and in early 2016. In reality, a lot of that cash flow was due to leveraging, so it wasn’t strong and tangible, and it evaporated when those companies weren’t able to keep financing it. Isolating companies that did indeed have strong tangible cash flow led the team towards energy businesses that weren’t spending as much to grow their production.
“In the downturn, the energy companies we owned were the ones that had a lot of cash [and] were still generating free [tangible] cash flow, because they had profitable enterprises that required little capital to grow and they could weather that downturn. Instead, they were actually buying up all the weaker players with quality assets,” Blais says. “So, look through to the other side, they came out stronger, better and more valuable, and they’re actually some of our best performers even though they’ve weathered an oil downturn.” Some, he adds, are trading at higher prices than when oil was US$100/barrel.
Putting the strategy to work
For the Manulife Fundamental Equity Fund¹ and Manulife Fundamental Balanced Class, Blais tends to favour companies in the industrials, information technology and consumer sectors, and is underweight in more capital-intensive industries where a lot of leverage is required to sustain even modest returns, such as the real estate, utilities and materials sectors. Historically, his team’s approach has delivered 90% to 95% of the upside in a strong bull market, but it really shines when markets are challenging, potentially generating significant downside outperformance.
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