The conceptual premise supporting Cardinal’s investment approach is that a company’s ability to generate excess cash flow and redeploy that cash to enhance shareholder value determines its long-term value. From a market and opportunity perspective, Cardinal believes that if there is no change, earnings are a good proxy for cash flow, and if there is good analyst coverage, the equity market is relatively efficient. However, when there is change, earnings are a poor proxy for cash flow, and if there is little analyst coverage, equity prices may not reflect underlying values. Many traditional value investment approaches buy stocks based on financial statistics and value stocks relative to the market; however, Cardinal believes that conventional measures of value, such as earnings and book value, can be overly influenced by accounting conventions and provide no sustainable competitive advantage. Instead, Cardinal seeks to generate above-average returns with less risk of loss by buying good businesses at a discount and valuing a company’s equity to target a high absolute return. The dissemination of information when there is change prevents many managers using backward-looking screen-based approaches from identifying the investment opportunities that Cardinal seeks. For example:
- Opportunities arise because of the conventional wisdom that earnings, which can be overly influenced by accounting conventions, are a suitable proxy for free cash flow. Cardinal believes that companies that use little working capital, require low maintenance capital expenditures and pay little in cash taxes are systematically undervalued by the stock market because these measures are not adequately captured in traditional earnings-based valuations.
- The market favors organic revenue growth, is often willing to pay a premium for it and is biased towards assuming that current growth will persist. By contrast, Cardinal is comfortable with revenue growth that comes via acquisition so long as the rate of return on the acquisitions is satisfactory, and the opportunity set is sufficiently large to make the strategy sustainable. The focus is not on a company’s current revenue growth rate, but instead on achieving high long-term reinvestment rates on its free cash flow.
- The market prefers improving short-term earnings growth. Cardinal believes that near-term earnings changes have little bearing on long-term value creation.