Investment Process Special (Part 1 Of 3): The Core Value Drivers With Novo Nordisk And W.W. Grainger

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Includes: CHRW, FAST, GWW, NVO
by: Oyat
Summary

The main drivers of value creation over time are growth and return on invested capital (in relation to cost of capital).

The investing world has created investment styles such as growth and value, but this ignores interconnections and often leaves investors misguided.

This piece focuses on how value is created and our perspective on value investing and the relative insignificance of the market, while future pieces will focus on growth and ROIC.

We provide examples from our holdings to demonstrate the core value drivers in an investment process.

Value investing jumped into the spotlight in the early 1930s when Benjamin Graham developed his approach to find and buy stocks at a discount to their intrinsic value. Famous investors from Warren Buffett to Peter Lynch have deployed the investment style from one perspective or another. But nowadays, many market participants claim to be value investors without having a clear definition of value or even of investing. True value investors should understand the drivers of value and have a process that raises the odds of discovering value beyond simple speculation. This article discusses the origins of value, their importance in constructing an investment process and the relative insignificance of the market for a long-term value investing process like ours.

We conclude with examples from our holdings such as Novo Nordisk (NVO) and W.W. Grainger (GWW) that demonstrate integration of core value drivers in an investment process.

The search for true value investing

In an investing world that wants to separate growth from value and often thinks that value investing is based on low prices, it is easy to get confused on what value actually is or how it could be incorporated into an investment process. There seem to be hundreds of definitions for value investing with thousands of participants claiming the title of value investor. To gain some clarity, it may help to review how value is actually created by companies. Value is driven by growth and return on invested capital (ROIC) in excess of cost of capital (which we sometimes refer to as quality) as demonstrated by the simple graphic below.

Growth and ROIC drive value from McKinsey Valuation

Source: Valuation by McKinsey & Company

Separating growth from value makes little sense as growth is one of the main determinants of value. A growth investor can be a growth investor, but how can a value investor be a value investor without factoring in growth as one of the most important components of value? The investment world often embraces a focus on growth, but rarely in terms of its impact on value. We prefer not to separate the two or look at growth in isolation from return on invested capital, the other key fundamental contributor to value.

We are also surprised how many value investors define their process by the price paid for a company. A low price-to-earnings (PE) ratio is all that is required to make someone a value investor it would seem. But how can value be determined without a proper assessment of the product being purchased? With almost any product people buy, from clothes to cars, the quality of the product is core to the purchase. If consumers could pay the same price for a new Porsche or a used Volkwagen Golf, they would pick the Porsche every time. Value is not determined by the price, but by the combination of price and quality.

Why is it that if the product is an equity investment, people are allowed to call themselves value investors simply if they pay a low price? A low price in isolation does not equal value. The key question is price relative to what. But even on a relative basis, investors are often misguided. Investors regularly claim value when they find a metric for price, a PE ratio for example, that is low relative to peers or relative to the market as a whole. But this again largely ignores the quality of the product. Value exists when the price for a company is cheap relative to its own worth (intrinsic value), independent of peers or the market.

Our definition of value investing does not include simply buying stocks that are statistically cheap compared to other stocks. We prefer a process focused on buying high quality companies which are more valuable than average or poor quality companies and paying attractive prices for them – which could represent good value even if those prices are not statistically cheap compared to prices of lower quality companies or the market.

Aside from providing a price, markets are largely irrelevant for determining value, and investors might consider forgetting about them most of the time. A company’s value is dependent on its own ability to generate sustainable (and hopefully growing) cash returns. If investors can buy companies below their own intrinsic worth, they are value investors from our perspective. The market offers a price, not value.

At Oyat Advisors, we own many equity positions that are growing faster than the market and/or are trading at PE ratios above the market average. But we consider all of them value investments.

Defining value is important for defining investing

Our view on equity investing focuses on value creation by companies rather than possible stock price swings (which lends itself to the long term). Equity investors own the cash returns of a business. Rational owners commit capital when cash returns are attractive, reasonably predictable and in line with core principles. Owners also seek to benefit from these cash returns over long periods of time, if not indefinitely, putting extra emphasis on their predictability and sustainability. When we invest in equities, we are owners and seek to invest alongside other owners and managers whose interests are aligned with our own. And so we view equity investing as committing capital to become owners of businesses producing attractive and reasonably predictable cash returns in line with our core principles over the long term.

Critically, the focus is on cash returns generated by businesses, not on selling an ownership stake at a higher price in the future. Buying a company based largely on the hope of selling it for a higher price in the future wanders dangerously close to speculation in our opinion. It requires other investors to act according to our wishes, something that is largely unpredictable. And it requires a market for trading. Such an action is not entirely in line with our definition of investing as it is not based on the ownership of cash returns and is not reasonably predictable. It also requires the sale of the business to achieve the desired return, rather than motivating the potentially indefinite ownership of a sustainable stream of cash flows. When building an investment process, we prefer to minimize the reliance on the actions of other investors or even of the market as a whole, while focusing more on the results of the businesses themselves.

It’s also important to focus on the degree of predictability of cash returns. Or said another way, the more predictable cash returns are, the further down the spectrum we can slide toward investing and away from speculation. Effective investment processes generally seek to optimize the predictability of cash returns, a topic we will cover in more detail in parts 2 and 3 of this series.

An investment process focused on long-term value creation for long-term owners through sustainable growth and return on invested capital generally leads to ownership of companies that have demonstrated a focus on exactly those drivers over long periods of time.

Real world examples of companies with value creation and shareholders in mind

Novo Nordisk: Novo Nordisk is a leader in diabetes care and has a stellar track record of ROIC. It makes for a good example of a company which deserves a premium valuation based on its high levels of value creation, meaning even above average valuation multiples might very well provide value investment opportunities. Novo Nordisk has demonstrated solid growth for much of the past decade and was generally priced for such growth with a long-term PE ratio average nicely over 20x. But recent growth pressure led to buying opportunities that didn’t require a premium for sustained high growth. Investors had multiple opportunities to pick up shares of the company at a PE ratio around 15-16x over the last few years despite the fact that Novo Nordisk has multiple potential drivers for long-term growth, including the rise of diabetic and obese people across the world and new product introductions soon to include its oral version of Semaglutide. More importantly perhaps, the company’s return on invested capital profile is easily one of the most attractive in the market. The company also has long-term protection for many of its key products and scale that will defend its ROIC going forward.

Novo Nordisk impressive ROIC profile

Source: Thomson Reuters Eikon

Investors looking at the balance sheet will note the large net-cash position. Some will argue that the company could optimize its cost of capital by levering up to some extent, and they might be right, but we prefer to look at the incredible financial cushion as more potential upside should the company put its cash pile to work, and certainly as abundant security for any rough patches. Why not buy the company at an attractive price and let it create long-term value for you?

W.W. Grainger: Grainger is an industrial distribution company we have written about in multiple articles. It is also a good example of how wildly a stock price can swing despite the underlying fundamentals of a company remaining quite attractive. Therefore, it serves to demonstrate that even long-term investors like ourselves may trim or even sell core-type holdings if the market price exceeds our estimate of intrinsic value. An investment process built on sustainable value drivers means investors can generally hold investments indefinitely for their cash returns, but extreme market prices do offer opportunities to optimize portfolios.

Grainger has a solid growth profile with a large scope for continued growth. The company’s strong presence with large corporate clients is growing, and the company’s recent new pricing strategy has accelerated growth in the small and mid-sized client arenas. Considering the fragmented marketplace and the shift toward online solutions (which plays to Grainger’s strength), there is plenty of runway for continued growth. We also like the relatively defensive nature of the company’s business despite operating in the industrial space, which can be seen in the growth and ROIC profiles below.

WW Grainger impressive growth and ROIC profile

Source: Thomson Reuters Eikon

For investors demanding steady and highly-value adding ROIC combined with reasonable growth, Grainger fits the bill. Stock price fluctuations in recent years have offered investors multiple opportunities to pick up the high-quality company at attractive valuations such as PE multiples of 15x or below. A PE of 15x might not sound like the cheapest value investment when only considering price, but for the quality of steady ROIC averaging 18.6% (ahead of the market median around 10%) and EPS growth averaging near 10%, it sure looks like value to us.

Novo Nordisk and W.W. Grainger will likely appear as core-holding candidates when using an investment process based on steady double-digit ROIC and reasonable growth (like ours). Long-term investors just need to be patient until a good entry point arrives. Similar examples of our holdings include C.H. Robinson Worldwide (CHRW) and Grainger’s peer Fastenal (FAST).

Defining value and its core drivers is a good start for investing

Growth and return on invested capital (in relation to cost of capital) drive value, but modern investment styles often try to split the two, potentially leaving investors misguided. Simplistic “value investing” techniques based primarily on low prices or focusing on stock price fluctuations often ignore the core drivers of value or their interconnections and may lead market participants dangerously close to speculation. It is important for investors to understand how value is defined and how it is incorporated into an investment process. For long-term investors, remembering that equity instruments represent ownership and that the value of ownership is largely determined by the sustainable cash returns of a business can help when constructing an investment process based on true value.

Value creation based on return on invested capital and reasonable growth projections is a basis for finding high quality companies at attractive prices. In future articles, we will discuss how to balance growth and return on invested capital within an investment process in an effort to tilt the odds in favor of superior investment results.

Disclosure: I am/we are long NVO, GWW, CHRW, FAST. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: The information enclosed in this article is deemed to be accurate and reliable, but is not guaranteed to or by the author. This article does not constitute investment advice.