In today’s volatile markets, superficial sentiment often influences short-term stock movements. By exploring the core of a company’s business, we believe investors can identify those with intrinsic value that can thrive through turbulent times.
Companies that create value are excellent sources of equity returns, in our view. That may sound self-evident, but identifying businesses that truly create value is anything but simple.
To start, we define value-creating companies as those that can expand their businesses without tying up too much capital. Companies that fit this bill must simultaneously maintain a sharp focus on growth, profitability and asset efficiency—while many only concentrate on the first and/or second. Why is this important? Because a company that’s making good use of its assets is capable of growing earnings while rewarding shareholders via buybacks and dividends. On the flip side, companies may also create value by shrinking unprofitable businesses, which allows them to unlock capital.
Asset Efficiency Points the Way
How can investors find companies like these? Look for companies that aren’t simply focused on profit margins, which can be volatile, but focused more on sustaining a business dynamic that can withstand competitive threats and market challenges. In particular, companies that continually optimize and improve the use of their assets generally are better positioned to create value than less efficient competitors—even if their margins are similar or lower. Business textbooks have talked about asset efficiency for decades, yet it isn’t often a standard component in equity investors’ toolkits.
It’s also important to take a qualitative look at the structure of an industry. This allows you to understand whether the environment in which a company operates is conducive to generating profits or not. Changes to technologies, patents and brand strength are all potential threats to a company’s business.
For many companies, strong product life cycles grant value-creating characteristics for a few years. Apple is a great example, as it has ridden the wave of its product cycles to boost revenue with relatively modest investment in recent years, given the scale of its success.
But the real challenge is to find those that can create value over the longer term. Sustainable value creators include companies like Kone, the Finnish elevator manufacturer, which has focused on its high-margin service business to make more efficient use of its assets.
Companies that are shrinking to create value include Fuji Heavy Industries and Veolia Environnement, both of which are shedding unprofitable businesses. In financials, Credit Suisse is reducing its investment banking operations to generate value by growing its more profitable asset management business.
Identifying Companies that Create Value
Today, investors face an array of challenges that can obscure value creation. Fluctuations in commodity prices have clouded the outlook for energy, metals and mining companies. In financials, the changing regulatory environment and heightened default risk has reduced visibility for many banking groups, especially in Europe. But investors can still find strong value-creating candidates in several parts of the market, such as:
Non-bank financials: although traditional banking groups are facing formidable challenges, pockets of the financial sector are worth exploring. Think about exchange companies. New securities trading technologies allow them to execute orders in nanoseconds. So an exchange group that invests in cutting-edge digital infrastructure can expand the value of its business and pay dividends, too.
Technology: Changes in information technology are excellent sources of value creation for both innovators and companies that adapt. For example, as the “cloud” becomes increasingly central for software sales and storage, look for traditional software companies that shift their business models to the new environment to boost asset turns.
Biotechnology: companies transforming the medical industry can generate value with relatively little investment. But tread carefully and evaluate the longevity of a company’s products and business model. Biotech companies with very high profitability tend to crash and burn quickly when patents expire.
Industries with stable dynamics and structurally high profit levels tend to produce the best value-creating investment candidates, in our view. As a rule of thumb, we believe that asset-intensive industries such as telecom and utilities, which require lots of capital investment, are generally not conducive to value creation.
Buying at the Right Price
The hunt for value creators requires active engagement with management to understand whether the corporate culture is suited to cope with change while rewarding shareholders. And of course, after identifying value-creating companies across regions and sectors, it’s important to make an investment move when the stock is attractively priced in order to maximize the return potential.
It’s not easy to stay focused on value creation in a world that’s easily shaken by the news of the day. Yet with a disciplined approach that gets to the heart of a company’s growth potential—and its ability to reward shareholders—we believe active investors can create a portfolio that can stand the test of time through changing markets conditions.
The views expressed herein do not constitute research, investment advice or trade recommendations and do not necessarily represent the views of all AB portfolio-management teams.