We think of ourselves as disciplined value investors, who are simply trying to systematically underpay for the assets we invest in. In our view, this is the best way to generate long-term outperformance – to underpay for future cashflows or earnings.
To do this, firstly we screen the entire global universe of stocks to focus in on the cheapest quintile – the 20% of stocks that look most lowly valued. This often means that something has gone wrong at a business – why would something be in the cheapest quintile of stocks if there was nothing wrong? So, typically, current earnings among the cheapest stocks will be well below historic norms.
There are only two types of businesses in the world – the ones that have a problem today and the ones that are going to have a problem tomorrow. That is why we focus on the ones with problems today. It is the problems that prompt the value opportunity.
Now, where the real fundamental research work begins is in identifying which problems are temporary and which are permanent. This is where we spend most of our time and we have a team of 25 people doing it. Approximately two-thirds of the stocks that pass our initial screen we will not pursue, either because we believe their problems are permanent or because we can’t figure it out and have no angle on it. That leaves us with about 6-7% of the global investment universe, where we will undertake a full fundamental research project, constructing detailed financial models, engaging with management and examining the bear-case perspective, all with the objective of fully understanding a company’s normalised earnings power.
What we are looking for is businesses that are actually fine – capable of recovering from their temporary problems, competitively well-positioned and set up for the long run. Last but not least, we believe it’s important to understand the downside. If we are buying a business when something has gone wrong, we want to make sure we are paying a price that already reflects the pain. Then we can feel confident that we will be exposing our clients to a positive skew in terms of potential future outcomes.
We know from history that the spread between the cheapest stocks and the most expensive stocks tends to become much more extreme when there is some form of new “thesis” in the world. That is what we saw in the dotcom bubble of 1999-2000, when the so-called “new paradigm” meant that anything to do with the internet performed really well and became extremely expensive, whilst the “old economy” stocks were left behind. That led to a significant spread between the cheapest stocks and the most expensive stocks for a period, but they then converged quickly when the bubble burst. A similar phenomenon occurred in the mid-to-late eighties, when Japan was briefly thought to be taking over the world.
Now we have another period during which the whole world is caught up in the same valuation phenomenon. In many different parts of the world, we are now way beyond where we were during the dotcom bubble. The valuation stretch in markets started long before the global pandemic shook the world, but last year’s health crisis amplified the dispersion between the expensive growth stocks, seen as COVID winners, and the substantially cheaper economically sensitive stock that are generally seen as COVID losers.
So, valuation has gone crazy again, but why should this change? One reason to expect it to change is that valuation extremes have always eventually normalised in the past. One other thing to point out is that recessions usually signal the start of a good value cycle. The fact that many of the cheapest stocks have a closer tie to the economy, means that value has cyclical element to it. Traditionally cyclical sectors such as industrials, consumer discretionary and financials, tend to get hammered on the way into a recession. But they then start to work immediately once earnings have bottomed. This is because, when you start to look to the other side of a recession, earnings from cyclical businesses typically outpace those of non-cyclical sectors. This effect tends to start when things feel at their bleakest, but it is sustained for several years into the recovery. This bodes extremely well for value investors around the world.
Another thing to consider is that interest rates have been a massive headwind to value over the last forty years. Interest rates in the US, and indeed across much of Europe, have been in consistent decline since the early eighties.
Official interest rates reflect the rate at which future cashflows are discounted, so a lower interest rate increases the value of future cashflows from equity investments. In theory, this should increase the current value of all equities, but it tends to favour growth companies, where a greater proportion of current value is deemed to be associated with future cashflows, more than it does value companies, where more of the value is associated with the here and now.
In reality, it is interesting that in the most recent move lower in interest rates, this theory has not been working. The most expensive stocks have continued to become even more expensive, but the cheapest stocks have actually become cheaper.
From here, of course, interest rates are now so close to zero that they cannot continue to move lower. Interest rates don’t need to go up for value to stage a recovery – they just need to stop declining. That is where we are now. We believe this sets up a multi-year opportunity in value, just because value stocks have become so cheap.
A really good example is Volkswagen, which is a holding in our global portfolio, in comparison to Tesla. Of course, Volkswagen has faced its challenges in recent years – we all remember Dieselgate – but these have acted as a catalyst for change within the business.
We are great believers in looking through the windshield rather than the rear-view mirror, to get a view of the future of a business, not its history. Companies can and do undergo change. There was a compelling reason for Volkswagen to get out of diesel and they started this in earnest a number of years back. Inevitably, electric vehicles (EV) represent the future for the automotive industry, and that is why the comparison between Volkswagen, which we own, and Tesla, which we do not own, is interesting.
If we look at the amount invested in EV to date, the amounts are broadly comparable. Volkswagen has invested a little less, but it has one more fully dedicated EV plant than Tesla. In terms of models, as of today Volkswagen has five, Tesla has four. But by 2025, Volkswagen will have 40 full EV models, Tesla will have eight. This is where it gets interesting. Volkswagen has so many powerful brands in its stable – such as Porsche, Audi, even Lamborghini – and it aims to port its EV technology into a wide range of brands and models by 2025. We estimate that, by 2025, Volkswagen will be producing three million EV cars a year, compared to two million from Tesla.
In terms of valuation, Volkswagen trades on approximately 6x earnings, Tesla trades on 156x earnings. I make these points to illustrate how low the valuation is for Volkswagen. There is a successful EV business hidden in Volkswagen, which investors are getting for free. Meanwhile, there is also a stream of c. $15bn a year in cashflow from the legacy internal combustion engine business, which is not going to zero very quickly.
The two big problems for value would be interest rates and the economy. As we’ve already discussed, interest rates are at zero and there is no room for them to fall further. Plus, there is room for optimism on the economy. It amuses me that people worry about something really bad happening to value, when the worst possible thing that could’ve happened, occurred in the second quarter of last year. We are currently seeing another bout of COVID in many parts of the world, but it is not having the same impact on corporate earnings and cashflows. This is a hugely important point. We should be feeling optimistic that, economically speaking, we are through the worst of this. And, if the vaccine works, as we move through 2021, we have the very real prospect of economic recovery, with a substantial amount of pent-up spending just waiting to be unleashed.
When you are analysing a business, don’t constrain yourself to a narrow viewpoint. To be honest, every major downturn tends to reinforce this discipline. Following the global financial crisis of 2007-09 we did modify what we were doing to build a more dramatic liquidity crisis scenario into our thinking. When COVID hit, my initial instinct was that we would have to sell a few positions that looked most threatened by what was unfolding. However, when we looked at the cashflow sensitivities, we saw that our anti-debt framework had really saved us. We didn’t have excess leverage in the portfolio.
So, this taught us yet again to stay loose. Don’t get tunnel vision. We do our best to estimate the future, but we must have a wide range of outcomes in mind, so we don’t get trapped. Remember everything in the cheapest quintile already has a problem – we cannot just assume that problem away. Murphy’s Law can always strike again, so stay loose.
Pzena is a fund manager for St. James's Place.
Where the views and opinions of our fund managers have been quoted these are not necessarily held by St. James's Place Wealth Management or other investment managers and are subject to market or economic changes. This material is not a recommendation, or intended to be relied upon as a forecast, research or advice.
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