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1 For Institutional and Registered Representative use only; Not for Public viewing or distribution. CROCI View October 2015 Value Traps Adjusting Valuation for Risk Value traps nightmare of equity investors The term value trap usually refers to a stock that appears cheap on valuation measures, but whose price never recovers or falls even further. Such stocks are an attendant risk to any value-based investment process. Within the CROCI team, we believe there are two types of value traps. The first type results from a lack of proper due diligence on a company s fundamentals. A company may seem cheap when valuations are based on unadjusted accounting data. But without the proper due diligence, investment might not be wise. CROCI s systematic adjustments to accounting data to derive an economic appraisal of a company (its Real Value ) have been at the heart of the CROCI process for nearly two decades. 1 A dedicated team of analysts perform due diligence on all available company data with the aim of thoroughly understanding that company s underlying economic nature. Based on the Real Value methodology, our analysis shows that cheaper companies have delivered better returns with a lower level of risk. The second type of value trap concerns the sustainability of earnings over the long term. A company may seem cheap based on its current earnings. But if these earnings were to fall in the future, then the company may actually turn out to have been expensive. The difficulty with this second type of value trap is finding a methodology that can properly adjust for it. Analyst forecasts are a possible starting point, but generally they are only focused on the next 2 to 3 years. The vast majority of cash flows which underpin the current share price are generated beyond the next few years. An additional problem with forecasts in general is their lack of reliability. Within this brief report, we introduce CROCI s way of identifying with this risk to incorporate share price volatility within the CROCI Economic Price-to-Earnings (P/E) ratio. Main Contributors: Francesco Curto Colin Mckenzie Sarvesh Agrawal Dirk Schlueter Other CROCI contacts: Markus Barth Virginie Galas Jean-Baptiste Mayer Karan Mehta Fabio Pinna Chris Town 1 Please see Appendix B for a full definition of the CROCI term Real Value Deutsche Bank AG This paper has been produced by the CROCI team of DeAWM and represents the views of only the CROCI team. It does not constitute investment advice, investment recommendation or independent research. The CROCI team bases its views on the application of the CROCI valuation methodology as well as its own views on the financial markets. The CROCI team does not manage client portfolios. The CROCI Investment Strategy and Valuation Group is responsible for devising the CROCI strategy and calculating the CROCI Economic P/E Ratios. The CROCI Investment Strategy and Valuation Group is not responsible for the management of the funds and does not act in a fiduciary capacity in relation to the funds or the investors in the funds. For distribution in the US and Canada only.

2 1 Value Trap Type I: Lack of due diligence In an ideal world, conventional price-to-earnings ratios should be comparable. In practice, however, they are not CROCI believes that the problem lies in the execution rather than in the financial theory. For example, look at the financial statements of Exxon. During the high inflation early 1980s, the company was required to report both conventional and inflation-adjusted accounts. These provide a glimpse into the distortions that inflation can cause. Revenues are generated over the reporting year and are therefore unchanged by inflation adjustments. However, depreciation is a function of historical cost assets. So, after adjusting for inflation, depreciation increases from $3.3bn to $5.9bn. The company looked profitable under conventional accounting, but after adjusting for inflation the profits turn into a loss. Figure 1: Selected data of Exxon from 1982 USD mn As reported Inflation-Adjusted Sales 103, ,559 Depreciation 3,333 5,929 Net Income 4, Equity 28,440 69,154 Return on Equity (ROE) 14.7% -0.4% Price-to-Earnings ratio (P/E) 5.9x NM Source: Deutsche Bank, CROCI, Exxon 1982 Annual Report. Example is for illustration only and does not constitute investment advice or recommendation. That s not all. Take another company, Coca-Cola, for the same period. Its inflation-adjusted profits are also lower but, because of its lower capital intensity and shorter asset lives, the impact is not nearly as significant. Figure 2: Selected data of Coca-Cola from 1982 USD mn As reported Inflation-Adjusted Sales 6,250 6,250 Depreciation Net Income Equity 2,779 3,617 Return on Equity (ROE) 18.4% 11.2% Price-to-Earnings ratio (P/E) 9.4x 11.9x Source: Deutsche Bank, CROCI, Coca-Cola 1982 Annual Report. Example is for illustration only and does not constitute investment advice or recommendation. Exxon looked cheaper based on reported accounts, but in reality, Coca-Cola was the cheaper company. Reported accounts should therefore be adjusted to reflect economic reality Inflation is only one example of the sort of distortion that can affect unadjusted data. To achieve a better understanding of the economic position of a company, CROCI believes that reported accounts need multiple adjustments, such as capitalizing hidden assets and operating leases; remedying inconsistent depreciation policies; and adding advance payments and retirement obligations to more conventional financial liabilities. The CROCI process was created almost two decades ago to do exactly this. Dedicated analysts rigorously perform due diligence on all available company data to thoroughly understand what CROCI believes to be the true economic nature of a company. They deconstruct the reported accounts and build them up again using consistent economic principles; the intention is to allow the confident comparison of companies regardless of region or sector. Real Value can be very different from unadjusted value Economic adjustments can substantially change the valuation and ranking of companies. Below are some selected examples. Figure 3: Valuation and ranking using reported and CROCI framework 2014 data Accounting P/E (ranking) Economic P/E (ranking) Amazon (10) 47.6 (10) Amgen 15.2 (7) 16.4 (3) Apple 12.9 (6) 14.0 (1) Gazprom 3.6 (1) 29.0 (8) General Motors 8.5 (3) 25.7 (7) IBM 11.2 (5) 15.8 (2) LVMH 17.0 (8) 18.2 (4) Orange 9.5 (4) 43.1 (9) Petrobras 8.5 (2) 19.2 (5) Pepsi 17.5 (9) 20.1 (6) Source: Deutsche Bank, CROCI, Factset Research Systems. These examples are for illustration only and do not constitute any investment advice or recommendation. Data is as of January 3, Amongst these 10 companies, Apple ranked as the sixth cheapest, based on accounting P/E. However, after economic adjustments had been made, it rose five places to become the cheapest company. Similarly, Gazprom looked like a deep value company with a P/E of just 3.6x, based on Deutsche Bank AG 2

3 accounting data. However, on CROCI s data, its Economic P/E rose to 29.0x, and it became the third most expensive stock. Exposure to the value end of the market has generated a higher return Figure 4 shows that between January 2000 and September 2015, companies with the lowest Economic P/E achieved a better return than those with a higher Economic P/E, without any increase in risk, simply by determining the Real Value of companies through thorough due diligence, and then by focusing on the most attractive companies in the market. Multiple academic studies have demonstrated that value works over the long term on average and some of our own data also supports this. But long-term performance does not come without short-term challenges. Not every seemingly cheap company sees its share price rise; remember that cheapness in a company can often indicate fundamental problems. But we believe that by using CROCI data rather than accounting-based data, the risk of missing information relevant to the investment decision is lower. The process tends to result in a portfolio with lower levels of financial liabilities, higher free cash flow generation and more attractive cash valuation and returns. been misled into thinking that the returns would rebound. That would have been a mistake, however, as Figure 5 shows. In the late 2000s, the returns fell even further and the company ultimately filed for bankruptcy. Figure 5: Eastman Kodak CROCI cash returns CROCI % 15% 10% 5% 0% -5% -10% -15% -80.8% CROCI ex Goodwill Unsustainable returns COC Source: Deutsche Bank, CROCI. Example is for illustration only and does not constitute investment advice or recommendation. Data as of 9/7/15. The risk of unsustainable earnings is attendant upon any measure focusing on spot valuation. But, unlike Type I value traps, a solution is not so easy to find. 2 Value Trap Type II: Sustainability of earnings The due diligence process described above, however, does not address the long-term sustainability of earnings. A company may look cheap on valuation, but if its earnings are not sustainable in the long term, then it may turn out to be an expensive investment. This is the second type of value trap. Eastman Kodak provides a good example of the Type II value trap. Cash returns averaged 6.6% in the 1990s but then fell below the cost of capital. Investors could have Forward looking valuation measures (such as next twelve month P/E) have been put forward as possible tools for addressing this risk. In effect, however, this relies on predicting the future, which makes us skeptical. Forecasts are often imprecise. Even if we did believe them to be accurate, they would still only provide estimates for the next two or three years, and so would fail to capture the bulk of the cash flows that underpin a company s value. An example will illustrate this. Consider a company whose price is $100 and whose earnings are $5. If the discount rate is 5%, then the next three years profits (on which analysts typically focus) account for only 14% of the price paid (i.e. the present value of $5 per year for three years, as a percentage of $100). Thus, these forecasts will not Figure 4: The lowest Economic P/E decile has generated the best return Performance of the CROCI coverage of the MSCI World Index by Economic P/E deciles between 1/1/00 and 9/30/15 Lowest Economic P/E Highest Economic P/E Deciles Annualized net total return 13.5% 9.7% 9.1% 7.6% 6.8% 5.0% 5.1% 6.4% 2.3% 0.9% Volatility 16.9% 17.0% 16.2% 16.3% 15.4% 16.0% 14.7% 14.9% 16.1% 20.9% Sharpe ratio (1.97%) Source: Deutsche Bank, CROCI, Datastream and Factset Research Systems. Data as of 10/6/15. Deciles are constructed from the CROCI coverage of the MSCI World Index. Annualized total return shows the compounded annual growth rate (CAGR) of each Economic P/E deciles between 1/1/00 and 9/30/15. Volatility shows the annualized standard deviations of daily log returns over this period. Performance is historical and does not guarantee future results. Deutsche Bank AG 3

4 capture 86% of the value of the company, which is derived from cash flows generated after the third year. Looking for a measure of long-term risk Estimating sustainability is difficult, but below we suggest one possible solution. Instead of looking at the past or future earnings, we look at the volatility of share price. This may seem counterintuitive, but the logic of using it as a measure of sustainability is straightforward. The price of any company is simply the present value of the future expected earnings of that company. Higher relative volatility of a company then suggests that there is greater uncertainty about future earnings of that company. Let s look at it through an example. Consider two value companies, A and B, with the same share price and current earnings. The volatility of their share prices, however, is materially different. Company A s volatility is 60%, but Company B s is only 15%. Both the companies are cheap, but because of lower volatility, we can assume, all other things being equal, that the market has more confidence in sustainability of Company B s earnings over the long term. Valuation ought to incorporate risk, but in reality it does not Modern Portfolio Theory postulates that an asset with higher risk should compensate investors with a higher expected return (i.e. lower P/E in the case of equities). Under this assumption, the distribution of expected return and risk across the market should resemble the following chart: Figure 6: Relationship between risk and return as suggested by portfolio theory 30% Excess return (over risk-free rate) 25% 20% 15% 10% 5% 0% 0% 10% 20% 30% 40% 50% 60% 70% Volatility Source: Deutsche Bank, CROCI. The data in this chart is hypothetical and is for illustration only. The data is not based on any empirical analysis. For the purposes of this paper, we use Economic Earnings yield (= 1/Economic P/E) as a proxy for Expected Return, and our analysis shows that there is no clear tendency for higher risk stocks to trade at lower Economic P/E. 2 In fact, it is remarkable that for stocks on the same Economic P/E, the range of associated volatilities can be very high: for example, in the following chart stocks on an earnings yield of 5% to 6% have exhibited volatilities anywhere between 15% and 35%. Thus, adjusting for risk is fundamental in a value-driven approach. Figure 7: There is no clear relationship between Economic P/E (1 / Economic Earnings Yield) and Volatility Trailing 12M Ec. Earning Yield 10% 8% 6% 4% 2% 0% 0% 10% 20% 30% 40% 50% 60% Trailing 12M Volatility Source: Deutsche Bank, CROCI, Datastream and Factset Research Systems. The chart shows the relationship between Economic Earnings yield (1/ Economic P/E) and volatility of the U.S., European and Japanese companies covered by CROCI. Companies with negative Economic Earnings yields are excluded from this analysis. Data as of 6/17/15. Adding a risk measure to Economic P/E We can use this approach to reduce the risk of Type II value traps, i.e. situations where the low P/E actually reflects the market s expectation of a structural decline in profitability. In performance terms, the picture is more uneven than for standard Economic P/E. However, as Figure 8 shows, both the cheapest decile and the cheaper half of our coverage have outperformed the broader coverage universe. The Sharpe Ratio (return per unit of risk) shows the merit of incorporating volatility into Economic P/E. The Sharpe ratio for the cheapest P/E decile after incorporating volatility is higher than that for standard Economic P/E. We therefore believe that incorporating share price volatility in valuation can thus be an effective way of dealing with the Type II value traps. Figure 8: The risk-adjusted return (Sharpe Ratio) of the cheaper deciles improves significantly when volatility is included in Deutsche Bank AG 4

5 Economic P/E Performance of the CROCI coverage of the MSCI World Index by Economic P/E deciles (inc. volatility) between 1/1/00 and 9/ 30/15 Lowest Economic P/E (inc. vol.) Highest Economic P/E (inc. vol.) Deciles Annualized net total return 12.8% 8.9% 9.6% 9.1% 7.6% 5.2% 6.0% 2.7% 2.8% 1.0% Volatility 12.7% 13.5% 14.3% 14.7% 15.5% 16.5% 16.9% 18.5% 19.9% 23.7% Sharpe ratio (1.97%) Source: Deutsche Bank, CROCI, Datastream and Factset Research Systems. Data as of 10/ 6/15. Deciles are constructed from the CROCI coverage of the MSCI World Index. Annualized total return shows the compounded annual growth rate (CAGR) of each Economic P/E deciles between 1/1/00 and 9/30/15. Volatility shows the annualized standard deviations of daily log returns over this period. Performance is historical and does not guarantee future results. Deutsche Bank AG 5

6 Appendix A: Introduction to CROCI Brief introduction to CROCI Cash Return on Capital Invested (CROCI) is a cash-flow-based analysis which, by making a series of economic adjustments to traditional accounting data, aims to make non-financial companies comparable - regardless of industry or domicile. The main areas where the economic data differ from the accounting data are as follows:- Accounting for hidden liabilities CROCI Enterprise Value (EV) includes not only financial liabilities (such as debt), but also operational liabilities (such as operating lease commitments, warranties, pension funding, specific provisions etc). Depreciating similar assets in a similar manner - Adjusting depreciation to reflect economic depreciation and effective useful economic life. Replacement value of assets Inflating the value of net assets using the relevant inflator (based on the age of assets). Unreported assets Systematically capitalizing cash-generative assets that are left off the balance sheet. Research and development costs and advertising are examples of such assets. Definitions: Enterprise Value (EV): Market value of equity (market cap), debt, and other liabilities, such as pension underfunding, warranties, leases. Net Capital Invested (NCI): Estimated replacement value of the economic asset base, comprising the inflation-adjusted tangible assets, capitalized intangible assets (e.g. brands, R&D), leases and net working capital. Cash Return on Capital Invested (CROCI): the economic equivalent of return on equity, is a real (inflation-adjusted) economic cash return. It is the internal rate of return of gross cash flows (taxed, adjusted EBDIT) over the average asset life of the company s assets against the gross capital invested. CROCI 5YA: Average CROCI over the past five years Economic PE (Ec PE): is the CROCI version of the PE ratio and is calculated as EV/(CROCI * NCI) or (EV/NCI)/CROCI EV/NCI: is the CROCI version of the price-to-book ratio and can be thought of as a proxy for replacement value or Tobin s Q at a company level. It is calculated by dividing EV by Net Capital Invested. Free Cash Flow (FCF) Yield: represents firm level free cash flow yield on EV. It is calculated before payment of interest on borrowed capital. Implied CROCI: Level of return implied by the market as sustainable. It is calculated as EV / NCI * Cost of Capital. Deutsche Bank AG 6

7 Appendix B: CROCI & Real Value Real Value: Economic value as calculated by the CROCI process via the adjustments to, and normalizations of, reported financial statements, conducted by CROCI s team of company analysts. Notes: The CROCI process seeks to make company financial data more consistent, comparable and economically meaningful through a series of reviews and adjustments. This contrasts with more conventional definitions of Value that tend to be based on accounting measures such as equity or profits. The principal indicator of Real Value is CROCI s Economic P/E. An attractive Economic P/E ratio suggests that the market is undervaluing the cash flow being produced by the operating assets, all other things being equal. The term Real Value can therefore be used attributively to refer to companies with the lowest CROCI Economic P/E. Real Investor: Definition: An investor whose investments are driven principally by the careful analysis of company fundamentals, including their economic cash returns and their economic valuation. Specifically, a Real Investor has two characteristics: 1. Fundamental: any investment is informed or driven by the interplay between the cash flow generation, the capital intensity and the valuation of that company. 2. Skeptical of reported financial statements as a guide to investing: Real Investors believe that the income statement and balance sheet in a company's accounts are not necessarily designed to be helpful to equity investors, and that a synthesis of all the notes to the accounts and diligent restatement of the accounts must happen in order to render valuations comparable and meaningful; and Real Investors look to economic value to inform investment, and believe that the reported financial statement data may not be representative of the economic reality of a company. Since CROCI makes adjustments to financial statements in order to include all relevant information in the notes to the accounts, and restates the accounts in order to render economic valuations, which are meaningful and comparable; CROCI may be one valuable approach. Deutsche Bank AG 7

8 Appendix C: Important Information on Backtested Data Backtested performance is not an indicator of future actual results. The results reflect performance of a strategy not historically offered to investors and do not represent returns that any investor actually attained. Backtested results are calculated by the retroactive application of a model constructed on the basis of historical data and based on assumptions integral to the model which may or may not be testable and are subject to losses. General assumptions include: The index would have been able to purchase the securities recommended by the model and the markets were sufficiently liquid to permit all trading. Changes in these assumptions may have a material impact on the backtested returns presented. This information is provided for illustrative purposes only. Backtested performance is developed with the benefit of hindsight and has inherent limitations. Specifically, backtested results do not reflect actual trading or the effect of material economic and market factors on the decision-making process. Since trades have not actually been executed, results may have under- or over-compensated for the impact, if any, of certain market factors, such as lack of liquidity, and may not reflect the impact that certain economic or market factors may have had on the decision-making process. Actual performance may differ significantly from backtested performance. Backtested results are adjusted to reflect the reinvestment of dividends and other income and, except where otherwise indicated, are presented gross-of-fees and do not include the effect of backtested transaction costs, management fees, performance fees or expenses, if applicable. All CROCI indices have a history that combines backtested data with live data. Inception dates refer to the first instance of a CROCI index which would have been backtested. Live dates refer to the moment in time when a particular CROCI index was no longer backtested (i.e. live ). All CROCI performance shown reflects the returns of an index and not any investment product, portfolio management or mandated strategy. Deutsche Bank AG 8

9 Further Information CROCI Team Deutsche Bank AG Important Information: This document is intended for discussion purposes only and does not create any legally binding obligations on the part of Deutsche Bank AG and/or its affiliates ( DB ). Without limitation, this document does not constitute an offer, an invitation to offer or a recommendation to enter into any transaction. When making an investment decision, you should rely solely on the final documentation relating to the transaction and not the summary contained herein. DB is not acting as your financial adviser or in any other fiduciary capacity with respect to this proposed transaction. The transaction(s) or products(s) mentioned herein may not be appropriate for all investors and before entering into any transaction you should take steps to ensure that you fully understand the transaction and have made an independent assessment of the appropriateness of the transaction in the light of your own objectives and circumstances, including the possible risks and benefits of entering into such transaction. You should also consider seeking advice from your own advisers in making this assessment. If you decide to enter into a transaction with DB, you do so in reliance on your own judgment. The information contained in this document is based on material we believe to be reliable; however, we do not represent that it is accurate, current, complete, or error free. Assumptions, estimates and opinions contained in this document constitute our judgment as of the date of the document and are subject to change without notice. Any projections are based on a number of assumptions as to market conditions and there can be no guarantee that any projected results will be achieved. Past performance is not a guarantee of future results. The distribution of this document and availability of these products and services in certain jurisdictions may be restricted by law. You may not distribute this document, in whole or in part, without our express written permission. CROCI is a registered trade mark of Deutsche Bank AG in certain jurisdictions. Deutsche Bank AG reserves all of its registered and unregistered trade mark rights. CROCI is DeAWM's proprietary equity valuation process and is a Deutsche Bank registered trademark. Deutsche Investment Management Americas, Inc. ("DIMA" or the "Advisor") intends to utilize the CROCI teams proprietary investment valuation process and indices to develop and manage investment strategies. - The CROCI valuation process is not managed or executed by Deutsche Investment Management Americas, Inc. ("DIMA"). - The members of the CROCI team are not employees of DIMA nor do they provide investment advisory services on behalf of DIMA. - However, DIMA expects to utilize the results of the CROCI team's proprietary investment process/methodology and indices in the development and management of certain investment mandates. Deutsche Asset & Wealth Management represents the asset management and wealth management activities conducted by Deutsche Bank AG or any of its subsidiaries. Clients will be provided Deutsche Asset & Wealth Management products or services by one or more legal entities that will be identified to clients pursuant to the contracts, agreements, offering materials or other documentation relevant to such products or services. R (10/15) 2015 Deutsche Bank AG. All rights reserved.