Commentary
Overview
We were ill-prepared for the pandemic and slow to recognise the significance of the first reports from China in January and the worsening situation in February. Had we been quicker, there are changes which we would have made: in particular, reducing exposure to banks and airlines. As it is, we made one significant change a month ago with the sale of easyJet; we have subsequently bought back (a smaller position) after a 40% fall in the share price since sale.
We are constantly re-evaluating all our holdings – the fundamental factors, balance sheets, and share prices - in this extraordinary difficult environment in which making any kind of forecast about the immediate future, always suspect, is almost ridiculous. The three things which we can be sure of are, first, that revenues for most companies will be sharply impacted for a while, and they will have large losses; second, that governments will ‘do whatever it takes’ to protect their economies; third, that the companies whose shares we hold have low valuations in any normal circumstances (but that, of course, begs the question as to when normal will return, and what a new normal will look like).
The various government measures – guarantees, loans, subsidies, grants, deferrals, reductions – are being referred to often as stimulus, but this is a misnomer. These are all part of a relief operation; the stimulus will, we believe, come later when Covid 19 is judged to have receded. Stimulus then will be vitally necessary to get economies moving again. Ironically the global financial crisis (GFC) has made possible the economic measures which with luck will offer remedies, though ultimately dangerous, to the current crisis: the GFC created zero and near-zero interest rates which make government borrowing on an enormous scale possible; and in the years after the GFC we discovered, or rediscovered, quantitative easing and helicopter money. Central banks will inflate their balance sheets without constraint, and will buy newly issued government bonds. A multinational agreement about the fiscal boost, which Gordon Brown has argued for, seems very necessary since otherwise particular currencies would be hecticly volatile; but if everyone is doing it there need be no particular major currency victim.
All the same, higher inflation seems a likely eventual outcome of the recovery. In the initial stages, with so much capacity having been frozen or taken away altogether, demand seems likely to outstrip supply, pushing up prices; and in the medium term so much monetary fuel, with still low interest rates encouraging governments not to hesitate in keeping the taps flowing and central banks preferring to err on the side of generosity, should be inflationary. Tim Congdon pointed out in the Financial Times that within two years of the end of each of the twentieth century world wars, inflation in Britain was over 20%. We may finally have seen the peak in bond markets after nearly four decades, and the low in inflation.
Portfolio commentary
We are sorry to be reporting such painful results; while we can be sure of more market turbulence in the short term, we feel that in the long run shares in the portfolio are seriously undervalued. The priority is to be as sure as possible that the companies in which we have invested will survive. In some cases their income is a fraction of the normal level while their fixed costs largely remain. This involves reassessing balance sheets, reviewing debt structures and maturities, and checking levels of, and access to, liquidity. EasyJet is one company to which this question applies particularly. We have never before sold and repurchased shares in the same company within the month, as we have now done with easyJet. We suspect that the new normal, when it arrives, will involve less flying, but we regard easyJet as one of the strongest companies in the sector. Governments can be expected to intervene to rescue the largest national airlines – the Italian government has already announced the nationalisation of Alitalia, and the French government has not ruled out nationalisation of Air France – but there are 200 airlines in Europe which together account for 30% of flights, and many of these are likely to vanish. Even allowing for losses as a result of not flying for the next 12 months, we think that easyJet shares are worth more than £10, compared with the current price of £6. If the company repays debts resulting from these losses over the following 18 months, our original target price of £22 over the next three or four years is achievable.
Stagecoach also is suffering from the disappearance of passengers during the lockdown. Net debt is 1.9 times last year’s earnings before interest, tax and depreciation. Last year sales in the bus division (the train operations now being irrelevant since they have lost their franchises) were about £1 billion; they have close to £300 million in cash and just over £300 million in loan facilities outstanding. In the short term it will be necessary for them to get the banks to waive loan covenants. In the medium term, operating margins in bus services have been extremely steady at around 10% and there is no reason to think that this will change significantly. Net margins are, normally, around 5 to 6%. With a current market capitalisation of around £500 million, the normalised price earnings ratio is therefore under 10, for what should be, again normally, a steady business.
East Japan Railway is also vulnerable to a reduced level of passenger traffic. 27% of journeys are by commuters. Again this is a very steady business. Operating profits have moved in a narrow range over the last five years, between ¥427 billion and ¥487 billion, despite the highly disruptive typhoon in one of those years. Japan has been remarkable in dealing with natural disaster. The caution of Japanese companies has sometimes been a frustration, but it is now an enormous strength. Both Toyota Industries and Kyocera have no net debt, instead large amounts of Treasury cash. Both are on very modest valuations – less than book value, and moderate price earnings ratios.
The banking sector has been hard hit. Lloyds share price was down 36% in local currency terms in March, Alpha Bank down 48%, MUFG down 22% and Deutsche down 26%. All the banks have much stronger balance sheets than they had in 2008-9. Leading banks internationally have a capital ratio (common equity tier 1) of around 12-14%, compared with 2-5% in 2007. In the Bank of England’s most adverse stress scenario, Lloyds Bank would have a ratio of more than 11% compared with a hurdle rate of 7.5%. In their own severe downside scenario, the bank assumes additional provisioning of £1.4 billion. More, of course, might be necessary. This compares with a charge of £2.2 billion in 2019 for PPI mis-selling. On its mortgage book, Lloyds has a loan to value ratio of 43%. Though the stress may be even greater, these stress tests give some comfort. Like the other bank holdings in the portfolio, Lloyds trades at a fraction of book value.
Among the most cyclical companies in the portfolio is ArcelorMittal, the steel company. Net debt, €9 billion, is now at the lowest level since Arcelor and Mittal merged, and compares with operating cash flow last year of €6.5 billion. It is one of the least geared steel companies as well as the largest, with sales of €70 billion last year, producing 90 million tonnes of steel, and a market capitalisation now of less than €10 billion.
Liquidity has been an increasing concern in markets. The average market capitalisation of companies in the portfolio is $17 billion. There are two small companies, Stagecoach and Reach, with market capitalisations less than $1 billion. Reach, the company resulting from the merger of the two newspaper companies that publish the Mirror and the Express, is remarkably undervalued and, were it not for its liquidity, we would want to add. The company had £122 million in net income in 2019 and has a market capitalisation of £300 million, the valuation reflecting extreme caution about newspaper sales. Circulation is indeed declining fast, but Reach has successfully cut costs and is increasing the proportion of sales, now 15%, which come from digital. They have no debt, cash of £20 million and a £65 million facility. They are vulnerable to a decline in advertising revenues which account for 22% of print revenues. The shares fell 29% in March (and 23% year-to-date, having given a return of 142% last year).
We can claim very few companies that have been doing well during this crisis. Tesco has hired 20,000 extra employees (an increase of 10%) to deal with extra demand. The share price rose slightly during March. The price-earnings ratio is just over 10. Trading margins have been steadily increasing from the nadir several years ago and are now at 4.5%, while debt has been reduced and will be reduced further by the sale of the Thai subsidiary for £8 billion. Barrick Gold, also up marginally during the month, has benefited from a great deal of operational progress as well as the strength in the price of gold.
Conclusion
Those who read these newsletters know all too well that we are firmly committed to “value” investing. This is not some whimsical affectation; it comes from a firm conviction that over time investing in companies with low valuations tends to produce good returns. “Tends” is a caveat: there are periods when it does not, and this has been one of them, an unduly and painfully long period in which the commitment to this style not only means our investors in these portfolios missing out on major technological innovation but also being concentrated in some cyclical companies which are then vulnerable to the sort of shock (not that there has ever been anything quite like this) that we are now seeing. We remain committed both because it is in our blood and because statistics show its long-term advantages.
A friend with a very different investment approach recently said to us “the inability for quantitative models to take on board behavioural change is embarrassing.” He has a point. Quantitative models do not explicitly allow for behavioural change; but behavioural change is not a novelty which has suddenly emerged in the last 10 years, and quantitative models do implicitly take account of all sorts of changes over the periods to which they apply. Ibbotson Associates, an investment consulting firm, found in a recent study that, since 1927, “value” (focussing on the portion of markets consisting of companies with low valuations in terms of price-earnings, price-sales, price-book, price-cash flow, and dividend yields) has outperformed growth in 84% of all the 10-year periods.
We have just had a 10-year period in which this has not been the case. The last really good year (apart from very mild outperformance last year) in this ex-US strategy was 2016. The last really good longer period was 2009-10 when the return was 77% in US dollar terms, 66% in sterling terms. The background now is utterly different from that in 2009 or 2016, but the similarity is that, focusing on valuations, we see the upside to our target valuations at levels previously only reached on those two occasions when it happened that exceptionally strong returns followed.
We have confidence in the medium term for the portfolio – three to five years. The near term is different: there might, as is typically the case, be a retest of market lows as the news worsens in coming weeks. If we knew that to be so we could take some actions, selling some of the most vulnerable holdings in the hope of reinvesting when the clouds clear. But the chances of getting that right are minimal, while we believe that the chances of strong returns from these very depressed levels over the medium term are good; and so here we stand.
Operational resilience
These are difficult times for us all and we want to reassure you that at Oldfield Partners our staff are healthy, our systems and processes are resilient, and we are operating as close to normal as possible. The investment team are communicating with each other constantly and our weekly investment meeting takes place via video conference. Our research effort continues unaffected.
Liquidity
A key part of our operational risk analysis is to focus on the liquidity of the portfolio. We are pleased to report that over the recent period of volatility we have not experienced any issues with the underlying liquidity of our holdings. Our focus on the larger end of the market capitalization scale and on the underlying liquidity of our holdings proves its worth at times like these. This is monitored by our Risk Management Committee.
Commentary
Overview
We were ill-prepared for the pandemic and slow to recognise the significance of the first reports from China in January and the worsening situation in February. Had we been quicker, there are changes which we would have made: in particular, reducing exposure to banks and airlines. As it is, we made one significant change a month ago with the sale of easyJet; we have subsequently bought back (a smaller position) after a 40% fall in the share price since sale.
We are constantly re-evaluating all our holdings – the fundamental factors, balance sheets, and share prices - in this extraordinary difficult environment in which making any kind of forecast about the immediate future, always suspect, is almost ridiculous. The three things which we can be sure of are, first, that revenues for most companies will be sharply impacted for a while, and they will have large losses; second, that governments will ‘do whatever it takes’ to protect their economies; third, that the companies whose shares we hold have low valuations in any normal circumstances (but that, of course, begs the question as to when normal will return, and what a new normal will look like).
The various government measures – guarantees, loans, subsidies, grants, deferrals, reductions – are being referred to often as stimulus, but this is a misnomer. These are all part of a relief operation; the stimulus will, we believe, come later when Covid 19 is judged to have receded. Stimulus then will be vitally necessary to get economies moving again. Ironically the global financial crisis (GFC) has made possible the economic measures which with luck will offer remedies, though ultimately dangerous, to the current crisis: the GFC created zero and near-zero interest rates which make government borrowing on an enormous scale possible; and in the years after the GFC we discovered, or rediscovered, quantitative easing and helicopter money. Central banks will inflate their balance sheets without constraint, and will buy newly issued government bonds. A multinational agreement about the fiscal boost, which Gordon Brown has argued for, seems very necessary since otherwise particular currencies would be hecticly volatile; but if everyone is doing it there need be no particular major currency victim.
All the same, higher inflation seems a likely eventual outcome of the recovery. In the initial stages, with so much capacity having been frozen or taken away altogether, demand seems likely to outstrip supply, pushing up prices; and in the medium term so much monetary fuel, with still low interest rates encouraging governments not to hesitate in keeping the taps flowing and central banks preferring to err on the side of generosity, should be inflationary. Tim Congdon pointed out in the Financial Times that within two years of the end of each of the twentieth century world wars, inflation in Britain was over 20%. We may finally have seen the peak in bond markets after nearly four decades, and the low in inflation.
Portfolio commentary
We are sorry to be reporting such painful results; while we can be sure of more market turbulence in the short term, we feel that in the long run shares in the portfolio are seriously undervalued. The priority is to be as sure as possible that the companies in which we have invested will survive. In some cases their income is a fraction of the normal level while their fixed costs largely remain. This involves reassessing balance sheets, reviewing debt structures and maturities, and checking levels of, and access to, liquidity. EasyJet is one company to which this question applies particularly. We have never before sold and repurchased shares in the same company within the month, as we have now done with easyJet. We suspect that the new normal, when it arrives, will involve less flying, but we regard easyJet as one of the strongest companies in the sector. Governments can be expected to intervene to rescue the largest national airlines – the Italian government has already announced the nationalisation of Alitalia, and the French government has not ruled out nationalisation of Air France – but there are 200 airlines in Europe which together account for 30% of flights, and many of these are likely to vanish. Even allowing for losses as a result of not flying for the next 12 months, we think that easyJet shares are worth more than £10, compared with the current price of £6. If the company repays debts resulting from these losses over the following 18 months, our original target price of £22 over the next three or four years is achievable.
Stagecoach also is suffering from the disappearance of passengers during the lockdown. Net debt is 1.9 times last year’s earnings before interest, tax and depreciation. Last year sales in the bus division (the train operations now being irrelevant since they have lost their franchises) were about £1 billion; they have close to £300 million in cash and just over £300 million in loan facilities outstanding. In the short term it will be necessary for them to get the banks to waive loan covenants. In the medium term, operating margins in bus services have been extremely steady at around 10% and there is no reason to think that this will change significantly. Net margins are, normally, around 5 to 6%. With a current market capitalisation of around £500 million, the normalised price earnings ratio is therefore under 10, for what should be, again normally, a steady business.
East Japan Railway is also vulnerable to a reduced level of passenger traffic. 27% of journeys are by commuters. Again this is a very steady business. Operating profits have moved in a narrow range over the last five years, between ¥427 billion and ¥487 billion, despite the highly disruptive typhoon in one of those years. Japan has been remarkable in dealing with natural disaster. The caution of Japanese companies has sometimes been a frustration, but it is now an enormous strength. Both Toyota Industries and Kyocera have no net debt, instead large amounts of Treasury cash. Both are on very modest valuations – less than book value, and moderate price earnings ratios.
The banking sector has been hard hit. Lloyds share price was down 36% in local currency terms in March, Alpha Bank down 48%, MUFG down 22% and Deutsche down 26%. All the banks have much stronger balance sheets than they had in 2008-9. Leading banks internationally have a capital ratio (common equity tier 1) of around 12-14%, compared with 2-5% in 2007. In the Bank of England’s most adverse stress scenario, Lloyds Bank would have a ratio of more than 11% compared with a hurdle rate of 7.5%. In their own severe downside scenario, the bank assumes additional provisioning of £1.4 billion. More, of course, might be necessary. This compares with a charge of £2.2 billion in 2019 for PPI mis-selling. On its mortgage book, Lloyds has a loan to value ratio of 43%. Though the stress may be even greater, these stress tests give some comfort. Like the other bank holdings in the portfolio, Lloyds trades at a fraction of book value.
Among the most cyclical companies in the portfolio is ArcelorMittal, the steel company. Net debt, €9 billion, is now at the lowest level since Arcelor and Mittal merged, and compares with operating cash flow last year of €6.5 billion. It is one of the least geared steel companies as well as the largest, with sales of €70 billion last year, producing 90 million tonnes of steel, and a market capitalisation now of less than €10 billion.
Liquidity has been an increasing concern in markets. The average market capitalisation of companies in the portfolio is $17 billion. There are two small companies, Stagecoach and Reach, with market capitalisations less than $1 billion. Reach, the company resulting from the merger of the two newspaper companies that publish the Mirror and the Express, is remarkably undervalued and, were it not for its liquidity, we would want to add. The company had £122 million in net income in 2019 and has a market capitalisation of £300 million, the valuation reflecting extreme caution about newspaper sales. Circulation is indeed declining fast, but Reach has successfully cut costs and is increasing the proportion of sales, now 15%, which come from digital. They have no debt, cash of £20 million and a £65 million facility. They are vulnerable to a decline in advertising revenues which account for 22% of print revenues. The shares fell 29% in March (and 23% year-to-date, having given a return of 142% last year).
We can claim very few companies that have been doing well during this crisis. Tesco has hired 20,000 extra employees (an increase of 10%) to deal with extra demand. The share price rose slightly during March. The price-earnings ratio is just over 10. Trading margins have been steadily increasing from the nadir several years ago and are now at 4.5%, while debt has been reduced and will be reduced further by the sale of the Thai subsidiary for £8 billion. Barrick Gold, also up marginally during the month, has benefited from a great deal of operational progress as well as the strength in the price of gold.
Conclusion
Those who read these newsletters know all too well that we are firmly committed to “value” investing. This is not some whimsical affectation; it comes from a firm conviction that over time investing in companies with low valuations tends to produce good returns. “Tends” is a caveat: there are periods when it does not, and this has been one of them, an unduly and painfully long period in which the commitment to this style not only means our investors in these portfolios missing out on major technological innovation but also being concentrated in some cyclical companies which are then vulnerable to the sort of shock (not that there has ever been anything quite like this) that we are now seeing. We remain committed both because it is in our blood and because statistics show its long-term advantages.
A friend with a very different investment approach recently said to us “the inability for quantitative models to take on board behavioural change is embarrassing.” He has a point. Quantitative models do not explicitly allow for behavioural change; but behavioural change is not a novelty which has suddenly emerged in the last 10 years, and quantitative models do implicitly take account of all sorts of changes over the periods to which they apply. Ibbotson Associates, an investment consulting firm, found in a recent study that, since 1927, “value” (focussing on the portion of markets consisting of companies with low valuations in terms of price-earnings, price-sales, price-book, price-cash flow, and dividend yields) has outperformed growth in 84% of all the 10-year periods.
We have just had a 10-year period in which this has not been the case. The last really good year (apart from very mild outperformance last year) in this ex-US strategy was 2016. The last really good longer period was 2009-10 when the return was 77% in US dollar terms, 66% in sterling terms. The background now is utterly different from that in 2009 or 2016, but the similarity is that, focusing on valuations, we see the upside to our target valuations at levels previously only reached on those two occasions when it happened that exceptionally strong returns followed.
We have confidence in the medium term for the portfolio – three to five years. The near term is different: there might, as is typically the case, be a retest of market lows as the news worsens in coming weeks. If we knew that to be so we could take some actions, selling some of the most vulnerable holdings in the hope of reinvesting when the clouds clear. But the chances of getting that right are minimal, while we believe that the chances of strong returns from these very depressed levels over the medium term are good; and so here we stand.
Operational resilience
These are difficult times for us all and we want to reassure you that at Oldfield Partners our staff are healthy, our systems and processes are resilient, and we are operating as close to normal as possible. The investment team are communicating with each other constantly and our weekly investment meeting takes place via video conference. Our research effort continues unaffected.
Liquidity
A key part of our operational risk analysis is to focus on the liquidity of the portfolio. We are pleased to report that over the recent period of volatility we have not experienced any issues with the underlying liquidity of our holdings. Our focus on the larger end of the market capitalization scale and on the underlying liquidity of our holdings proves its worth at times like these. This is monitored by our Risk Management Committee.