EVP: A New Vision for Value -Tom Stubbe Olsen and Léon Kirch
Some funds chase every upswing in markets and risk a hit from sudden downturns. Instead, Tom Stubbe Olsen and Léon Kirch of European Value Partners recommend a style of value investing that puts the fundamentals of individual companies centre-stage.
Volatile markets offer opportunities for high returns and major losses, and the difference between the two is timing. There is, however, a different way to look for returns from listed shares. Its proponents call it ‘value investing’, and it has its roots firmly in the fundamentals of the companies that make up an investment portfolio.
European Value Partners (EVP) has a unique investment philosophy, which relies on spotting companies that are undervalued on the stock market and have sufficient earning power to increase shareholder value over time.
‘Our starting point is the whole European universe, and we hunt for the jewels,’ says EVP co-founder Tom Stubbe Olsen. ‘We only add companies to our portfolio if they can be bought at 40–50% less than what they are worth.’
Olsen and his fellow co-founder Léon Kirch were investment managers and are now advisors to the award-winning Nordea 1 European Value Fund. In addition, they are investment managers of their recently launched Polaris Equity Fund. Together, they focus on applying their tried and tested investment principles to European companies on behalf of institutional and retail clients.
Carefully balancing risk and return, EVP only invests in companies that make it through its strict seven-point due diligence process, aimed to assess the true earning power of the businesses.
The result is usually a concentrated portfolio of fewer than 50 stocks, in which EVP invests over a time horizon of four to five years, in order to allow the stock market to close the gap between the price at which the stock of a business is bought and sold on the stock market, and the true worth of that same business.
The key to the success of its investment lies in the precision with which Olsen and Kirch can establish the value of a company and the strength of its earning power.
The importance of earning power
Earning power is the key determinant of value for EVP, but it is not a factor that is obviously visible from the figures that companies release to the stock market. Olsen and Kirch must dig a little deeper and look beyond the quarterly earnings headline figures.
‘When buying a business, earning power is the most important ingredient in determining value. We define it as the ability to generate discretionary free cash flow over a business cycle,’ explains Olsen.
‘It is not an accounting measure and it does not come off the annual report. Discretionary free cash flow is the cash available to a company after it has invested to sustain its business. It can be used to reinvest in the business, pay dividends or buy back shares. Also, we do not measure it over one year, but over the entire business cycle,’ confirms Kirch. They point out that earning power and earnings statements do overlap at times in the cycle, but often only briefly before one outstrips the other.
‘There is often uncertainty over how companies value their own success in their accounts. We must analyse the underlying earning power or be victim to accounting standards. We understand the economics of how entrepreneurs approach their business. Earning power is a long-term measure of corporate success, not a quarterly measure. For us, quarterly earnings reporting just confirms our investment case. It lets us check whether we are on track,’ Kirch adds.
At the same time, they are keen to stress that there is nothing vague or hocus pocus about their measure of earning power. It is the result of a clear and committed process of analysis and the patience of their long-term perspective. To evaluate the earning power of business, Olsen and Kirch typically only consider the tangible drivers within a business, not hopes on any positive future development.
‘We don’t consider anything that is not rooted in the business itself. We don’t look at what might happen in the future. We can’t include a company’s dreams for the future in establishing its value. It is a question of maintaining a sceptical or critical approach,’ says Olsen.
For instance, in evaluating a pharmaceutical company EVP would look at existing franchises, but would not consider the pipeline of products in development, as they do not yet have a market and cannot, therefore, be accurately assessed for their contribution to earning power.
Confidence stems from due diligence
EVP only invests in a stock if Olsen and Kirch share a very strong conviction about its value and earning power. Their decision is based on a rigorous, seven-step due diligence process, which brings to the fore the many elements that define earning power.
Step one is to establish that a prospective investment is not in a situation where it is obviously open to abuse by minority shareholders.
Step two is to look at historical financial statements to establish which items need to be adjusted to turn accounting earnings to the measure of economic earnings that EVP considers.
The third step is to establish where a company fits into its industry, highlighting the competitive landscape and the balance between a company and its supplier, customers and competitors.
Step four is to place the company in its value chain, and here EVP’s approach deviates from traditional analysis in the corporate world. ‘We try to establish how much a company can influence its own destiny,’ says Olsen. ‘We look at its pricing power, and we like companies that are at the high end of the value chain.’
Step five is to assess the lifecycle of the company’s products and gauge the stability of its historic earnings.
The penultimate measure is to examine the company’s operating environment. ‘We put ourselves in the shoes of the management to see how the market will affect the business. We look at economic growth, interest rates, foreign exchange rates and the regulatory framework, each of which can impact earning power,’ Olsen adds.
The final stage of the due diligence process is to look at the history of the company’s decision makers to evaluate their decision-making skills of the past and have proved beneficial to all shareholders.
‘We must have dialogue with the companies themselves and get insight from the management team. We like companies with co-operative management, who are willing to talk to us,’ stresses Olsen.
These steps are similar to the approach of private equity investors, but are based on the analysis of readily available public information. EVP also differs from many of its competitors in its approach to assessing risk.
‘Our assessment of risk is linked to the fundamentals of the business, not the volatility of the stock market. So, we have to get those fundamentals and our valuations right,’ says Kirch. ‘That defines EVP and our investment portfolios,’ adds Olsen. ‘We invest only when we see an attractive valuation.
We are not afraid to hold cash and can deviate from the market benchmark. We are looking to achieve an absolute return over time, and we approach that goal with discipline. We have shown that we are prepared to live by our principles.’
EVP’s investment strategy has kept it away from markets such as energy or other commodity markets. This is not because Olsen and Kirch doubt the potential of these markets to perform.
They firmly believe that it is not possible to assess risk accurately in those markets unless you can predict future prices of the commodities – a feat that many specialist commodity market analysts have often failed to do with precision or consistency.
Furthermore, enterprises such as automobile manufacturers, airline companies or heavy industrial companies etc, rarely fit into EVP’s criteria for value because they are highly capital-intensive, so usually generate relatively less discretionary free cash flow, as a large proportion of their earnings is ploughed back into the business.
EVP also leans towards companies with a proven business model and sustainable competitive advantage. This strategy has endured many dramatic changes in the market, and it is unlikely to change. Once investors have understood EVP’s approach to value they can rest assured that this approach will remain consistent.
‘It is an extension of our personalities,’ says Olsen. ‘It’s the way we are wired,’ agrees Kirch. Investors know what they can expect from EVP – an original and proven method of unearthing hidden value.