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The state of value investing vs. value rotation

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Rafael Resendes, co-founder of Applied Finance Capital Management, joins Yahoo Finance to discuss Applied Finance's "intrinsic value and wealth creation" factors and investment picks.

Video Transcript

MYLES UDLAND: Well, let's start the conversation this morning with talking about the value to-- value rotation, rotation away from growth and into value. It's now really moving into its eighth month, if we track this, beginning all the way back to when we saw that initial news from Pfizer and BioNTech about their COVID vaccine. That was way back in the middle of November. Let's bring in Rafael Resendes right now-- he is the co-founder of Applied Finance Capital Management-- to talk about the state of the value rotation and just the state of value investing in general.

So Rafael, let's start with the rotation that we see within the market, how long it's gone, and what your view is on it. Is this something that's real? Is this something you would expected as we got into a new economic cycle? And what have you made of the last few months in the markets?

RAFAEL RESENDES: Sure, great question and a great topic because it's been a really interesting market period since last year. Going into 2021 towards the end of 2020, we thought that finally, value was ready for sort of a renaissance. Up until about August 2020, we really didn't see a major discrepancy in intrinsic value between, quote, the value style and the growth style. For us, they were, more or less, trading within statistical normality.

Beginning in August, we really thought value had started to become statistically undervalued, so to speak. And we kind of issued a newsletter, an article, kind of looking at the different styles across the market. And value really popped up as being attractive on a relative basis. When we look at the relative merits of growth versus value style now, what we see is that more or less, from an intrinsic value perspective, which is very different than kind of how value was thought of generally as a multiple, but from an intrinsic value perspective, we see the two styles as approximately equally attractive in the marketplace today.

What we think is quite interesting is some of the larger mega cap names, super high quality companies we think are really trading at attractive intrinsic valuations relative to their traded share price. And we end up with very different perspectives than a traditional value look that's looking at a static multiple that doesn't properly account for a company's ability to create wealth and reinvest and become a super compounder.

But in today's market, you can buy Apple for basically 1% sales growth going forward from 2022 forward. Facebook, you're actually paying for them to shrink at these valuation levels. So there's really, you end up with some very different insights, thinking about stocks and their ability to create wealth and what's implied in their current stock price when you actually go out and look at implied valuations and intrinsic values, rather than static multiples.

JULIE HYMAN: You know, Rafael, this is really interesting. So you're saying effectively, Facebook is a value stock, judging by the way that you measure it?

RAFAEL RESENDES: We would say Facebook is an incredible intrinsic value opportunity. Yeah, in a traditional growth value dichotomy, it wouldn't show up as a value stock simply because most value stocks are measured on the basis of book equity. But Facebook has done such an amazing job generating economic returns on its investment and its ability to reinvest and continue compounding that, well, Facebook is trading at basically the fact that the market's implying five years from now, Facebook's sales will be less than it is today. And we think that's really a compelling story that you're not going to capture with the static multiple.

JULIE HYMAN: This is really interesting to me. So describe to me, then, your process. Like, what does intrinsic value mean? You mentioned a couple of metrics that you look at, that beyond the traditional PE, PE to B, kinds of things. So how do you figure it out?

RAFAEL RESENDES: Sure, so great question. When we think of intrinsic value, what we're looking at is what is a company's economic return. In other words, once we strip out and fix for a number of accounting distortions, the effects of inflation, a company's expenditure of research and development, depreciation, once we move to what we call an operations-based cash flow, we compare that relative to how much capital has been invested in the firm. And then we net out the risk of the company, its cost of capital. That gives us what we call an economic margin.

And we're able to forecast those economic margins with an estimate of a company's reinvestment rate to drive out what we call economic profits. We discount those economic profits to today to figure out or to estimate what the total value of the firm is. We subtract out debt to get an estimate of what its equity intrinsic value is, divide by number of shares, and that is an intrinsic value per share that we compare to traded prices. And we do that around the world every week. We've been doing that for 20,000 companies, going back to when we started back in 1995.

And it's the same approach we've been doing since. We apply it in a number of different strategies. And fortunately, we developed these models in the mid '90s. They work very well. Each of our strategies, when measured against their comparable universes, they're all in the top 10, top 5% of total returns since inception. So we're very humbled and proud of the work that we've developed and particularly pioneering the concept of applying intrinsic value consistently on a broad base through time to publicly traded equities. No one else is doing that to the extent we are managing assets directly with this approach. And it's paid off very well for us and our investors.

BRIAN SOZZI: Rafael, for the novice investor, what is a value stock? And how can you find one today?

RAFAEL RESENDES: Right, so, to me, the common sense answer of a value stock is a company trading below its intrinsic value, right? That's the bottom line. You know, you look at a low or a stock trading with a cheap relative to book value, the problem is, companies have undertaken so many share buybacks over the last 20 years since the safe harbor provisions were passed decades ago, that share buybacks have almost become a substitute or a complementary way of returning capital to owners as dividends.

So book equity per se is really a distorted guide to help you understand is the stock a value or a growth stock. Further, a company's ability to grow the rate of return it generates on its investment really conflates so many issues. When you look at a book to price ratio, we believe it's too confusing and provides too many false signals. Unfortunately, there's no shortcut to getting at what is a value stock. You really have to do the work in getting to an intrinsic value to answer the question.

We think there's a great opportunity to educate and grow the investment community in that regard. We actually are finishing up a project that we call intrinsicvalue.com. It's a website we'll make available in the near future so that, globally, anybody can get online, build a pro forma financial statement and generate estimates of intrinsic value for companies and share it much like you would a tweet, and build kind of an entire valuation community for the world to share. We're thinking that it's an exciting project. We're getting some academics that are joining us in this effort. And we hope to make that available to the public before the end of the year.

MYLES UDLAND: All right, interesting stuff. Rafael Resendes, co-founder at Applied Finance Capital Management. Rafael, really appreciate you taking some time to talk through stuff with us this morning. We'll talk to you soon.

RAFAEL RESENDES: Thank you. My pleasure.