Commentary
“The basic situation is wonderfully clear. In all free-enterprise (once called capitalist) attitudes there is a strong tendency to believe that the more money, either as income or assets, of which an individual is possessed or with which he is associated, the deeper and more compelling his economic and social perception, the more astute and penetrating his mental processes. Money is the measure of capitalist achievement and the intelligence that supports it.” JK Galbraith - A Short History of Financial Euphoria.
The success or failure of differing investment strategies naturally confers upon them an efficacy building confidence in those that follow them and creating a fear of missing out in those that have stood outside. This leads to all manner of pressures on participants in the financial markets and leads many to do things that they do not truly believe. These pressures build and build, making it harder and harder for others not to follow the prevailing strategy of the day which becomes the accepted wisdom of the crowd. Galbraith has observed this in financial markets throughout history. This naturally sets the conditions in play for an ending of that prevailing strategy’s performance, for in the capitulation is set the seeds for a change in leadership. We all know it is coming, even those who are benefitting from the current set of circumstances, we just do not know when.
For the full year 2019 the OP EAFE strategy returned 16.7% (up 4.7% in December), a respectable return in absolute terms but lagging the MSCI EAFE index return of 22.0% (up 3.2% in December). The MSCI EAFE Value index was up 16.1% (up 3.7% in December). The performance of markets in 2019 must be set against the steep falls that were experienced in the fourth quarter of 2018, when the MSCI EAFE index fell by some 13%. The moves by the US Federal Reserve in lowering interest rates stoked the liquidity fueled market rally in 2019, making this one of the best years on record for global stocks and rounding out a decade long stock market rally. While 2019 was poor for value overall, this obscures the fact that since the end of August 2019 the Value style has once again started to reassert itself, a trend we first witnessed in 2016. Since the end of August to year end, the MSCI EAFE Value index is up +13.0% and the MSCI EAFE Growth index is up 9.7%. As we saw in 2016, when the Value style does well, the OP EAFE strategy does very well, and the OP EAFE strategy is up 18.2% over this period. After yet another year led by growth stocks (certainly the first eight months of 2019), investors quite rightly question the efficacy of Value investing. We stick firmly to our discipline of Value investing. We may make mistakes along the way in individual stocks and these hurt in a concentrated portfolio but by adhering to the discipline of value investing, the long history of empirical evidence shows that this is the best way to generate long-term capital growth.
Nomura was the strongest contributor to the EAFE strategy in 2019, up 39% in local currency terms. The share price of Nomura had fallen sharply from the start of 2018 to mid-2019. Poor results from its wholesale banking operations, in common with many global investment banks, were compounded by the ongoing decline in its traditional core retail brokerage arm. Management has responded by reducing costs and by expanding into wider financial advisory services - to create a more sustainable and ultimately more valuable business. In June, Nomura announced that it would sell down one third of its stake in the Nomura Research Institute (a separately listed entity trading on 4.5 times price to book value) to buy back its own shares which were valued at less than half book value. We have been engaging with management and encouraging them to do this which the CFO told us has been helpful in the various board discussions. We continue to hold the shares and the company is at last showing signs of progress in its operational turnaround.
Our holding in Samsung was the third best contributor to performance after our holding in Tesco (+38% total return in local currency). The shares of Samsung Electronics recovered sharply in 2019 and were up +47% for the year, having been hit hard in the fourth quarter of 2018, on the expectation of a turn in the semiconductor cycle and a margin recovery in the mobile handset division. Of all our holdings this is the most geared to the prevailing market sentiment around technology shares which has driven markets higher in 2019. The valuation is now 1.5 times book value and 17 times earnings expected in 2019, a cyclical low point (but only 7.5 times earnings produced in 2018) underlining how operationally leveraged the business is to prices for computer memory. However, the company has no financial leverage with net cash on its balance sheet equivalent to 30% of its market capitalisation. This balance sheet will ensure that Samsung emerges from this downcycle even more competitive as its ability to invest in newer technology far outweighs its competitors, SK Hynix of Korea and Micron Technology of the US.
In 2019 we also purchased the German company Bayer, a leading agrochemical and pharmaceutical company which was our fourth best contributor to performance for the year. Bayer’s share price peaked at over €140 a share in 2015. In the second quarter of 2016 it launched a bid for the US seeds business Monsanto. Just weeks after completion Monsanto lost a court case that claimed their best-selling herbicide glyphosate caused non-Hodgkin lymphoma, a form of cancer. Jurors in California awarded the plaintiff $250 million in punitive damages and $39m for economic loss. Not surprisingly this has led to numerous lawsuits and Bayer’s share price falling to below €55, giving it a market capitalisation below $60 billion, having spent $66 billion on Monsanto alone just the year before. We have developed a ‘base case’ and a ‘stressed case’ sum of the parts valuation for the company. Most estimates for the potential legal liability were at around €5 billion, but in our sum of the parts ‘stressed case’ we used €10 billion. This is not to negate the issues around glyphosate but to outline how in our judgement these are manageable and well within the cash flow generation capabilities of the company. For the pharma business we have ended up at a headline valuation of 8 to 10 times price to earnings, which is well below peers to reflect the patent expiry risk. For Crop Science we are using a multiple of 10 times EV/EBITDA as there is now a clear listed comparable in the form of Corteva and we do think Bayer’s crop science is a substantially better business. Even in our ‘stressed case’ we forecast a total return of over 28% at purchase. We assigned a 60% probability to our ‘base case’ and a 40% probability to the ‘stressed case’ which results in a valuation target of €75 per share, generating a total return of 47% at the time of purchase.
The shares of BT, the UK’s telecom incumbent, was the worst performer (-12%) for overall fund contribution for the year. Investors have shunned BT given the perceived risks around higher capex for fibre which could lead to a cut in the dividend and continued macro fears around the UK, intensified by Labour’s threat to nationalize its core infrastructure asset - Openreach. The valuation is very attractive on a price to earnings ratio of just eight times earnings for March 2021 and at five times operating cash flows. BT will invest more in fibre, as per the UK government’s wishes, if the payback from such investments is clear and attractive. In September, BT's CEO spent nearly £1 million buying shares at £1.71 per share. So far, he has spent nearly £6 million on BT shares (previous purchases were at £2.02 and £2.58 per share), prices not too dissimilar to ours. We believe there is a significant recovery potential given the resounding victory of the Conservative Party in the recent UK election, which offers a marked improvement in the political environment for a full fibre roll-out across the UK.
Kansai Electric Power was also one of our worst performers in share price terms in the year 2019 (down 21%), having been our best performer in 2018. It suffered after Japan’s Nuclear Regulation Authority (NRA) unexpectedly refused to allow any further extensions to existing deadlines for nuclear plants to have completed the engineering work required to strengthen a facility against terrorist attack. The share price was hit further when a scandal broke that the company had received bribes from local officials. It is often when a sense of crisis grips a company in Japan that we witness real corporate change for the better. Whilst the scandal has little impact operationally it has led to a wholesale change in the top management at the company. We are engaging closely with the company to ensure that this opportunity is not wasted. The return to service of Kansai’s nuclear reactors remains a national priority for Japan and this is still seen as transformational for its financial fortunes. The shares remain attractively valued at around eight times the net profits expected in the current fiscal year and yielding almost four per cent.
In December, we initiated two new positions for the EAFE strategy. Embraer, the Brazilian aerospace company is held in our dedicated Emerging Market strategy. The share price has been weak given anti-trust delays in its sale to Boeing of its commercial aviation business. We believe that this deal means we are effectively getting Embraer’s Defence and Executive Jets businesses for free. We will see a significant return of capital to shareholders on completion of the deal too. The shares were trading at just over book value. We also initiated a position in Carnival, the cruise ship operator, which has suffered from concerns around the economic outlook at a time of significant capital investment. This as an attractive industry with good long-term growth and return prospects and we made our purchase at an historically low ratio of enterprise value to invested capital. The shares trade on a forward price to earnings ratio of less than 11 times and yield over four percent. To fund these purchases, we sold the holdings in Investor and AP Moller-Maersk. Investor, the Swedish family-controlled conglomerate, has done very well returning over 40% in 2019. Maersk also had a strong year and was up over 36%. Both achieved our estimate of intrinsic worth.
The depth of the underperformance of our style of investing is as great as in the Dotcom boom and the duration is as long as in the great depression of the 1920s. This in itself does not mean value will outperform from here, and there are many commentators making rational arguments about why value as a style may now be dead (e.g. ever lower interest rates, higher non-tangible assets, increasing technological disruption etc.). Indeed, this time it could well be different, but we know these are reputed to be the most expensive words in investment. It is the capitulation of investors in value that sows the seeds for its outperformance. The change in market leadership since August 2019 in favour of value investing is encouraging and given the depth and duration of the underperformance the reversal will be dramatic but only by sticking to the discipline of value investing can this opportunity be fully captured. We continue to stick to this time-tested methodology of buying essentially sound but lowly valued companies, believing that this is the best way to grow and protect capital over the long-term. The two-year weighted average anticipated total return for the portfolio is currently 28%. The portfolio is valued on a forward price to earnings ratio of 11 times and less than one times price to book value compared to 15 times price to earnings and 1.7 times price to book value for the MSCI EAFE Index.
Commentary
“The basic situation is wonderfully clear. In all free-enterprise (once called capitalist) attitudes there is a strong tendency to believe that the more money, either as income or assets, of which an individual is possessed or with which he is associated, the deeper and more compelling his economic and social perception, the more astute and penetrating his mental processes. Money is the measure of capitalist achievement and the intelligence that supports it.” JK Galbraith - A Short History of Financial Euphoria.
The success or failure of differing investment strategies naturally confers upon them an efficacy building confidence in those that follow them and creating a fear of missing out in those that have stood outside. This leads to all manner of pressures on participants in the financial markets and leads many to do things that they do not truly believe. These pressures build and build, making it harder and harder for others not to follow the prevailing strategy of the day which becomes the accepted wisdom of the crowd. Galbraith has observed this in financial markets throughout history. This naturally sets the conditions in play for an ending of that prevailing strategy’s performance, for in the capitulation is set the seeds for a change in leadership. We all know it is coming, even those who are benefitting from the current set of circumstances, we just do not know when.
For the full year 2019 the OP EAFE strategy returned 16.7% (up 4.7% in December), a respectable return in absolute terms but lagging the MSCI EAFE index return of 22.0% (up 3.2% in December). The MSCI EAFE Value index was up 16.1% (up 3.7% in December). The performance of markets in 2019 must be set against the steep falls that were experienced in the fourth quarter of 2018, when the MSCI EAFE index fell by some 13%. The moves by the US Federal Reserve in lowering interest rates stoked the liquidity fueled market rally in 2019, making this one of the best years on record for global stocks and rounding out a decade long stock market rally. While 2019 was poor for value overall, this obscures the fact that since the end of August 2019 the Value style has once again started to reassert itself, a trend we first witnessed in 2016. Since the end of August to year end, the MSCI EAFE Value index is up +13.0% and the MSCI EAFE Growth index is up 9.7%. As we saw in 2016, when the Value style does well, the OP EAFE strategy does very well, and the OP EAFE strategy is up 18.2% over this period. After yet another year led by growth stocks (certainly the first eight months of 2019), investors quite rightly question the efficacy of Value investing. We stick firmly to our discipline of Value investing. We may make mistakes along the way in individual stocks and these hurt in a concentrated portfolio but by adhering to the discipline of value investing, the long history of empirical evidence shows that this is the best way to generate long-term capital growth.
Nomura was the strongest contributor to the EAFE strategy in 2019, up 39% in local currency terms. The share price of Nomura had fallen sharply from the start of 2018 to mid-2019. Poor results from its wholesale banking operations, in common with many global investment banks, were compounded by the ongoing decline in its traditional core retail brokerage arm. Management has responded by reducing costs and by expanding into wider financial advisory services - to create a more sustainable and ultimately more valuable business. In June, Nomura announced that it would sell down one third of its stake in the Nomura Research Institute (a separately listed entity trading on 4.5 times price to book value) to buy back its own shares which were valued at less than half book value. We have been engaging with management and encouraging them to do this which the CFO told us has been helpful in the various board discussions. We continue to hold the shares and the company is at last showing signs of progress in its operational turnaround.
Our holding in Samsung was the third best contributor to performance after our holding in Tesco (+38% total return in local currency). The shares of Samsung Electronics recovered sharply in 2019 and were up +47% for the year, having been hit hard in the fourth quarter of 2018, on the expectation of a turn in the semiconductor cycle and a margin recovery in the mobile handset division. Of all our holdings this is the most geared to the prevailing market sentiment around technology shares which has driven markets higher in 2019. The valuation is now 1.5 times book value and 17 times earnings expected in 2019, a cyclical low point (but only 7.5 times earnings produced in 2018) underlining how operationally leveraged the business is to prices for computer memory. However, the company has no financial leverage with net cash on its balance sheet equivalent to 30% of its market capitalisation. This balance sheet will ensure that Samsung emerges from this downcycle even more competitive as its ability to invest in newer technology far outweighs its competitors, SK Hynix of Korea and Micron Technology of the US.
In 2019 we also purchased the German company Bayer, a leading agrochemical and pharmaceutical company which was our fourth best contributor to performance for the year. Bayer’s share price peaked at over €140 a share in 2015. In the second quarter of 2016 it launched a bid for the US seeds business Monsanto. Just weeks after completion Monsanto lost a court case that claimed their best-selling herbicide glyphosate caused non-Hodgkin lymphoma, a form of cancer. Jurors in California awarded the plaintiff $250 million in punitive damages and $39m for economic loss. Not surprisingly this has led to numerous lawsuits and Bayer’s share price falling to below €55, giving it a market capitalisation below $60 billion, having spent $66 billion on Monsanto alone just the year before. We have developed a ‘base case’ and a ‘stressed case’ sum of the parts valuation for the company. Most estimates for the potential legal liability were at around €5 billion, but in our sum of the parts ‘stressed case’ we used €10 billion. This is not to negate the issues around glyphosate but to outline how in our judgement these are manageable and well within the cash flow generation capabilities of the company. For the pharma business we have ended up at a headline valuation of 8 to 10 times price to earnings, which is well below peers to reflect the patent expiry risk. For Crop Science we are using a multiple of 10 times EV/EBITDA as there is now a clear listed comparable in the form of Corteva and we do think Bayer’s crop science is a substantially better business. Even in our ‘stressed case’ we forecast a total return of over 28% at purchase. We assigned a 60% probability to our ‘base case’ and a 40% probability to the ‘stressed case’ which results in a valuation target of €75 per share, generating a total return of 47% at the time of purchase.
The shares of BT, the UK’s telecom incumbent, was the worst performer (-12%) for overall fund contribution for the year. Investors have shunned BT given the perceived risks around higher capex for fibre which could lead to a cut in the dividend and continued macro fears around the UK, intensified by Labour’s threat to nationalize its core infrastructure asset - Openreach. The valuation is very attractive on a price to earnings ratio of just eight times earnings for March 2021 and at five times operating cash flows. BT will invest more in fibre, as per the UK government’s wishes, if the payback from such investments is clear and attractive. In September, BT's CEO spent nearly £1 million buying shares at £1.71 per share. So far, he has spent nearly £6 million on BT shares (previous purchases were at £2.02 and £2.58 per share), prices not too dissimilar to ours. We believe there is a significant recovery potential given the resounding victory of the Conservative Party in the recent UK election, which offers a marked improvement in the political environment for a full fibre roll-out across the UK.
Kansai Electric Power was also one of our worst performers in share price terms in the year 2019 (down 21%), having been our best performer in 2018. It suffered after Japan’s Nuclear Regulation Authority (NRA) unexpectedly refused to allow any further extensions to existing deadlines for nuclear plants to have completed the engineering work required to strengthen a facility against terrorist attack. The share price was hit further when a scandal broke that the company had received bribes from local officials. It is often when a sense of crisis grips a company in Japan that we witness real corporate change for the better. Whilst the scandal has little impact operationally it has led to a wholesale change in the top management at the company. We are engaging closely with the company to ensure that this opportunity is not wasted. The return to service of Kansai’s nuclear reactors remains a national priority for Japan and this is still seen as transformational for its financial fortunes. The shares remain attractively valued at around eight times the net profits expected in the current fiscal year and yielding almost four per cent.
In December, we initiated two new positions for the EAFE strategy. Embraer, the Brazilian aerospace company is held in our dedicated Emerging Market strategy. The share price has been weak given anti-trust delays in its sale to Boeing of its commercial aviation business. We believe that this deal means we are effectively getting Embraer’s Defence and Executive Jets businesses for free. We will see a significant return of capital to shareholders on completion of the deal too. The shares were trading at just over book value. We also initiated a position in Carnival, the cruise ship operator, which has suffered from concerns around the economic outlook at a time of significant capital investment. This as an attractive industry with good long-term growth and return prospects and we made our purchase at an historically low ratio of enterprise value to invested capital. The shares trade on a forward price to earnings ratio of less than 11 times and yield over four percent. To fund these purchases, we sold the holdings in Investor and AP Moller-Maersk. Investor, the Swedish family-controlled conglomerate, has done very well returning over 40% in 2019. Maersk also had a strong year and was up over 36%. Both achieved our estimate of intrinsic worth.
The depth of the underperformance of our style of investing is as great as in the Dotcom boom and the duration is as long as in the great depression of the 1920s. This in itself does not mean value will outperform from here, and there are many commentators making rational arguments about why value as a style may now be dead (e.g. ever lower interest rates, higher non-tangible assets, increasing technological disruption etc.). Indeed, this time it could well be different, but we know these are reputed to be the most expensive words in investment. It is the capitulation of investors in value that sows the seeds for its outperformance. The change in market leadership since August 2019 in favour of value investing is encouraging and given the depth and duration of the underperformance the reversal will be dramatic but only by sticking to the discipline of value investing can this opportunity be fully captured. We continue to stick to this time-tested methodology of buying essentially sound but lowly valued companies, believing that this is the best way to grow and protect capital over the long-term. The two-year weighted average anticipated total return for the portfolio is currently 28%. The portfolio is valued on a forward price to earnings ratio of 11 times and less than one times price to book value compared to 15 times price to earnings and 1.7 times price to book value for the MSCI EAFE Index.