Arguably the greatest investor of all time, Warren Buffett, began his career as what one would describe as a deep value investor. He closely followed the Ben Graham style of investing, whereby one aims to acquire an asset at a meaningful discount to intrinsic value. A common outcome of such thinking was that it often gravitated towards businesses with less than desirable prospects. This explains why it is also frequently referred to as ”cigar butt” investing.
Over time however, Buffet’s process became increasingly influenced by other considerations which have been critical to his outstanding success. A key individual of influence was Phil Fisher, the author of “Common Stocks and Uncommon Profits.” Fisher looked beyond the investment as a static entity to be bought at a bargain price, but rather sought out great businesses that had the ability to compound value over the long term at a fair price. He was not agnostic to the price paid, but instead put greater emphasis on the quality of the underlying company.
A further critical element of Berkshire Hathaway’s (Warren Buffet’s company) long-term success has been Charlie Munger, Buffett’s longtime business partner and a brilliant investor in his own right. During the time of their reign as the leaders of Berkshire, Munger further pulled Buffet in the direction of seeking quality companies, and the company has returned roughly 2,000,000% on its initial value, or 20,000 to 1. As Warren explains,
“Charlie Munger changed my views - he refined them in a huge way, in terms of looking for the quality companies, and looking out for the ability to make an investment that will work out for five or 10 or 20 years as opposed to something where there might be one more puff left in the cigar.”
Academics have deconstructed the factors behind Berkshire’s incredible performance record over the long-term and concluded that the quality attributes of the companies owned were key drivers of the excess returns. Buffett stresses the importance of not just owning quality but owning quality at a reasonable price. Sound familiar? Maybe because this is the philosophy we follow at Cambridge because we believe that over the long-term, it works.
What about Value and Growth?
In describing managers, it is common for investment styles to be assigned a label and while there are many monikers, "value" (finding stocks that are undervalued and holding them until they rise) or "growth" (looking for companies who have above-average growth, even if the share price appears expensive) are frequently used. When we are asked the question of which of the two Cambridge identifies with, we respond with “neither.” At Cambridge, we are investors who seek quality, at a reasonable price (QARP).
Our investment process within Cambridge’s Canadian mandates, simply put, aims to own quality companies at a reasonable price. The price we pay (value attributes) is dependent on several factors including our expectations for the speed and quality of its future growth (growth attributes) as well as the quality and durability of the business. It is logical to be willing to pay more for a business that has excellent growth potential and has a durable operating model.
We have no interest in owning an undervalued company with poor future prospects that is likely to be worth less down the road than it is today. Internally, we call these businesses ”melting ice cubes” and aim to avoid them at all costs.
Conversely, we have no interest in owning high quality businesses that could be growing rapidly but are trading at prices that are well above what we view as the intrinsic value that takes these considerations into account. In an extreme example of a quality asset at an unreasonable price, in 1989 when the Japanese real estate boom was at its peak, the land under the Imperial Palace was estimated to be worth more than the entire state of California. There is no doubt that the Imperial Palace was, and is, an incredibly valuable property, just not that valuable.
Below is a list of well-known Canadian companies that are currently identified as either value or growth businesses. The businesses shaded below are owned in Cambridge Canadian portfolios and offer a reasonable sample as to the types of positions held.
|Holdings Within Cambridge’s Canadian Portfolios|
|Canopy Growth||Gildan Activewear|
|Alimentation Couche-Tard||Canadian Tire|
|CP Rail||Imperial Oil|
|Restaurant Brands International||Canadian Natural Resources|
|Emera||Bank of Nova Scotia|
Source: StyleAnalytics data as at March 31, 2020.
Note: The grey/bolded names are held in Cambridge funds.
According to StyleAnalytics data, growth companies have higher than average five-year historical earnings growth, while value stocks are defined as having lower than average price-to-earnings (P/E) multiples. Interestingly, companies we own such as TFI International, Great Canadian Gaming, Keyera and Fairfax Financial have both growth and value characteristics, meaning they have grown faster than average, but are valued lower than average. Does this mean they are growth or value stocks? Frankly, we do not put much weight in how they are identified, but rather we seek to own them if we believe they are “quality at a good price.”
As the list above demonstrates, we are willing to own companies in both classically defined “value” and “growth” categories. What ties them together, however, is that we consider all of these companies to be “quality” businesses. The table below illustrates that in Cambridge Canadian Dividend Fund, we focus on owning high quality companies (higher return on investment with lower leverage) that have demonstrated a strong track record of growth (higher earnings per share growth). A collection of businesses generating higher returns while simultaneously operating with lower leverage results in greater sustainability and protection, particularly in more challenging economic conditions. Additionally, we do our best to avoid overpaying for these businesses as seen as a below average price earnings ratio on average, despite these being much better than average businesses.
|Comparison: Cambridge Canadian Dividend Fund and TSX||ROE
(3 yr avg)
|Cambridge Canadian Dividend||15.2%||126%||14.1%||10.8x|
|Higher returns||Lower leverage||Faster EPS growth||Lower price|
Source: StyleAnalytics data as at March 31, 2020
The following further illustrates how various quality attributes for Cambridge Canadian Dividend Fund compare to the underlying S&P TSX.
Source: StyleAnalytics as at March 31, 2020
To be clear, while not every company can have the abnormally high-quality characteristics of a Dollarama, Intact Financial or CP Rail, there is an absolute quality standard we require. While owning quality at a reasonable price is intuitive and over time should perform well, we also are aware that there will be periods of underperformance.
Over the past couple years in our Canadian portfolios, the proportion of companies that could be defined as value-oriented has gradually increased. This has occurred for a couple reasons.
1. The Canadian sample size is small.
Given the small market size and breadth within Canada, a few select holdings can quickly skew the style of a portfolio. For example, choosing to not own Shopify and cannabis companies can quickly make a portfolio far less growth oriented.
2. The valuation gap between high-quality growth companies and high-quality value companies has widened significantly.
There has been a considerable premium paid for faster growing companies. The reasons for this can be the topic for another day; suffice to say that there has been a major multiple expansion in growth-oriented companies, while their value-defined peers have seen their valuations compress. In Canada, no company exemplifies this trend more clearly than Shopify. In under a year, Shopify has seen its price to sales (P/S) multiple more than double to over 40 times forward sales. It does not have a P/E multiple as it remains unprofitable, but today is worth more than every Canadian company including the Royal Bank of Canada. We wish them well; however, for current shareholders, it will need to become an exceptionally profitable business to justify this valuation. Shopify recently passed RBC in becoming Canada’s most valuable company, joining the list of other once highly regarded businesses such as Blackberry, Nortel, Potash Corp and even Valeant. These companies certainly did not live up to the very high expectations that investors had embedded into the valuations at their peaks. We have found other opportunities in Canada which we believe offer more attractive risk/reward.
While we are attracted to many of the businesses in the growth column, in some cases we find the shares pricing in aggressively optimistic assumptions. Conversely, many of the businesses deemed value are trading at some of the most attractive multiples seen in decades, despite also having attractive prospects.
To see how our portfolios have reflected this dynamic, below is a comparison of the position size of the different holdings and how they have changed over time.
|Cambridge Canadian Dividend Position Size
(expressed in %)
|Restaurant Brands International||1.8|
|Canadian Natural Resources||2.8||3.5|
Source: Cambridge GAM as of April 30, 2020
Over the past couple years, we continue to have meaningful investments in a number of high-quality businesses identified as growth stocks, even if some of them have been reduced as the risk/reward was deemed to be less attractive. At the same time, several quality stocks with value attributes have become increasingly attractive warranting higher position sizes over that same time.
We are seeking quality and the risk/reward framework employed across Cambridge is a critical component of the team’s process in determining what to own and when. By creating upside and downside targets for each of the businesses owned, we aim to determine the appropriate time and price to own more or less of a security. These targets are based on what we believe the business is worth under different economic environments, but also reflect what we believe is the appropriate multiple for that business. This process is both art and science and important considerations in this analysis include industry competitive dynamics, quality of management, growth prospects, returns on invested capital, financial leverage employed etc.
In essence, we define ourselves as quality investors. Quality, however, will grow at different rates and come in different sizes. A fast growing, well-run smaller business with high returns on invested capital could appeal to us. So too could a very large, mature and entrenched business with fewer prospects for growth, but offering a substantial free cash flow stream which can be paid out to shareholders.
We remain consistent in our process, but flexible in our application. We believe this is critical in a world of such rapidly changing market conditions. Thank you for your continued support.
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Published May 19, 2020