Our differentiation starts with our investment evaluation philosophy. In contrast to an “accounting” (earnings, EPS) valuation approach used by brokers, we use an “economic” approach.

The critical step in equity investing involves estimating whether management, through its strategy and capital allocation policies, is likely to destroy or create incremental shareholder value.

Accounting vs Economic approach

Conventional equity analysis based around an “accounting/earnings approach” can fail to capture this due to its overwhelming focus on the income statement. This approach, arguably one “created by auditors, for auditors”, is not ideal for investment evaluation. It is also favored by management due to the flexibility it gives in presenting accounts, but this makes it vulnerable to manipulation with reported numbers such as EPS concealing underlying value
destruction.

The methodology behind an “economic” approach uses an integrated analytical approach, bringing together line items from all three financial statements with the aim of scrutinizing the success of management strategy in maximizing returns relative to the invested capital deployed. However, while this approach as probably the most accurate measure of profitability, we think that it is of limited value alpha generation as the trend in value creation is more important. In our approach, even a stock enjoying strong absolute cash flow generation does not necessarily make for a compelling buy idea as what actually matters for valuation is the incremental cash flow growth outlook. Our calculation of I-EVA (incremental economic value added) captures shareholder value creation as incremental cash flow generation - the “economic” profit as an “incremental” metric. This trend in this metric is, in our view, a key driver of equity valuations and therefore has a central position in our stock selection framework.

Quantifying qualitative factors

We bring objectivity to subjective concepts that are important to the evaluation process by giving numerical measures for some important hard-to-quantify concepts which are typically discusses only qualitatively. What is the likely sustainability of the shareholder value creation outlook? Is management adopting an aggressive or defensive strategy for shareholder value creation? What of the outlook for value creation is already priced-in by Mr Market? Are management guidance/consensus forecasts over-optimistic?

Such calibration overcomes the challenges of incorporating a qualitative analysis into a stock selection process. For instance, everything else being equal, how can an investor compile a list of stocks where management are not too aggressive with their strategy? How to select from stocks when many seem to enjoy similar competitive advantage? From a shortlist of stocks, how can an investor select stock that are not suffering exuberance in share price?