Think about anything you might purchase — a refrigerator, a boat, an inexpensive suit, a company… If it’s not very functional or it’s broken and beyond repair — if it has lost or never had any intrinsic quality — does it have any value? We say “no quality, no value” and follow an approach that we believe bolsters value’s underlying premise while navigating its pitfalls.

KAR consistently believes that value stocks can deliver attractive risk-adjusted performance. And by “consistently,” we mean even when standard value indices are clearly underperforming. We are dedicated to this belief because we base it on our definition of value, a definition that frankly does not mirror the textbook definition of value.

What is Traditional Value Investing and Why Doesn’t it Always Work

Traditional value investing focuses on companies that are considered underappreciated and have been overlooked while the market pursues more exciting growth stocks. Typically, the rationale for investing in an underappreciated company is the chance to earn outsized returns when the market realizes the stock is underpriced. Based on this narrative, investors will smack their collective foreheads for the oversight and buy the stock, pushing up its price and delivering strong returns to those who had the foresight to buy earlier.

We believe this is valid as long as there is, in fact, a viable business at the core of the “overlooked” company. But is there? The widely followed indices (Russell, MCSI USA, Morningstar) rely on one or more simple financial ratios to identify value stocks — book-to-market ratios, dividend yield, 12-month forward earnings, etc. From our perspective, these metrics can have serious flaws when it comes to signaling viability:

• Stocks may have high book-to-market ratios because investors recognize that the firm’s assets are not likely to generate value in the future.
• A high-dividend yield may occur when a stock’s price has justifiably declined due to a poor long-term outlook, but its dividend has not (yet) been cut.
• A relatively weak 12-month earnings forecast may not just be a temporary setback; it may be the beginning of the end.

In other words, some stocks identified as value have not actually been overlooked. They may have been accurately assessed by the market as having poor future prospects. A cheap company may deserve to be cheap and, worse, to continue to get cheaper. And hoping for a “magical” turnaround before one is underway is much like wishing on a star. Either one could work, but it’s risky.

KAR Value Investing Strategy — Following the “Spirit” Rather Than the “Law”

In our view, defining a value stock based on simple financial ratios such as price-to-book or dividend yield can be a road to low returns because ratios do not capture what matters most: quality. So-called value businesses may lack the characteristics to sustain steady operations. Even if they stay afloat, they can sputter along without attracting the necessary investor attention to raise prices and generate nice returns.

KAR’s value strategies do not fit the traditional mold by design. At KAR, we aim to identify “quality value” companies by the strength of their balance sheets, and by how they deploy capital and use free cash flow. We seek low-capital intensity companies that pay a healthy dividend and buy back shares to boost return on equity (ROE). We avoid those companies with a history of using free cash flow to make acquisitions or expand into product lines that do not fit the core business just to achieve top-line growth.

This approach leads us to the type of companies we believe value investing is meant to revolve around — companies that are currently undervalued by the market and likely to show significant stock price increases as the market comes around. Instead of falling into the trap of buying cheap stocks and waiting for a possible turnaround, KAR’s approach focuses on the promise of value investing.

Contact Kayne Anderson Rudnick today to speak with our team about our investment strategy.