European equities fund manager Nick Sheridan utilises a proprietary analytical screening tool to identify stocks that are being incorrectly priced and offer value in the market. This is a model that he has been developing since he first started running money in the late 1980s. The model is based around four key metrics: ‘Dividends; Earnings; Net Asset Value; and Value of Growth’, with the portfolio constructed from those stocks that offer the most overall value. This, the third in a series, looks at the ‘Net Asset Value’ pillar in more detail.
Operating within a margin of safety
Our strategy is designed to set aside the sentiment and incorporate in-depth analysis of meaningful data, to help identify those undervalued stocks that are best placed to outperform. Market volatility can contribute to a degree of change, but focusing on measurable factors can give us a reasonably accurate idea of what expectations we should have for future returns.
Net asset value (NAV) is the most tangible value component, helping us to ‘kick the tyres’ of any prospective investment. Having a figure that provides some indication of the intrinsic worth of a company’s assets can help us to understand whether or not the stock is priced at a discount to market value. The calculation of the net asset value of a company is simple – equating to the value of a company’s assets, less the value of any debt or liabilities. But the figure may need some adjustment to reflect economic reality.
Timing and opportunity are critical for value-focused investors, but NAV should be taken into account with other factors, such as the sustainability of earnings, the affordability of debt and quality of management. Understanding the framework for a company’s NAV helps us to ascertain whether it is genuinely undervalued, or the dreaded ‘value trap’ (a company that appears to be good value after a significant fall in price, but which is still expensive relative to its underlying value or prospects). Understanding the context of asset value is one area where many investors fall short, and where in-depth analysis can provide an edge.
We put our capital to work in those situations where strong corporate fundamentals have been overlooked and where we have the biggest conviction that the valuation discrepancy will dissipate. And, by investing in those stocks with the biggest discount to fair value, investors start with a healthy margin of safety against future market volatility.
We have no particular preference for countries, although we do tend to focus primarily on core European markets. This is a consequence of process, as the quality of the data is something that can be lacking in some peripheral markets.
Stock example: Renault
Companies are priced taking into account their ability to generate revenues on an ongoing basis. The price to book ratio (P/B) is a financial measure used to compare the current market price of a company with the value of its assets, as expressed on the balance sheet. A P/B of 1.0 indicates that a company is being priced at a similar level to the cost of its assets, without any expectation of future earnings. Any lower, and it would suggest that the company could be worth more to its shareholders if all its assets were sold.
Car companies across Europe (and beyond) were hard-hit by the furore over the VW emissions crisis, and this created some value in the industry, on a stock-by-stock basis. In the case of Renault, the P/B ratio is close to 1.0 (as at 21 December 2015) – lower than many of its competitors.
To us, this shows that Renault represents clear value. The company is run by an experienced management team that has successfully reined in capital expenditure, and focused on value-accretive investments. Renault’s net income rebound sharply in 2014, with earnings per share (in euros) increasing to 6.92 from 2.15 in 2013, although this was not reflected in investors’ total return at the time (as the chart here shows). Over 2.7 million new Renault cars were sold worldwide in 2014, an increase of 3.2% on the previous year, a trend that has continued in 2015. And yet the stock remains priced at a level that suggests the company will struggle to produce any future economic value.
Renault: no future value for investors?
Source: Bloomberg, as at 17 December 2015. Bars indicate total shareholder return for each year, calculated as the movement in the share price, plus any dividends paid, divided by the starting share price. 2015 figure is an estimate.