If I get kicked out of the value investor club, so be it.

A lot of people want to know if we can still call ourselves value investors, or is there a style shift happening in our funds? It’s a question we received after our recent roadshow, when we revealed that around a third of our Forager Australian Shares Fund (FASF) is currently invested in tech stocks.

Value may include strong growth prospects

For me, value investing has always meant investing in a company’s stock at a significant discount to the company’s underlying value. This has often priced in companies with significant growth prospects, so long as those growth prospects are not reflected in the stock price.

Going back five years to our 2017 performance report, many of the top performers that year were growth companies and technology companies.

Jumbo InteractiveGBST (since delisted) and To believe were all technology stocks. Jumbo and GBST were barely profitable when we bought them. Dicker data was a growth stock (even though it was trading on a low earnings multiple at the time of acquisition).

Jumbo Interactive

Dicker data

Source: Morningstar.com

Most of our historically successful investments were in companies that grew, even if their price was not expected to grow at the time of our first investment.

The best-known value investors are perfectly capable of valuing growing companies. One of Warren Buffett’s most successful investments, the Coca-Cola Company, was one of the biggest growth stocks of the 20th century. Seth Klarman’s publicly disclosed holdings currently include Amazon and semiconductor company Qorvo.

Clinging to the nickname of value

The challenge is that the understanding of what constitutes a value investor has changed with the rise and rise of index funds. By categorizing the market as either ‘value’, for stocks with high dividend yields and low price-to-earnings ratios, or ‘growth’, for those with the opposite characteristics, index providers were able to offer factor funds.

But I’m not ready to give up the nickname just yet. Value investors valued growth companies long before the index fund existed, and the distinction between us and everyone else is still important.

Quality and growth are not criteria for our portfolios, but simply inputs into our valuations. We want to own quality when it’s unloved or underappreciated, not quality for quality’s sake. We currently have investments in Seven Media Westmining services and Qantas, and neither would respond to a “quality” filter. We simply invest on estimates of future cash returns to shareholders. This is also true of Global RPMwhere income will increase.

Not anymore, because the time has come

There are two good reasons why we have ‘drift’ towards a higher allocation to growth companies over the past few years.

FirstLook at this 2017 list and you’ll also see Boom Logistics, Hughes Drilling and RNY Property Trust, a group of asset-heavy companies we’ve invested in at substantial discounts to the ‘value’ of their tangible assets. These did not do well and were later joined by Thorn Group and iSelect, equally “cheap” stocks that never generated the expected profits. Every business has a price. But the gap between the right price for a shrinking business and a growing one is a chasm. We have learned this more than once.

Second, investors should expect us to “drift” a lot. We have a particularly high weighting for tech stocks at the moment, but they are all established companies with predictable and growing revenue streams.

Investors didn’t care about earnings 18 months ago and tech stocks traded on earnings multiples. Today, stock prices have been absolutely hammered and everyone cares about nothing but profitability.

The change in accounting standards is an opportunity

Yes, some of them are currently reporting losses. But much of that depends on making significant investments to attract new customers, rather than thinking about the profitability of existing customers. Twenty years ago, accounting standards allowed companies to capitalize customer acquisition costs and allocate expenses over the life of the expected revenue stream. This, predictably, has led to a proliferation of aggressive, unrealistic assumptions and overstated profitability.

Today’s accounting standards, where all customer acquisition costs are charged up front, lead to an understatement of economic reality.

For the value investor, this is where the opportunity lies. These companies are no more difficult to value than most, and our estimates have not changed significantly over the past 18 months. Yet some stock prices are 70% below, taking them from premiums to our valuation estimates to deep discounts. We buy them when they are cheap.

If the price of these stocks goes up a lot and everyone gets bullish, you should expect us to move on to the next sector that is no longer in vogue.

If that kicks us out of the value investing club, so be it.

Steve Johnson is CIO at Browse funds, a Sydney-based boutique fund manager. This article provides background information to help you understand our investment approach. It does not take into account your personal situation and may not be suitable for you.

Robert D. Coleman