As markets turn, undervalued companies present new opportunities

Companies with solid financials, management, and growth prospects are nonetheless being discounted by the stock market, leading to exciting opportunities for investors, says Vim Thasan of Beutel Goodman Investment Counsel.

“The market is a voting machine in the short term, but it is a weighing machine over the long term,” said Thasan, vice-president of Canadian equities with Toronto-based Beutel Goodman. “We look out three to five years, while the market may look out three to five days. This lets us form a view of a company that may be different from what’s reflected in stock prices or market expectations.”

According to Thasan, fear of a recession is creating opportunities — particularly in the consumer discretionary and financial sectors, where observers fear many companies have hit peak earnings.

He said where some smell fear, value hunters smell potential.

“For us, the first-level thinking is about the earnings risk and the near-term concerns of earnings risk. But the second-level thinking is, what’s priced into these expectations and stock prices?” he said. “We may consider — and we do consider — near-term earnings to seek out advantages and opportunities. But we try to look through to what normalized earnings potential is for each of these companies.”

Opportunities can also be found in company-specific situations where a mis-execution or misallocation of capital creates a discounted valuation, suggesting that such opportunities are occurring in the pipeline and technology spaces.

According to Thasan, owning businesses at excessive valuations, regardless of quality, puts investors at risk of losing capital. In recent years, low rates and high growth expectations resulted in excessive multiples and high business valuations, even for companies with negative free cash flow. Now, with ongoing concerns about a potential recession, the normalization of business following the pandemic and higher interest rates, multiples are dropping. This has affected more speculative growth areas most.

Investors should continue to focus on company fundamentals and favourable market dynamics, rather than unrealistic expectations borne of emotion, he said.

“Markets are ultimately driven by fear, greed and short-termism,” he said. “As value investors, our job is to take advantage of these emotional cycles and invest in companies at attractive valuations that can provide that path to long-term value creation.”

Investors that rely on conventional wisdom to guide their purchases may be getting an incomplete picture of the market, he added.

“Conventional wisdom creates simple stories to explain very complex situations,” he said. “It’s important to break apart the companies, and then build them back up. This lets you understand the nuances of what will drive future value.”

As for value traps, analysis minimizes that threat.

“We define value traps as companies that look cheap on valuation metrics but continue to underperform on a fundamental basis,” he said. “This may be due to a structural decline in earnings power.”

Thasan said the best defence against value traps is to have a solid understanding of the company’s fundamentals and the dynamics of its industry.

“Value traps tend to be created if you purchase a low-quality franchise and are wrong on the fundamental outlook,” he said. “Valuations follow fundamentals over the long term.”

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This article is part of the Soundbites program, sponsored by Canada Life. The article was written without sponsor input.