Google-parent Alphabet and Netflix are actually value stocks rather than the growth companies they have come to be viewed as, according to Harris Associates’ Danny Nicholas.
Nicholas, a client portfolio manager at Natixis Investment Managers’ value-focused affiliate Harris Associates, said the stocks – part of the FAANG (Facebook, Amazon, Apple, Netflix, Google) group –are trading at a significant discount to their intrinsic value.
Multi-national tech conglomerate Alphabet and online subscription media provider Netflix, he said, are underrated and under-priced: two of the main characteristics of value stocks.
According to Nicholas, the reason many value managers don’t include companies such as Alphabet in their portfolio is that they often overlook the intangible assets the company has.
The intangible assets, he said, are a key aspect to consider when taking a value approach, together with the tangible and the price-to-book value.
Reducing the spectrum of stocks value funds can own by screening for a low price-to-book value, he said, leads investors to invest in companies that may be trading at low multiples, but that lack the intangible assets that make a stock a true value stock.
“What you need in your active managers is an approach that can value the whole business and takes those really rigorous steps to value the whole business looking at the earning assets and the non-earning assets,” he explained.
“Alphabet is 26x earnings, so it has a high P/E [price-to-earnings ratio]. Value managers wouldn’t own Google but if you adjust the earnings to try to figure out what it is worth as a per cent of Alphabet, you can quickly find out that Google’s earnings are being hurt by the venture capital investments.
“These venture capital investments are expensed today but they are generating intangible assets that we think have a value in the future.”
Performance of Alphabet over 5yrs
Source: Google Finance
An example of Alphabet’s intangible assets is US video-sharing website YouTube, which was bought by Google for $1.6bn in 2006. YouTube, Nicholas said, has chosen to grow users and subscribers but is not monetising them.
“YouTube has grown this huge viewership and, if you took a private equity approach to say ‘how do we value that viewership’ and come up with an intangible asset, we think it could be worth $400 a share,” said Nicholas.
“Let’s call it $200 per share. You then take Alphabet’s share price of $1,000 and subtract out $200 and you get closer to what Google is worth.”
The self-driving technology company Waymo, which originated as a project of Google and then became a subsidiary of Alphabet, is another intangible asset.
“We believe Alphabet’s management team has been very wise to allocate their current free cash flow to grow this intangible asset and, if you were to value that, there will be an asset value there as well,” the manager said.
“So, you can subtract out all these assets in the future from the share price to come up with the Google price.”
He added: “We would also then increase the earnings-per-share because today all of those expenses from those future assets are coming out of current earnings, they are depressing earnings.
“So, if you move up earnings to about $55 a share and then you have that Alphabet price you’ll get closer to 15x P/E multiple for Google. We think there’s value, there is a margin of safety there.”
Alphabet is one of the top 10 holdings of the $2.2bn Natixis Harris Associates Global Equity fund, a strategy the managers define as “employing a disciplined value approach and long-term absolute return orientation”.
Other top holdings include Lloyds Banking Group, car makers Daimler and General Motors, and financial services provider Mastercard.
Another holding that would never be present in a value-oriented fund but is considered under-appreciated by the team at Harris Associates is Netflix.
Performance of Netflix over 5yrs
Source: Google Finance
According to Nicholas, Netflix can today be compared to cable and satellite television network HBO.
“The idea was that for Netflix, it was going to be too expensive to spend on content to meet the content value of HBO,” he explained.
“However, they have ended up doing a very smart thing: they are giving up current earnings for future subscribers.”
He added: “Netflix have placed their product at $10 per subscriber per month and what we would actually see is that other subscription services – like for example Apple music – are actually closer to $15 a month.
“So, if they were to raise their prices 50 per cent in line with other subscription services, the stock multiple would go from 100x to 15x earnings.”
Nicholas believes current earnings in rule of thumb multiples may mislead investors, who may end up buying into the wrong type of businesses that aren’t growing.
To decide whether a stock has intrinsic value and add it to the portfolios, Nicholas said it takes into consideration three criteria.
Firstly, the business has to be growing per share value. Other value managers may not look for that but may look for price first. But by focusing on price first they may invest in value traps, he said.
The team then focuses on the company’s management team, who Nicholas said have to “think and act as owners” and know how to defend the business, how to generate excess economic return and how to allocate the excess-free cashflow.
“A new buy in our portfolio would have to start at 70 per cent of value or a 30 per cent discount to our view of intrinsic value,” he explained.
Performance of fund vs sector and benchmark since launch
Source: FE Analytics
Since launch, Natixis Harris Associates Global Equity has delivered a 73.73 per cent total return compared with a 77.41 per cent gain for the average fund in the IA Global sector and a gain of 98.49 per cent for the MSCI World index.