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Valuing and Investing in Equities
“In investing there are always two sides, the investor and the company. It is essential to look at capital and return from both sides.” — Francesco Curto
Since the end of the Second World War private investing has spiked, increasing the amount of liquid capital and driving growth and innovation. To facilitate and encourage investing by individuals, the investment industry has reinvented itself through the cooperation of regulators, accountants, and publicly-held companies worldwide. Investing has become democratized, an important development of our capitalistic societies explains Francesco Curto, Co-Head of Research House at DWS, a subsidiary of Deutsche Bank.
It has become common for people to invest small and large amounts through brokers, banks, and other middlemen. At the same time, the proliferation of intermediaries, the increased accessibility of financial markets—sometimes bound together by rules, as in the EU and US, and sometimes not—and the increasing number of investment targets can distract and confuse investors. Curto’s book Valuing and Investing in Equities describes how professional and amateur investors alike should understand the investment process. More importantly, and based on his work with CROCI, the book takes its reader through the process of making sound investment decisions.
The world of equities is complex but understandable if investors remember that investment is about capital and return. Curto begins the book by focusing on first principles and—here is how he distinguishes his work from others—presents a due diligence system of valuation and analysis that enables consistent measurement across sectors and markets. The framework, “Cash Return on Capital Invested” (CROCI), concentrates on assessing the true economic value of capital, return, and price paid. Emphasizing the nature of the obligation assumed by investors when purchasing an equity stake in a company, he looks methodically at its balance sheet, the sustainability of its business model in a continually evolving environment, and its profitability.
If she want to buy a piece of a company, the real investor (whom he distinguishes from speculators interested only in price dynamics) performs due diligence on its accounts, making the necessary adjustments to ensure a proper economic basis for valuing the company. Curto shows the reader how to perform due diligence to ensure the proper valuation of capital, return, and profitability. Some companies are easy to analyze, others are more complicated, and still others are impossible. If the latter is the case, then the real investor moves on to the next one. CROCI provides a universally-applicable basis for comparing valuations across sectors and markets. In a world of systematic investing, this is of paramount importance.
Curto brings more details to bear on the CROCI method during his discussion of valuation, the basis of the investment process. The challenges for investors start early, as data used for valuation are typically created by accountants for accountants, not by investors and economists. He demonstrates how valuations can differ by 50% on average if investors use accounting data rather than economic and investment data. He also shows the reader how valuation is the net result of two factors, earnings and the discount rate. Both change constantly, but only earnings receive the on-going attention of publicly-held companies and the financial industry. Earnings are typically projected two years into the future, and that projection only affects about 20% of the overall valuation. Investors can encounter significant problems unless they possess a framework for valuing equities. CROCI offers such a framework, and Curto provides tangible examples that dispel uncertainties often faced by investors.
Along the way, Valuing and Investing in Equities touches related subjects such as the ways inflation distorts the long-term valuation of equities and the arguments about whether bubbles in equities actually exist. He reveals the often-conflicting goals of accountants and academics and preaches skepticism about their perspectives, which are often at odds with the needs of investors. Ultimately investors are best served by developing a benchmark based on dedicated research, then creating a strategy that can beat the benchmark. Investors can group their investments into this strategy and can be confident that they adhere to the same criteria. Once the parameters are defined (volatility, tracking error, etc), the investor knows where he is going and how he is going to get there.
The best finance books describe for the reader a scientific worldview; that is, one that can be replicated and applied. They also resemble cookbooks, taking the reader step-by-step through stages of analysis and decision-making. Valuing and Investing in Equities embodies both of these characteristics. Curto argues that equity investing is a young discipline. Its signs are an excessive focus on price dynamics, the superficial attitude of policymakers towards equities, the use of accounting data for investment purposes, and the high number of books written by practitioners. For the real value investor, who seeks only to get exposure to companies with the most attractive valuations, Curto and the CROCI framework offer a way forward built on commonsense research.
About the author
Francesco Curto, PhD is Head of the CROCI® Investment Strategy and Valuation Group at DWS, and Co-Head of Research at DWS. He joined Deutsche Bank in September 1998. In his time at DB, he has been Senior European Strategist, Senior Global Strategist and has been involved in all the major developments of CROCI® (database, bottom-up research, indices). He joined from Warwick Business School, where he was a Research Fellow. He holds a degree in Business Economics (Economia Aziendale) from “Universita’ di Venezia” and a PhD in Strategic Management from Warwick University. His interests are fundamental valuation, value strategies, politics, economics and the dynamics of industrial and corporate change. He is a regular guest-host at CNBC.
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