Valuation

GARP’s approach to valuation considering the effects of non-GAAP accounting, M&A, and share repurchase

As our name implies, our investment criteria are based upon growth and value, since the GARP acronym stands for “growth-at-a-reasonable price.” Many in the professional investment community think this merely involves using statistical techniques to select stocks that trade at low-to-average multiples of near-term profits, but whose earnings growth rate might exceed that of a chosen benchmark.

In our opinion, this can often be a recipe for a classic “value trap” situation. This would arise when sellers possessing deep knowledge have driven shares below historical bands of valuation, but conventional Wall Street analysts as a whole have not yet adjusted earnings forecasts to reflect the changed outlook just over the horizon.

This is why GARP developed its proprietary growth-value matrix that classifies stocks into two sets of quintiles that, importantly, are based upon our view of earnings three years out, as compared to the present, rather than just watching near-term financial metrics. In this way, the risk control built into our methodology helps us choose not to swim in crowded and potentially dangerous waters. More often than not, our analysis must be deep and penetrating, and most of all somewhat contrarian. Otherwise, true to our learning of finance, most information generally smattered across statistical screens is already “priced in” to valuation, one way or the other.

Sometimes we will qualitatively override the message being transmitted by our matrix, choosing to be bullish, for instance, if we think earnings beyond our three-year vista would accelerate substantially. Often this happens when we find a company with two segments in sharply different stages of maturity. In these situations, it’s quite likely that such determinations cannot be made without a detailed financial modelling capability by sub-segment, for emerging businesses are often enfolded by earnings non-materiality or the tyranny of historical reporting. We believe GARP Research has perfected the art form of tearing apart financials and populating sub-segments that must resolve to a corporate total.

On the other hand, we are mindful that even we might not have clarity on what the future may bring, so the most enticing matrix could still be indicative of a value trap, and some black swan could be flying beyond the skyline. We try to be mindful of this, and it prompts us to review our assumptions regularly. But, operating in an imperfect world, generally we think our mission is to keep our ear close to the ground and see if good stories actually would permit us to find money-making ideas when run through our matrix. We hope our adherence to this common sense discipline at least helps us avoid engaging in the mania of investment crowds, at least more often than not.

We believe the current accepted state of investment analysis among institutions can, from time-to-time, suffer from too many wild cards inserted into the financial reporting deck, making it difficult for analysts to deeply comprehend whether a company is truly profitable. Many companies provide “adjusted” earnings or EBITDA, disclaiming these with mind-numbing preambles, reassuring us that such restatements could provide auxiliary insight into the “true” earnings power of a corporation. Certainly these do, but we beg to differ as to what can be legitimately considered for exclusion from operating expenses communicated through GAAP accounting.

Most often, especially in the technology sector, we find that stock comp can be very material. Technically stock comp is non-cash expense, and we think it is hard to measure even when empowered by the exactitude of a Black-Scholes model. In our valuation work, we think GAAP conventions have it right by choosing to deduct this cost from a company’s profits. Only time will tell if technology investments will underperform due to excessive stock comp, which often is excluded when valuation work is performed.

EBITDA, seemingly foolproof because it is a “clean” measure, is flawed because some businesses must make capital expenditures into assets with limited lives in order to be continuing concerns. This opens to interpretation just how much capex is needed for maintenance, a discernment we perceive as ripe for manipulation. We think REITs and energy MLPs are poster children for this misunderstanding.

Conversely, GAAP accounting includes a non-cash deduction from earnings for the amortization of intangibles expenses. Furthermore, we find the separation of deal premia into buckets of goodwill and intangibles, as well as the accounting litmus tests for impairment, to be a bit murky. Decades ago GAAP was modified to its present, more conservative interpretation. We think this determination was akin to firing a bullet over an intended victim’s shoulder, only to hit an innocent man. The real villain may have been the public’s inability to discern how pooling-of-interests deals could be accretive when stocks having high valuations gobbled up their low-multiple brethren.

We also think the use of financial leverage can cut both ways, never at the same time in the cycle. Many of the best performers in bull markets are firms that borrowed to build empires, because it’s easy to lever up and have an acquired income stream exceed interest expense, especially when interest rates are pinned to near zero. But a bear market can savagely reap what was sowed. Leverage is further amplified by off balance sheet arrangements or derivatives. These can surreptitiously be coaxed into existence by having a purely fiat-based fractional reserve lending system and foreign currency units that get stacked up in a reverse pyramid upon the dollar, a phenomenon falling into the category of bubble finance. Easy money is the hobgoblin of little minds, adored by analysts, CEOs, monetarists, Keynesians, and ETF buyers, so said Emerson, or maybe it was foolish consistency, like 7% annual M2 growth amid a moribund economy…

Even share repurchase can either be a glass half full or one half empty. Since GARP wants to screen for potentially high ROCE companies, and typically these have high gross margins and meager amounts of fixed plant, cash generation can be available to devote to share repurchase. In our opinion, that’s a good thing, but at the “right” price. Share repurchase is not a one-way street, but we think many perceive it as such. We’ve seen firms spend billions to cancel shares at the top, so managements can be every bit as susceptible to the mania of crowds as analysts, even including us. We also think it is often just an executive welfare program used to sterilize shares created through stock comp, all the time robbing regular shareholders by diverting cash flow that gets excluded when a management reviews itself using pro forma “adjusted” earnings.

Although non-GAAP adjustments such as stock comp can cause investors to overpay for equities, we think there is a sub-population of companies where the opposite presents an opportunity. At GARP Research, we prefer to not subtract intangible amortization from profit, but only when we think management can pass an acid test to demonstrate it has an understanding that M&A must result in accretion to GAAP earnings over the medium-to-long term. Such a conditional assessment would be impossible to incorporate into GAAP accounting standards, but we think it is an essential question to ask, and it’s one we strive to examine fully when we write our renowned capacious reports.

Just think about this. No rule or standard, from discredited soviet-style central planning (or bond market price-setting through QE) to the free market principles of the gold standard, can protect men from the cleverness of other men. As a race, our curse and blessing is we will work around whatever impediments may be placed by our wisest archons, be they central bankers, regulators, or accounting standards boards when there’s a palpable prospect of achieving a short-term gain. While sharks don’t swim in the fresh waters surrounding lower Manhattan, they surprisingly thrive on the corner of Wall and Broad.

All too often, deal making happens when excitement over new trends seems to make it imperative for managements to buy companies at almost any price. Many of the companies we examine have chronically low GAAP return on investment. This is usually caused by the denominator being bloated by acquisition premia, but remarkably it’s also triggered by difficulties in achieving earnings after a merger is consummated, usually because competitors proved not to be blind to sexy new opportunities, either.

The beauty of the investment marketplace is that one can enter into a position long after such disappointments have taken place, depressing valuation, and cathartic events usually bring with them new and more focused managements, sometimes even with the original growth vectors simply having been reset. Thus, if GARP Research can apply its subjective test of management’s M&A competence and sort out cases of wealth destruction from the rest, removing the investment chaff from the wheat, there can be circumstances wherein certain stocks may be valued more cheaply than others. But it’s just one piece of the equation. Ultimately, having a researcher which can evaluate a firm’s overall growth profile relative to value, per our matrix, is dependent upon the ability to deeply research a company and its competitive position, as well as the growth opportunity of its markets served. To wit, we invite you to engage us in your quest to uncover what we truly think will result in “growth-at-a-reasonable-price.”