We hear a lot about famous American value investors (Graham, Buffett, Schloss, Lynch), the odd Brit (Slater, Templeton) and even the occasional Aussie (Maple-Brown) or South African (Neilson), but it’s not too often a Spaniard gets a run.
They have great names the Spanish and play beautiful football but, particularly at the moment, they’re not known for their financial prowess. Francisco Garcia Parames is the exception that proves the rule, returning 16% a year for his Bestinfond investment fund between 1993 and 2011, compared to 8% a year for the Madrid Stock Exchange General Index. And his favourite sport is basketball (great name though).
Parames says the words of Charlie Munger are releveant for investors: “All I want to know is where I’m going to die, so I’ll never go there.”
“An investor doesn’t need to make personal investment mistakes to find out what doesn’t work,” explains Parames, “what’s needed is to read about others’ mistakes and never follow them.”
In this respect, The Value Investors: Lessons from the World’s Top Fund Managers by Ronald Chan – where I recently came across Parames – is worth a read.
Parames credits Peter Lunch’s One Up on Wall Street for setting him off on the righteous path of value investing. He singles out one paragraph from Lynch’s book in particular:
“Stock prices often move in opposite directions from fundamentals but long term, the direction and sustainability of profits will prevail. It takes remarkable patience to hold on to a stock in a company that excites you, but which everybody else seems to ignore. You begin to think everybody is right and you are wrong. But where the fundamentals are promising, patience is often rewarded; it’s only by sticking to a strategy through good years and bad that you’ll maximize your long-term gains.”
Cash is king
Like most successful investors, however, Parames’ approach is fundamentally very straightforward.
"We like to buy good-quality businesses with [free cash flow] multiples of less than 11 to 12 times. Our target price is usually set at 15 times. The rationale for 15 is that it is the long-term average at which stocks generally trade. It also implies a FCF yield of around 6.6%–not too bad in most market environments. Of course we always play around with the sensitivity of our assumptions to come up with a comfortable multiple. For example, if a business is good we use 17 times; if it is cyclical, then maybe 13 times."
A couple of things jump out about this. First, his focus is on cash flow, which of course is ultimately the essence of value. Strong cash flow was behind our recent recommendation of Carsales.com, despite its apparently expensive valuation based on earnings.
Second, his target for a yield is apparently pretty stable – although one presumes, for example, that it would have to rise in an inflationary environment. There are plenty of stocks around in Australia at the moment delivering free cash flow yields that might tempt Parames, and quite a few are on our Buy list.
Of course the big swing factor in Parames’ valuation guide is quality, with a target of a 17 times FCF multiple for high quality (ie a yield of 5.9%) and a 13 times multiple (a yield of 7.7%) for low quality.
To determine quality, Parames’ focus is on return on capital employed (ROCE) – a measure that we use abundantly on Intelligent Investor Share Advisor and have explained frequently in our Investor’s College, for example in The enigmatic return on equity, Take the ROCE road to bypass debt and Weighing up ROA, ROE and ROCE.
Parames puts it like this: “ROCE helps us understand the competitive landscape of industries, from which we can try to determine the competitive advantages of different businesses. There is no ideal figure for ROCE. It is a moving number from quarter to quarter and from year to year, but we generally look for companies with consistent returns and so we think around 20% is pretty good.
“The most important thing is to understand the business prospects. Even if the ROCE looks good based on historical trends or in comparison with the business’s competitors, it can still be a trap if the business does not have pricing power going forward. For example, if its profit margin is being squeezed by competition or inflation.”
As always, good investing should be pretty simple – but that doesn’t stop it from being hard.