Markets worldwide have traded in the range of 30-40 times current year free cash flow over the last many years, implying that the current year’s cashflow represents approximately 2.5 – 3.0% of the aggregate market value. If the pandemic’s hit on cash flows is for a definitive time period of a few months, the resulting impact on the value of a company will be limited. This is the reason why markets have behaved very differently during the second Covid wave.
As we had highlighted in our previous opinion piece (If 2020 made equity investing look easy, here’s how you navigate volatility, business cycle now), the market’s reaction to the first and second Covid wave reinforced our belief that market timing is a folly. As the active cases continue to decline and focus shifts to the economic recovery process, it is our firm belief that irrespective of the business cycle, for a winning portfolio it is best to have a balanced approach backed by a robust stock selection criterion.
We follow a simple bottom-up stock selection philosophy that outsized returns are earned over time by investing in great businesses at attractive valuations. This philosophy has two elements – business and valuation.
In order to be considered great, a business should have three key attributes – superior returns on incremental capital, scalability and well managed in terms of execution and governance. These attributes are rooted in the fundamental value equation where value is a function of cash flow and growth. Superior return on incremental capital is a pre-requisite to sustainable free cash flow generation. Scalability is about growing the business manifold over time compared with its present size relative to the industry. When you have such potential for free cash flows and growth, you need the right management that can execute with a long-term value creation focus. Lastly, but most importantly, the governance DNA of the company should be robust.
On valuations, it is essential to look beyond commonly followed parameters like P/E or EV/Ebidta multiples, because such metrics can be very misleading and can lead to wrong decisions. For gauging the true value of the company it is necessary to have a robust cash flow centric approach – the valuation is attractive when the current market price is at a substantial discount to intrinsic value, which is the present value of cash flows.
We have a unique and disciplined valuation framework that is built on the principles of free cash flows and return on invested capital, or what we call as the Opco-Finco model. This framework dissects the value of any company between two distinct components: one that is a function of invested capital in the business and the other that is a function of excess returns on the invested capital. Such the distinction is very insightful in understanding the sources of value in a business.
We believe this is a more robust approach as it helps to normalise the capital structure of the balance sheet which a traditional P/E multiple based approach fails to do. This approach can also be applied to all sectors across the market capitalization curve and lends itself very well for relative comparison.
From a portfolio perspective, we thus believe the best combination of the ‘right’ stock and the ‘correct’ price can be obtained by using an analytical cash flow framework which helps to capture true economic value of the underlying business.
(Aashish P Somaiyaa is CEO of White Oak Capital Management. Views are his own)