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Notices
Knowledge and best practice in this field are constantly changing. As new research and experience broaden our understanding, changes in research methods, professional practices, or medical treatment may become necessary.
Practitioners and researchers must always rely on their own experience and knowledge in evaluating and using any information, methods, compounds, or experiments described herein. In using such information or methods they should be mindful of their own safety and the safety of others, including parties for whom they have a professional responsibility.
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Francesco Curto is the Head of the CROCI Investment Valuation Group and the Head of the Research House at DWS, one of the world's leading asset managers.
The views expressed in this book are the author’s own views and are not the views of any of DWS Group GmbH & Co. KGaA or any of its affiliated companies (“DWS Group”).
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Dedication
To Chantal, Nicolas, Emanuel and Béatrice.
To my mother, Cosima, and my sisters, Giovanna, Anna, Daniela.
To Italy and Salento, that I miss more than I can say.
To my friends, ‘fore te capu’.
Le er to the reader
Dear reader,
CROCI® is a DWS Group trademark that stands for Cash Return on Capital Invested. The acronym refers to a valuation technique used for research and investments. It was coined by a group of friends who arrived at DB in the mid-1990s. Back then, the single European financial market was still in the making, and so comparing valuations of companies across Europe was a challenge. CROCI enabled full comparability across sectors and markets, providing an excellent basis for market analysis and investments.
In the early days, the team spent what now seems like an endless number of meetings explaining how we adjust valuation and why. Confusion was the norm, and the most common question was “why?” Why do you go through so much pain? Why do you make this adjustment? Our answer was to highlight the errors of traditional approaches and explain why adjustments to valuations were required. Now the answer is different: “we do this because it is what you would do if you were buying a company with your own money”. That is the simple reality: the moment that you consider buying a listed stock, you are about to buy a piece of a company. If you buy a piece of a company, then you perform due diligence on its accounts, making the necessary adjustments to ensure a proper economic basis for valuing the company. Some companies are easy to analyse, others are more complicated, and others still are impossible. If the la er is the case, then you move on to the next one. This is what you would do if you were buying the company with your own money. As agents we ought to do the same. Once you have a proper basis for comparing valuations, how should you build
an investment strategy? How should you analyse the market? Or the economy? Within this book, I take the reader through this journey. This is the frame of mind that people should be in when reading this book. At the beginning and at the end of the process, there is an investor who has some capital and is expecting a return. There are similarities between CROCI and Alice in Wonderland. Once you go through the looking glass, it is difficult to go back to the old ways. Whatever is your journey, I hope you enjoy this book!
Kind regards
Francesco Curto
Foreword
David Bianco, CFA, DWS Americas CIO, DWS Group, New York
Francesco Curto’s Valuing and Investing in Equities takes readers through his career as an investor who steadfastly advises and practices disciplined valuation. He writes about his professional journey at Deutsche Bank and then DWS, while showcasing the valuation technique at the foundation of his investment philosophy and analysis for over 20 years, a technique called Cash Return on Capital Invested (CROCI).
He demonstrates the great importance of the CROCI metric throughout this book. He explains how CROCI quantifies the economic success of a company and how such an assessment is crucial to intrinsic valuation. CROCI is more precise in measuring capital invested and the income that it generates than other return on capital metrics, owing to both its calculation and its many adjustments to reported accounting figures. However, the CROCI analysis presented throughout this book on companies from all over the world shows that CROCI is much more than a metric or even a valuation technique. It is an analytical framework grounded in the concept of assessing the use of capital to determine whether shareholder value was enhanced. Investors cannot assess the future potential of any business unless they fully understand its past.
Francesco generously shares details of the CROCI framework and lessons learned from its application over the past two decades with readers as if repaying a debt from being fortunate enough to be introduced to such a conceptually sound and profitable analytical framework early on in his career by esteemed colleagues and mentors. He has taken this entrusted wisdom and lead a team
dedicated to improving and broadening the use of the CROCI framework for investment strategies at DWS. CROCI is an analytical tool and an investment strategy that once an investor has in their collection, they only wish they had it sooner.
Rigorously assessing the productive use of resources is the spirit of CROCI. Investors now consider all resources that an enterprise might use. Resources include capital, intellectual property, interaction with society and environmental conservation. Analytical frameworks such as CROCI, brilliant minds like Francesco’s and books like this one will help investors and all of us find our way.
Read this book and keep it on your shelf.
Preface
I was certainly confused when I first arrived at Deutsche Bank in September 1998 after some real-life experiences: my family business, a good undergraduate degree in Business Economics, an excellent postgraduate education and some time as Research Fellow in a business school. Notwithstanding this solid background, it still took me a few years to make sense of the world of equity investment. Joining a sell-side organisation at the beginning of the biggest valuation bubble in living memory certainly didn’t help, but I think I was probably not alone in struggling.
I arrived in Equity Research in the depths of the Emerging Markets crisis (the first of many crises in my professional career), and I was faced with a difficult choice. Which research team I should join: Semiconductor, Pharmaceutical, Chemicals, or Equity Strategy? In the end, I clicked with a Frenchman by the name of Pascal Costantini who was to become my mentor and dear friend. As the European Strategist, he collaborated in developing two valuation models. One was called Running The Numbers; the other, more advanced, was called Cash Return on Capital Invested (CROCI).
CROCI1 was designed to enable full comparability across sectors and markets. Miko Giedroyc had long been working on using valuation to analyse equity markets the papers he wrote around that time are still treasured in our vaults. Meanwhile, Pascal brought the magic touch. He defined the framework and the discipline. Their idea was to use CROCI both as a differentiating factor for stock pickers and also as an input in a bo om-up equity market approach. This approach provided an interesting contrast to the sort of methodologies coming to light in the 1999 TMT bubble. Dot.com companies were valued using Enterprise Value-to-“Click” in other
words, valuation on the basis of the number of clicks received by a given website. Forget about earnings or revenues. This new valuation ratio was interested only in potential revenue generation. Think of valuing a shoe company based on how many steps people take in the shop. Characteristic of the period, EV/click came and went, but when someone left CROCI to join the technology team and a food manufacturing analyst became a software analyst, I felt as though I were a dying breed. Sometimes, though, one needs to trust one’s instincts my contrarian nature has always made me sceptical of fashions. And in due course, things started to fall into place and my confusion about equity investment faded away. In 2004, CROCI was used for the first time as a method for investing directly in the market and since 2013 the team has been part of DWS.2 Twenty years on and here I am, writing a book about two decades of CROCI.
CROCI is, in its strictest sense, a valuation technique. However, CROCI has, over time, become a way of life, a holistic approach to investment in listed securities. I analyse companies, sectors and markets using the CROCI mindset; I look at how the economy works through the CROCI mindset; I think about how investments should be built and managed using the CROCI mindset; I think of what the final investor and client should want in terms of service and returns using the CROCI mindset; I even gave a presentation recently on geopolitics using this framework. CROCI simply permeates everything I do professionally. This holistic approach has limits and there are several other approaches for analysing the world of equities, but I believe that it comes closest to what equities ought to represent.
So what should the book focus on? I have given a lot of thought to this. I have spoken to Pascal, to my colleagues, to my clients. I even went to Greece to seek inspiration from the muses. Within this book, I share with the reader the CROCI framework for valuing and investing in equities. Valuing and investing in equities in theory ought to be simple, but in practice is a real muddle. The more you look at it, the more you get confused by the complexity of the environment, which is populated by both active and passive, investors and speculators;
regulators, multiple layers of intermediaries between the company and the final investors, the media and several academic theories.
There was a risk, as I endeavoured to write this book, that I would have ended muddying the water by trying to cover too many issues. I weighed the option of just focusing on valuation or on investment. I decided to combine the issues as valuation and investment ought to be seen as the two side of the same coin and too many errors are generated by trying to separate the issues. I hope that readers will find the eclectic approach helpful. If have succeeded, then this book ought to be useful to practitioners, professionals, investors, consultants, students and academics.
The book is divided into three sections. Valuation, Investment and Through the Looking Glass. They follow a brief introduction that reviews the challenges that investors face and the context to them. Chapter 1, Investment and valuation, introduces the three sections, it defines the framework and analyses the pillars of an investment process: capital and returns.
Section 1 is about valuation, the basis of an investment process. The challenges for investors start early as data used for valuation is not defined by investors but by accountants and you discover that there is on average a 50% difference in valuation if you use accounting data rather than economic/investment data (Chapter 2: Valuing nonfinancial companies). You also discover that valuation is the net result of two factors (earnings and discount rate) that can both mutate and there appears not to be an obvious framework for either (Chapter 4: Stock picking based on economic fundamentals). Even when you define such framework, you deal with an industry that is telling you all about one of the variable (earnings) but only about the next 2 years, which has only 20% impact on valuation (Chapter 4: Stock picking based on economic fundamentals). Starting from first principles, I provide how CROCI defines a clear framework for valuing equities and provide tangible examples to help the reader.
Section 2 is about investing in equities. Valuation has historically been used by stock pickers to select the most a ractive companies to invest in. I start by describing the challenges that stock pickers face
and focus on how CROCI has been used as a systematic framework for investing in equities.
In Section 3, I discuss how CROCI is used as a basis for fundamental research on equities. It is a cry for help to the academic world. Over the past few years, I have come across a number of simple issues where our analysis had something very different to say. “Through the looking glass” is a reference to the novels by Lewis Carroll.3 In the journey towards a be er understanding of valuation, capital and return, I have traversed the looking glass and there is no easy way back. In this section, I focus on two issues: how inflation distorts the long-term valuation of equities and bubbles in equities as a way to discuss the need for more and be er fundamental research on equities.
In the concluding Chapter 11, Odysseus on valuing and investing in equities, I summarise the main points that ought to be remembered when valuing and investing.
2The DWS Group is majority owned by Deutsche Bank AG.
3(Alice’s Adventures in Wonderland, 1865; and “Through the looking glass”, and what Alice found there, 1871).
Acknowledgements
I have always enjoyed research and because of that moving to Finance was not an obvious choice for me back in 1998. Now, with the benefit of hindsight, I could reflect on this as one of the best decisions I could have taken. I have been able to carry on research throughout my professional career and develop my learning. It would be fair to say that I landed in possibly the best team. There are things that cannot be rationally explained and this is where luck kicks in. I was certainly lucky to land in the CROCI team. Although I was not able to work for long with Miko, Pascal welcomed me and was my mentor for a decade. It has been a great personal and working relationship at many levels. His uncompromising a itude and disdain for noise have helped me more than I can say. If this is my book and present my interpretation of CROCI, it certainly would have not happened without them.
CROCI has now evolved into a team that does not depend on individuals anymore. It is a collective approach to valuing and investing in equities and nothing would have been possible without the contribution of everyone working in the team. This is a fully integrated framework starting from first principles, moving to the analysis of companies, doing fundamental research, and defining investment strategies. A lot of work is required and that demands a fine structure behind it. If Pascal and Miko gifted us with their visions of CROCI; Virginie Galas, Colin McKenzie, and Mital Parekh helped to make it. They remain my most senior colleagues and deserve a special mention. Markus Barth, Joe Hall, Chris Town, and Janet Lear are no longer in CROCI but have helped to make the team as it is today. Sarvesh Agrawal and Dirk Schlueter have been very loyal for years and together with the entire Mumbai team (Bharat,
Mukarram, Venkat, Vikash, Yogi, and the more recent joiners) are the cornerstone of what CROCI is today. They have endless patience in providing support to all that is done and will ensure a sound future for CROCI. Michael Yakir, Lynn Mulligan, Annie Bullock, and Gina Niehaus make sure the CROCI machinery keeps working smoothly and I can never thank them enough for it. Each deserves a special acknowledgement for everything they have and continue to do.
CROCI, as a process, is best suited for a fiduciary business and I have been (again) lucky to be part of the DWS Group (majorityowned by the DB Group) since 2013. A special mention goes to Stefan Kreuzkamp, a man of few words, who trusted and helped me to become a wiser manager.
Finally, I wish to thank Sco Bentley, who scouted me and encouraged me to write this book. Without his patience and guidance throughout the past few years, this book would not be published.
Introduction
Simplicity does not precede complexity, but follows it
(Alan Perlis)
The real investor, a connoisseur of financial markets
Cecil Graham: What is a cynic?
Lord Darlington: A man who knows the price of everything, and the value of nothing.
Cecil Graham: And a sentimentalist, my dear Darlington, is a man who sees an absurd value in everything and doesn’t know the market price of any single thing.
(Oscar Wilde, Lady Windermere).
What Oscar Wilde never defined was the person who knows the price of an asset and its intrinsic value. Given his bohemian a itude, he might have called that person a connoisseur of markets. My preference is for ‘the real investor’, the person who has an intrinsic knowledge of the three cornerstones of investing: the price of an asset, its value and everything that may affect them. I add the term real to investor to distinguish it from its common definition, any participant in financial markets. I believe that being an investor requires sound judgement of the difference between price and value. Simply buying a financial asset does not make someone an investor, but the owner of a financial asset whose intentions need to be established. The acquisition of a financial asset could be for speculative purposes or for investment purposes. Adding ‘real’
removes any ambiguity. It is clear then that I am referring to a competent and experienced market operator, deeply aware of the difference between price and value as well as everything that affects them.
Investment and speculation
This a ention to detail may sound fussy, but it is of fundamental importance. To clarify, let's compare an investor with a speculator. If, strictly speaking, an investor is interested in the difference between the price paid and the value received, then a speculator is someone only interested in making money through arbitrage between the price paid and the price received. That is to say, the focus of a speculator is strictly on ‘price’. A speculator knows that an event is taking place and assumes that it will have an impact on prices, so she takes a position that takes advantage of it. Given the nature of markets and how fast prices can change, speculators tend to be on high alert – their time frame is generally short. For investors, assessing the value of a company and its fundamentals is of primary importance. Investors need to undertake a time-consuming preliminary analysis that, once finalised, requires less monitoring than speculation does. Such investors focus solely on valuation and ignore relative performance. Unfortunately true investors are a rare breed. There are different factors driving equities (value, growth, momentum, size, liquidity, volatility, etc.), and ignoring other factors and focusing just on valuation may sometimes lead to a prolonged period of poor relative performance. The net result is that investors less extreme in their views can become stuck in the middle of the spectrum.
