Transcripts

Speaker 1 (00:03):

Hi, my name is Steve Salzone and I'm an analyst and the co portfolio manager on our small cap quality value, uh, strategy here at Epoch. And I'm gonna spend some time talking today a little bit about our small cap strategy. And really there's, there's a few things that I'd like to get, get across really three key issues and we're gonna explore those key issues by addressing two foundational questions, uh, what we do, number two, why it matters. And then number three, some proof points that show that we do what we say we do. And then the two foundational questions that we're going to answer are, number one, what is value? And number two, how do you measure it? So let's jump right in to, um, to what is value? Value is getting something for less than it's worth. It's pretty simple. And just about all investors agree that the value of a business is the present value of its future Cash flows.

Speaker 1 (01:05):

Again, it's pretty simple. Now the next step step is where things get pretty challenging, and that's where you're getting into forecasting those future cash flows and thinking about what the right discount rate is. But that's really a topic for another day. Now, since forecasting those future cash flows is such a challenge and, and really a complex task market participants generally use valuation multiples as a shortcut. So then what valuation multiple should be used to measure value? Now that's really a key question, but before we jump into that, we're gonna do a little bit of a history lesson to think this through.

Speaker 1 (01:42):

So this chart shows investments made by corporate America over the last 40 years, and it breaks out these investments really into two buckets that are represented by the two lines. Tangible investments, which is represented by the dash dark blue line. These are investments that are in physical goods. These are the things that you can touch, things that you can feel, think about things like factories, all the machinery that goes into factories, retail stores, physical inventory trucks, construction equipment, all those types of things are tangible investments. The other line on this chart is the solid lighter blue line. These are intangible investments. Now these are things that you can't touch and you can't feel. Think about things like software code or all the patents and formulas that go into medical and the pharma industry. Things like name brands or e-commerce technology. Those are intangible investments. Well, over the last 40 years, the world has changed. When you think about capital investment made by corporate America today, it's really shifted quite a bit. 40 years

Speaker 2 (02:58):

Ago, it was mostly tangible. Fast forward to today, it is mostly intangible. And when you think about it, it's obvious. Technology has changed almost every aspect of our lives. Intangible investments are embedded into almost everything. Even when we interact with the major tangible investments in our lives, such as our cars and our homes, they're still filled with tangible assets. Think about driving your car with GPS or a home filled with various smart home and connected devices. Again, the world has changed a lot in 40 years and it doesn't seem like this is slowing down. One of the big topics of today is artificial intelligence. It's getting a lot of attention. So it seems unlikely that these lines are really gonna reverse course anytime soon, or if ever, in fact, if you look at the two lines and you look at what happened around the year 2000, think of the internet bubble and sort of when internet became, uh, widely available and adopted.

Speaker 2 (04:00):

That's really when things accelerated. So there's a possibility that over the next couple decades, things will accelerate further with things like artificial intelligence, but, but why does this matter so much? Why is it such a big deal? And here's where we get into that second foundational question of how do you measure value. The problem is many market participants have not changed how they measure value over the last, last decade. It's become very common to hear things like value investing is dead, or you know, maybe more politely. Value only works one out of every several years. Value is not dead. And I'm gonna explain why. But it is just being measured incorrectly. Accounting standards have not changed much, and they often miss the economic reality. Value continues to be largely defined by things like price to book or price to earnings. But companies routinely adjust their earnings sometimes heavily. And book value is losing its relevancy in the digital age due to the intangible investments. As a reminder, most intangible investments are expensed upfront while tangible investments are capitalized and then depreciated over the useful life of that asset, oftentimes at management discretion. So what ends up happening is companies that are investing heavily intangible assets and intangible investments end up expensing those things upfront. And the book value ends up being lower than a company that invests in tangible assets.

Speaker 2 (05:39):

So here's where our differentiated approach really matters. CD Epic was founded in 2004 on the basis of free cash flow investing since day one. Our style of investing has been rooted in free cash flow. We think about things like

Speaker 3 (05:57):

How much cash will the business earn each year? How does that cash earnings grow over time? How is that cash flow being allocated? And lastly, how much are we paying for that stream of cash flows? Okay, so I've said a bunch of things, but maybe, maybe it is time for some proof. Okay, now this slide has a lot of data on it. So let me unpack it. This data comes from Bloomberg, which is obviously a neutral third party, and Bloomberg analyzes 20 different valuation factors to show which factors work the best by comparing quintile performance, basically quintile one versus quintile five. And it has this data going back all the way for 15 years, which is how we've sorted the data on this chart.

Speaker 3 (06:46):

On this chart, on this chart, I've pointed out two factors that we think are the right way to measure value. It's free cash flow to enterprise value, and more commonly free cash flow yield. So if you define the way that we look at value, value is clearly alive and well. What's close to the bottom now is price to book. So when people say value is dead, this is why over the last 10 or 15 years, price to book value has not worked very well at all. And the reason is because we believe price to book is losing its relevancy in the digital age. Now, price to earnings that's done better than price to book, but still nearly not as well as free cashflow based metrics, which are towards the top. Now let's take a look at our small cap quality value portfolio to prove that we do what we say we do.

Speaker 3 (07:44):

So on this slide, we've compared our strategy versus the Russell 2000 value benchmark. So let's move from left to right and look at the differences. Now let's look at the first column on price to earnings. We're about the same as the benchmark, but that's actually misleading because Russell only looks at companies that earn money on a gap accounting basis and excludes companies that don't. Now, the next column, this is the metric that we like. This is price to cash flow. And as you can see, we're more than three and a half turns cheaper than even the value benchmark on this preferred metric.

Speaker 3 (08:27):

The next one is price to book, which we really just don't pay attention to. We think price to book is losing its relevancy in the digital age, as I've stated a couple times before. And over time, our metric of price to book can be higher or lower than the benchmark. The point is that's not what we're focused on. The next column shows percent of loss making stocks. Now here I mentioned a moment ago that when you look at price to earnings, it excludes all of these. So as you can see, the benchmark is approaching a quarter of the companies that are actually losing money or our portfolio is a much smaller percentage. Then if you shift to shift to the quality of the portfolio, you can see that return on equity is significantly higher in our portfolio than in the benchmark, and our companies are earning significantly higher operating margins. And the great thing about this is we're doing all this with leverage. That's about the same as the benchmark.

Speaker 3 (09:30):

Okay, so let's wrap this up with where we got started. What is value? Value is simply getting something for less than it's worth. How do you measure value? Well, hopefully you've seen that free cash flow based metrics have been the most efficacious valuation factors for the last 15 years. And the way things are going with the digital age and new investments, and whether it is AI or other forms of technology, there's no signs of that changing anytime soon. And we are indeed value investors. And when you look at our preferred metric, things like price to free cash flow, we're even cheaper than the value benchmark. So in other words, the things that we've focused on in the past have worked well and we've shown empirical evidence. We don't think the future's going to be any different in terms of what, what should work well and if we execute with our team and our investment philosophy sticking to our discipline process, we hope to have good returns in the future as well. Thank you for your time.