With equity markets at an all-time high, investors might worry that markets are overheated, fully valued, and mega-cap obsessed. They may be right, but that does not mean that there is nothing of interest to those looking for long-term value. Large segments of the stock market are very attractive. According to Chris Crawford and Scott Utzinger, Crawford Fund Management, you just have to know where to look. In the following analysis, Chris and Scott share just some of the strategies that work well for them and their team.
One result of the rise of US mega-cap stocks and passive investing is a general abandonment of the smaller end of the equity market. It has created one of the widest gaps between small and mid-cap and large-to-mega cap stocks in decades. Only by going back to 2000 or 1973 can you see small caps with such a tiny share of the total equity market as today.
Large market inefficiencies have built up as capital flows have favoured the Magnificent 7 and the mega-cap stocks. It has created an opportunity for stock pickers who do their homework. They must focus their research on individual companies and appraise value based on fundamentals. As ever-fewer investment professionals dedicate time to micro-level research, the probability of finding mispriced equities increases.
The trick to maximizing long-term performance is finding the right companies with the right people, trading at the right price. That sounds simple. But it means finding businesses with competitive advantages. Businesses should have strong, sustainable or rising returns on invested capital. Or they should have compelling internal re-investment opportunities that generate high growth with a clear path to improving returns on invested capital. That means spotting innovative firms developing new products and services with loyal customers.
Investors have to ask themselves: is management competent, and do they have integrity? That’s as much art as science and judging it accurately requires many years of interactions and observations. It is also critical to invest in properly incentivised management teams for whom it is more important to grow intrinsic value per share rather than maximize their own compensation. And finally, one aspect that differentiates investors from traders is that true investors should not be willing to pay more than a security is intrinsically worth, regardless of a stock’s current momentum.
One helpful mindset is to spend time assessing every stock as if it were a private equity investment. We use various valuation methods. For mature companies, we use multiples of book value or free cash flow. For growing companies, we build dynamic, discounted cash flow models. This applies to firms undertaking major growth initiatives, changing their cost structure, or scaling fixed costs. Sometimes, we seek to value more complex situations. For example, a business capable of spinning-off a company, or turning around a money-losing division. Or with a hidden asset, such as land or a natural resource that can be sold. In these circumstances we tend to rely heavily on sum-of-the-parts valuation models.
Aligned incentives
There is a further crucial step. We like management incentives to be aligned with our own in a framework of ‘owner operators.’ A small but still sufficient core of companies has a high ratio of equity ownership to compensation – we estimate as much as 15% of the publicly traded universe. This is a characteristic of the majority of our long holdings, and we look for it in under-followed, overlooked corners of the market.
To identify such firms is laborious. These are not just businesses with high insider ownership. Many companies have venture capital or private equity board members. They may own shares, but aren’t making operational decisions, and are often planning to sell their stake. Many public companies have low insider ownership, but that ownership is concentrated in key decision makers.
Why should an investor care about owner operators? Because their incentives tend to be well aligned with investors’. This is a win-win for managers and investors: the company’s equity matters much more to managers than the compensation they’re paid. A stock may have many attractive elements, but they do not always shield investors from bad corporate decisions or poor management. An investment in an owner-operator increases the odds of investment success and reduces the probability of costly mistakes.
Does the owner operator characteristic help a portfolio perform? We find that it does, but not in isolation. When combined with other metrics, it helps to build a portfolio that can deliver over the long term, and with significantly lower volatility than the classic stock market benchmarks. And importantly, it helps identify value outside the crowded, mega-cap market.
