'Croci' pushes the limits of value investing

SMART MONEY

Here is a quiz. Which of these stocks is cheaper; Gilead Sciences, in the booming biotech sector, which currently trades at a multiple of trailing earnings of about 26, or Gazprom, the hegemonic resources group in Russia, which trades at a price/earnings multiple of about 2.5?

The answer, according to Deutsche Bank's Francesco Curto, is Gilead. And this is not because of any attempt to measure the political risks surrounding Russia. Rather, it is driven by Deutsche's "Croci" investment process (it stands for "cash returned on capital invested"), an attempt to make a systematic search for value stocks, and make valid comparisons between otherwise different companies.

Like much of value investing, the insight behind Croci is simple, but putting it into practice involves a lot of hard work. It is based on adjustments to public accounts to screen out manipulations.

Instead of market value, Mr Curto's team at Deutsche uses enterprise value, thus including debt and operational liabilities such as future leases. Rather than the official book value (assets minus liabilities on the balance sheet), it uses net capital invested. This requires adjusting assumptions on depreciation, and instead imposing an "economic depreciation" based on an estimate of how long a company's assets will actually last. This allows an estimate of the actual replacement value of a company's assets. The team also values intangible assets that generate cash but do not appear on the balance sheet - such as brands and patents. Finally, it accounts for inflation.

This leads to a cash return on capital invested, to replace the accounting concept of return on equity, and an "economic p/e ratio" to replace what Mr Curto's team calls the "accounting p/e".

This is not a simple quantitative screen. Rebuilding a company's balance sheet to take into account economic factors requires assumptions, even if they are applied systematically. Deutsche employs some 60 analysts, most of them based in India, to do this work - so this is not as cheap as other value screens which can be bought as exchange traded funds.

The conclusions that Croci reaches are often fascinating. Perhaps most importantly, the Croci process suggests that much of emerging markets' current cheapness is "only optical". In the case of Gazprom, Deutsche estimates its true economic p/e at 28.6, radically higher than the published 3.5. The gap between the two is largely because Gazprom keeps engaging in wasteful capital expenditures. Meanwhile Gilead's p/e was only slightly changed, rising from 25.3 to 26.8 as a result of the exercise (which suggests that Gilead is also no bargain).

As for emerging markets as a whole, since 2007 economic earnings are down (after inflation is taken into account), and they are returning less capital now. In other words, their productivity is slowly falling, because they are over-investing. This helps the economy, at least in the short term, but does not help shareholders. Chinese steel companies, for example, suffer a mismatch between the economic life of their production facilities, and the likely demand for their product. Their factories are likely to outlive demand for steel, and this will create losses for banks.

Another insight is that healthcare and pharmaceuticals offer much better value than conventional analysis reveals. This is largely because their book values tend to be understated, thanks to the difficulties in accounting for brands and patents. Under the Croci process, healthcare has shown up as one of the three cheapest sectors globally every year since 2009.

Mr Curto points out that Pfizer now has much the same number of employees as it did ten years ago, even after a series of acquisitions. Pharma companies' costs, for sales networks and even for research and development, can be consolidated and cut far more easily than in other sectors.

Ακολουθήστε το Euro2day.gr στο Google News!Παρακολουθήστε τις εξελίξεις με την υπογραφη εγκυρότητας του Euro2day.gr

FOLLOW USΑκολουθήστε τη σελίδα του Euro2day.gr στο Linkedin

Thus Croci implies that the rash of deals in healthcare does not imply any great irrational exuberance. Rather it suggests a rational search to release the value that is trapped within healthcare companies.

Does the Croci approach work? The investment strategies that use the approach have been in operation since 2004, and manage some $12bn. Deutsche has also produced indices weighted according to Croci measures.

The US version of the Croci index has gained 170 per cent in the decade since launch, compared to 101 per cent for the S&P 500. In Europe, it has outperformed the Stoxx 50, by 114 per cent against 86 per cent. But in Japan, graveyard for many value strategies, the approach does not yet work so well. The Croci index has gained 43 per cent since launch, against 35 per cent for the Topix 1000 - but the Nikkei 225, crudely weighted using share prices, has gained 63 per cent.

The bottom line is that this is a fascinating attempt to systematise traditional value investing. It provides insights of which all investors should be aware.

© The Financial Times Limited 2014. All rights reserved.
FT and Financial Times are trademarks of the Financial Times Ltd.
Not to be redistributed, copied or modified in any way.
Euro2day.gr is solely responsible for providing this translation and the Financial Times Limited does not accept any liability for the accuracy or quality of the translation