Brandes Investment Partners Letter: Fundamental, Research-Driven Investing

Dear Clients and Friends,

Since our founding in 1974, Brandes has employed a fundamental research-driven approach to investing that is rooted in the writings of Benjamin Graham. Important to what Graham espoused was the concept of a businesslike approach to investing and it likely goes without saying that businesses and industries evolve over time. Accordingly, our implementation of value investing has adapted over time to economies that have changed and business models that have evolved. Back when the world was dominated by industrial “metal benders,” the intrinsic value of a company was often closely correlated to the net assets captured on its balance sheet. However, as economies have evolved and technologies have advanced, accounting principles have not always kept up at the same pace. As the importance of intangible assets have increased over time, our valuation approaches have become more nuanced to better capture what is truly intrinsic value. In other words, our investment approach has evolved in order to ensure that it remains ‘most businesslike.’

Although valuation methodologies have progressed, some observers maintain a simplistic view of value managers and of Brandes—thinking that we are limited to buying companies trading at low Price-to-Book or Price-to-Earnings ratios in a very formulaic way. This simplistic view belies what’s really happening behind the scenes at Brandes. At our core, and as mentioned above, we are all about analyzing companies with a ‘businesslike’ mindset and determining their true intrinsic value. Accordingly, we don’t rely exclusively on screening for companies based on widely available basic financial metrics as those measures are easily captured quantitatively and their mispricings have largely been arbitraged away. We do, however, rely on thoughtful, fundamentally-driven research where we use multiple valuation techniques to triangulate around an estimate of intrinsic value. We have a diverse group of experienced analysts who work in a supportive team-based environment housed within an independently owned firm. At Brandes, it’s our people, our structure, and our decades of experience combined with a singular focus on getting to the true intrinsic value that defines what real value means to us.

Some examples of nuances involved when estimating intrinsic value include the following:

• Consideration of qualitative factors related to individual businesses and their industries. We spend a great deal of time analyzing and debating issues such as network effects, switching costs, R&D (research and development) productivity, and the persistence of earnings. Reversion to the mean has long been a tenet of value investing and while it may still be alive and well in many instances, its gravitational pull may not be as dependable as it once was for many industries. By analyzing companies one at a time, we’re able to consider whether reversion is likely in each specific case. For example, when Microsoft (MSFT, Financial) makes significant investments in R&D, we generally feel confident that they are skilled and scaled to likely earn an adequate return on that investment. In such cases, we may capitalize that R&D as an asset on the balance sheet and amortize it in the income statement to better match those investments with their potential future benefit. On the other hand, a company that is not on the leading edge, lacks adequate scale, or does not have a track record of successful innovation may not earn an adequate return on its R&D ‘investment,’ suffer from “mean repulsion,” and never catch up.

• Recognition of the speed and intensity of disruption. Technological and competitive disruption has always been a part of value investing but the speed and intensity has grown over the recent past. A research driven approach can be in tune with whether the future is likely to look like the past. When disruption is anticipated, the market often reacts, and we can make a business-like assessment about whether the market has over or under reacted. As a hypothetical example, Amazon (AMZN, Financial) may make a declaration that it will enter a new industry and this will likely have market moving effects on incumbent industry participants. However, our experienced industry analysts and investment committees will thoughtfully evaluate whether the market’s reaction was appropriate or whether an opportunity exists.

• Ability to be nuanced when the market is indiscriminate. A recent example of this was at the beginning of the pandemic. The market was indiscriminate in selling economically sensitive companies and those with leveraged balance sheets. And while it’s true that there were many that did not have a strong enough financial position going into an economic downturn, a more careful analysis uncovered that some that had been sold off despite their strong – and in some cases improving - competitive positions.

• Capacity to deal with cyclical businesses. Cyclical businesses often represent attractive opportunities for longer-term investors, as the market’s increasingly short-term orientation tends to extrapolate the current environment – good or bad. At Brandes, we evaluate cyclical businesses via “normalized” or mid-cycle earnings. We appreciate the best time to invest in a cyclical business may be when its P/E is optically elevated due to cyclically depressed earnings, and that it can be quite risky to invest in low P/E cyclical companies if those earnings are inflated due to a cyclical peak. The events over the past year have offered up both conditions, with traditional economically sensitive companies experiencing depressed earnings, while ‘work from home’ beneficiaries have been experiencing a surge in profitability due to the pandemic.

We contend that a simple passive approach would struggle to make the discernments described above. One could argue that a quantitative approach could build rules to deal with cyclical companies but each industry cycle can be different in length and even those can change over time as the industry consolidates, becomes more or less capital-disciplined, faces emerging technologies, and adapts to changing regulations.

At Brandes, we carefully developed and have gradually refined our research infrastructure to consistently deliver value portfolios that are built with a businesslike mindset. Our global sector analyst teams are deeply experienced and provide insights developed over multiple cycles throughout their careers.

The Recent Resurgence of Value

The value style has had a strong resurgence, the start of which can be pinpointed to the November 9, 2020 announcement by Pfizer (PFE, Financial) and BioNTech (BNTX, Financial) of the success of their COVID-19 vaccine candidate. The market then saw a potential light at the end of the tunnel for the pandemic and the prospects for an eventual economic recovery. U.S. value stocks have historically led out of U.S. economic recessions. So far, the Russell 1000 Value and the MSCI ACWI ex US Value have outperformed their growth counterparts by +17% and +18% respectively since November 1, last year.²

At Brandes, we have long contended that our strategies tend to do well in value-led periods and we have seen a validation of this during the recent favorable environment for value. Between November 1, 2020 and May 31, 2021, the returns for our major asset class strategies relative to their benchmarks are as follows:

Sources: Brandes, MSCI, S&P. Composite performance net of management fees. Please see the accompanying composite performance pages. Past performance is not a guarantee of future results. Performance results were achieved in particular market conditions which may not be repeated. Moreover, the current market volatility and uncertain regulatory environment may have a negative impact on future performance.

While recent value performance has been strong, a frequent concern raised by many is whether this is another ‘head fake’ similar to those we have seen over the past decade when value had several periods of strong short-term relative performance. Although it can’t be ruled out, we believe the combination of a likely macro-economic recovery, the still wide valuation dispersion between the value and growth segments of the market, and the strong and improving fundamentals of the companies we own all bode well for value’s continued performance.

Thank you,
Brandes Investment Partners

¹ The Intelligent Investor, Revised Edition, 1973.
² Source: Russell, MSCI via FactSet. Russell 1000 Value Index vs Russell 1000 Growth (39.48 vs 22.60) and MSCI ACWI ex US Value vs MSCI ACWI ex US Growth (40.92 vs 23.29) for the period 11/1/2020 to 5/31/2021.
Price/Book: Price per share divided by book value per share.
Price/Earnings: Price per share divided by earnings per share.
The Russell 1000 Value Index with gross dividends measures performance of the large cap segment of the U.S. equity universe. Securities are categorized as growth or value based on their relative book-to-price ratios, historical sales growth, and expected earnings growth.
The Russell 1000 Growth Index with gross dividends measures performance of the large cap growth segment of the U.S. equity universe. Securities are categorized as growth or value based on their relative book-to-price ratios, historical sales growth, and expected earnings growth.
The MSCI ACWI ex USA Value Index with gross dividends captures large and mid cap securities across developed and emerging markets excluding the United States. Attributes for value index construction are book value to price, 12-month forward earnings to price, and dividend yield.
The MSCI ACWI ex USA Growth Index captures large and mid cap securities across developed and emerging markets excluding the United States. Attributes for growth index construction are long-term forward earnings per share (EPS) growth rate, short-term forward EPS growth rate, current internal growth rate, long-term historical EPS growth trend, and long-term historical sales per share growth trend.
The MSCI Emerging Markets Index with net dividends captures large and mid cap representation of emerging market countries. Data prior to 2001 is gross dividend and linked to the net dividend returns.
The MSCI World Index with net dividends captures large and mid cap representation of developed markets.
The MSCI EAFE Index with net dividends captures large and mid cap representation of developed market countries excluding the U.S. and Canada.
The S&P Developed Ex-U.S. SmallCap Index with net dividends measures the equity performance of small cap companies in developed markets excluding the United States.
The S&P 500 Index measures equity performance of 500 of the top companies in leading industries of the U.S. economy.
MSCI has not approved, reviewed or produced this report, makes no express or implied warranties or representations and is not liable whatsoever for any data in the report. You may not redistribute the MSCI data or use it as a basis for other indices or investment products.
Past performance is not a guarantee of future results. One cannot invest directly in an index.
The information provided in this material should not be considered a recommendation to purchase or sell any particular security. It should not be assumed that any security transactions, holdings or sectors discussed were or will be profitable, or that the investment recommendations or decisions we make in the future will be profitable or will equal the investment performance discussed herein. Strategies discussed are subject to change at any time by the investment manager in its discretion due to market conditions or opportunities. Market conditions may impact performance. The performance results presented were achieved in particular market conditions which may not be repeated. Moreover, the current market volatility and uncertain regulatory environment may have a negative impact on future performance. The Brandes investment approach tends to result in portfolios that are materially different than their benchmarks with regard to characteristics such as risk, volatility, diversification, and concentration. Diversification does not assure a profit or protect against a loss in a declining market. International and emerging markets investing is subject to certain risks such as currency fluctuation and social and political changes; such risks may result in greater share price volatility.
The foregoing reflects the thoughts and opinions of Brandes Investment Partners® exclusively and is subject to change without notice.
Brandes Investment Partners^® is a registered trademark of Brandes Investment Partners, L.P. in the United States and Canada.