As value investors, we typically look for investment opportunities in one of two categories: quality companies at discount prices or corporate transformation opportunities. To determine if an opportunity in one of those buckets will be successful, we rely on in-depth fundamental research and conversations with management teams.
Talk is cheap, and we need to know that management can move beyond the buzzwords and actually deliver and create shareholder value over time.
Quality Companies at Discount Prices
We seek to identify quality companies at discount prices. These high-quality companies have historically executed on the metrics we’re looking at, such as free cash flow and return on invested capital, but their valuations are often unattractive; they are simply too expensive.
Sometime, however, these companies may hit a speed bump. Perhaps investors overreact and sell the stock due to what we may consider as a transitory issue, for example. In those cases, as long as we feel confident, after a conversation with management that the company will return to executing the way it has historically, we will look to take advantage of that valuation opportunity.
A good example is a high-quality bank stock we bought years ago. Initially, it was too expensive in our view. The bank had previously made some acquisitions, and investors became concerned that these acquisitions would annualize and no longer support the bank’s future earnings growth, ultimately resulting in the underperformance of the stock and a more attractive valuation.
In talking to management, however, it was clear to us that the bank’s organic growth initiatives could more than offset the deceleration in year-over-year growth as the acquisition benefits rolled off. We ultimately bought the stock, as this conversation gave us confidence in the company’s potential.
Corporate Transformation Opportunities
Corporate transformation opportunities are stocks that historically have not executed on the metrics we’re looking at, but they look extremely attractive from a valuation perspective.
Many times, however, a corporate event provides an opportunity. Often it’s a management change, but it could also be an asset sale or a divestiture.
A good example of a corporate transformation opportunity is when a uniform rental company brought in a new CEO who pledged to improve the business operationally by shutting down its existing acquisition efforts, exiting unprofitable businesses, and focusing on improving asset utilization before pursuing any new growth opportunities.
The company had to get its house in order and earn the right to grow. We had confidence in the CEO’s ability to execute this game plan because he made operational improvements within the division he was previously running and had a history of success.
We had confidence in the CEO’s ability to execute this game plan because he made operational improvements within the division he was previously running and had a history of success.
Regardless of whether the opportunity is a quality company at a discount price or a corporate transformation opportunity, we need to know management is focused on the right metrics and has a logical plan to create shareholder value over time.
For example, is it consolidating its supply chain or changing its operating model to improve overall operational efficiency? What are the organic growth opportunities? Is it focused on the right metrics such as free cash flow, return on invested capital, and asset utilization?
Or, is management just giving you the buzzwords?
That’s where our on-the-ground research proves invaluable. Our familiarity with the companies in our coverage universe and their management teams allows us the opportunity to uncover insights.
In the case of the uniform rental company, we had confidence in the CEO’s ability to execute his game plan because of what he had accomplished internally and his track-record at his previous company, a stock we were also familiar with.
Meeting with management teams is an essential part of our fundamental research process. It’s easy for a company to put together a slide deck that explains the strategy, incorporating a number of industry buzzwords.
However, we need to know that we are on the same page with management and that it is focused on the right metrics in an effort to create shareholder value over time. This goes a long way in providing confidence that management will be able to deliver on its promises.
Chad Kilmer, CFA, CPA, partner, and David Mitchell, CFA, partner, are portfolio managers on William Blair’s U.S. Value Equity team.