Commentary
Lenin once said, "There are decades where nothing happens; and there are weeks where decades happen.” The last few weeks have evolved at unprecedented speed which has included the fastest ever declines in global stock markets. We are very sorry to report such painful results for the year to date but at times of great dislocation in markets, great opportunities are presented to the long-term and disciplined investor. Given the turmoil in markets this month’s newsletter offers a brief overview of our thoughts and is somewhat longer than is usual.
Summary
- The coronavirus has created great fear in markets, the response by governments across the world has been immense but the outlook remains uncertain.
- Performance for the EAFE Equity strategy year to date is down broadly in line with MSCI EAFE Value but lagging the MSCI EAFE index. In March the strategy fell less than MSCI EAFE Value but lagged MSCI EAFE index.
- At all times our focus is on generating attractive long-term returns while protecting capital from permanent loss. Outside of our exposure to utilities, the portfolio has significantly less financial leverage than the MSCI EAFE index.
- While the pandemic will have differing impacts across countries and sectors, we note that world markets entered this crisis at record highs.
- With the dislocation now taking place, with greed being replaced by fear, we are excited by the investment opportunities that are emerging.
- We are proceeding cautiously adhering to the time-tested discipline of our contrarian, value approach. We have been adding to those areas of the portfolio that have been marked down the most and more than we think reasonable namely: Bayer, ENI, Exor, Lloyds Bank, Mitsubishi Heavy Industries and Nokia. We have sold Carnival and initiated a new position in EasyJet.
- The upside for our existing portfolio has recently matched the highest levels in our history.
- For a turn in the fortunes of value a change in momentum and market leadership was required, the coronavirus could certainly bring this about and the outlook for value investing is now perhaps the best it has been in the last decade.
- OP is operating as business as usual, although with all staff working remotely.
The OP Global investment approach
Our approach is contrarian and value-focussed where we seek to invest in sound companies that are lowly valued in absolute terms and relative to their own history. We select investments through a bottom-up, research driven approach, searching for companies which have attractive business attributes and are trading at prices well below our view of their fair value. Our rigorous approach and discipline around valuation means that when we set our valuation targets these tend not to be based on market levels and thus driven ever higher as a bull market progresses. This may mean that we sell holdings that continue to re-rate, but this gives us assessments of fair value which are more consistent and robust. History suggests to us that these valuation levels have for the most part delivered over the long-term.
We are contrarian in our thinking, looking for investment opportunities in those areas of the market that are unloved and out of favour. Poor sentiment towards such companies from most market participants is completely normal and essential our proposition. The portfolio is concentrated – typically 20-30 holdings – and diversified across countries and sectors. Finally, and importantly, we are patient investors with a long-term mind-set. Our average holding period is 4-5 years which enables us to focus on long-term value.
This strategy, like everything we do at Oldfield Partners, is an equity strategy. There are two reasons that we run our equity strategies largely fully invested. The first is that this is what we tell all our clients we will do: our strategies are for investors who want to be invested in equities over the long term. The second is that, even in dire times, times of great uncertainty and great volatility, we remain convinced in the long-term returns from equity investment.
Positioning going into this crisis
We have always stressed caution over combining high levels of operational and financial leverage in an investment. Where we do take on such exposure in a single investment, we are always doing so in the context of a portfolio that, overall, does not combine excessive financial leverage with operational leverage. The few companies where we have higher levels of financial leverage are business models well suited to it, namely utilities: E.ON, Kansai Electric Power and KEPCO. The leverage of the overall portfolio excluding utilities is around one times operating cash flow, which is around half that of the benchmark. We do this to reduce the risk of the permanent loss of value for equity holders. The top five holdings in the portfolio are currently E.ON, Tesco, Siemens, Sanofi and BT Group. These are all very defensive businesses with strong cash flows, well placed given the challenging set of circumstances the world economy now faces. Siemens is a more cyclical business, but it has no financial debt at the industrial level and the underlying customers to its financial services business are largely utilities.
Performance
So far, the current crisis has proved a challenging one for markets and for the portfolio. Value as a class has underperformed growth with the MSCI EAFE Growth index down -9% versus -18% for the MSCI EAFE Value index in US dollars. The EAFE Equity strategy was down -17% for the month.
The largest positive contributors to performance in the month in order of attribution were Kansai Electric (+6%, in local currency terms), Tesco (+0%), Nomura (-5%), Sanofi (-5%) and East Japan Railway (-1%). Kansai Electric was positive for the monthly given its defensive characteristics as an integrated utility and it also resolved the issues around corporate governance and is moving to a much better corporate governance structure, something which we have lobbied for. Tesco, the UK’s largest food retailer, is our third largest holding and was a strong performer in the month and year to date due to the defensive nature of its business and the fact that it should benefit from consumers’ enforced switch to in-home dining. It has hired 20,000 extra employees (an increase of 10%) to deal with extra demand. 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. Our second largest holding is Sanofi, the French pharmaceutical group, which also held up well in the current environment. Sanofi is one of the four major players in the global vaccines industry that together account for c.90% of the market, split quite evenly between them. It also owns 21.5% of Regeneron, a leading bio-pharmaceutical company. Sanofi and Regeneron have one of the more promising treatments for the Coronavirus – their arthritis drug Kevzara which they began testing on COVID-19 patients in New York last week.
The largest negative contributors to performance in the month were Carnival (-71%, in local currency terms), Embraer (-51%), Lloyds Bank (-36%), Exor (-27%) and Porsche (-32%). The Travel and Leisure sector has been hit hard with all non-essential travel severely curtailed, if not stopped all together, with low visibility over when it will restart. The cruise industry has been at the forefront of this and we exited the small position in Carnival which we had recently started to build. The risk to shareholder’s equity is now too great given that the company is currently operating at a significant loss and must pay some $7 billion for new ships they are legally contracted to take this year. The stress on the balance sheet means that shareholders will be significantly impaired, if not wiped out altogether. Embraer, the Brazilian aircraft manufacturer is facing a near total freeze in the global aviation industry. It has a substantial order book of $16 billion but this is facing the prospect of deferrals as the airlines fight for survival. The deal with Boeing for the bulk of its regional jet business is under pressure, although both sides are committed and there has been no mention of price renegotiation. Much depends on the fate of Boeing, which has its own financial pressures, but Embraer could survive as a standalone entity if needed. It has no liquidity issues in this year. Embraer is an object of national pride and the Brazilian defence champion. The Brazilian government would come to its aid in the worst case. Embraer suffered given the fears over a downturn in the aviation industry given the grounding of flights. Our holding in Lloyds was very weak with financial stocks hit hard given the monetary stimulus enacted globally will put further pressure on net interest income and the provisioning cycle will now turn against them.
What have we been doing?
We have been exceptionally busy appraising both the existing holdings in our portfolio and several new investment opportunities. With the huge uncertainty surrounding the path of this crisis, we have been assessing stocks firstly for how we expect they might navigate it and to ensure shareholders’ equity will not be impaired. A re-focus on near-term balance sheets and cashflows has been key here. Secondarily we are assessing how the medium-term outlook for the companies may have changed. As investors with an average holding period of 4-5 years, we remain calm, making changes to the portfolio gradually with the aim of enhancing the prospective returns as we navigate this crisis.
With the proceeds from the sale of Carnival we have added to existing holdings that have suffered significantly in share price terms and where we do not have concerns about their balance sheets and liquidity. These include Bayer, ENI, EXOR, Lloyds Bank, Mitsubishi Heavy and Nokia. The share prices of banks have been hit hard in recent weeks and whilst earnings will come under severe pressure, many banks are in much better shape than when they entered the Global Financial Crisis in 2008. On our recent call, they highlighted the need for additional provisioning of £1.4bn under their own severe downside scenario but clearly provisioning may well be in excess of this. By way of contrast they incurred a charge of £2.2bn for the mis-selling of PPI (payment protection insurance) in the previous year and this should not recur. Under the Bank of England’s most adverse stress tests which involve a significant deterioration in the underlying economic conditions, Lloyds is seen as still maintaining a Common Equity Tier 1 ratio of 8.5%. Lloyds is seen as having a strong capital position going into the current crisis. Chastened in 2008, it has spent the last ten years building up its Core Tier One Equity Ratio to one of the highest levels in Europe. It has simplified its business model, focused on UK retail banking and it has a loan to value ratio on its mortgage book of 43%, giving it protection even if there are significant defaults and property price falls in the UK. It currently trades on around half book value. Using a multiple of book value is one of the ways we assess value in banks and given this we are relatively agnostic to dividend payouts. If capital is not paid out in dividends it will be retained to build book value, and so the recent moves by central banks to curtail dividends and share buybacks does not impact our investment thesis for our holdings in the banking sector.
In addition to adding to our existing holdings we have made one new purchase in recent weeks, EasyJet. We have been interested in EasyJet for a long time, but we have been patient, waiting for a better entry point which has now presented itself. EasyJet has a superior, low-cost business model amongst the airlines which means that it should continue to gain share from the incumbents and competitors that may fail. It has one of the youngest fleets unencumbered by debt and best balance sheets in the sector. It has taken action to furlough staff and reduce costs and has access to significant liquidity which means even if it does not fly for a year, we do not expect shareholder value to be permanently impaired.
Outlook
The economic fallout from the outbreak of the COVID-19 virus will be significant, with significant declines in global GDP leading to increased levels of unemployment perhaps not seen since 2009. The global fiscal and monetary support enacted by governments around the world is also immense in size, QE4 has begun. The swift and decisive action being taken by governments around the world should help mitigate the worst of the financial damage that might otherwise have occurred from bringing large parts of the global economy to a halt. The UK’s stimulus package is about 15% of the UK’s GDP. On the clinical side, South Korea shows that the virus can be contained, but the net economic impact on the global economy of the measures taken to date to protect lives is still far from clear.
We have faith in the long-term efficacy of investing in the equity markets. One of the main questions we have been asked in recent years is what will make the fortunes for the value style of investment turn. We believe the virus and the measures taken to arrest it will be the catalyst for a return to value investing. What was certainly required was a change in momentum and market leadership. Once the crowded momentum trades that have driven the underperformance of value start to unwind, value should deliver. Among Warren Buffet’s pearls of wisdom is his famous quote “you only find out who is swimming naked when the tide goes out”. The tide has now certainly turned. We believe investors will once again start to focus on valuations as a key driver of returns and the ability of companies to generate near-term cash flows. The upside to our target valuations for the strategy is now at levels, previously only reached in early 2009 and February 2016, both of which were followed by periods of exceptionally strong returns for our investors.
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
Lenin once said, "There are decades where nothing happens; and there are weeks where decades happen.” The last few weeks have evolved at unprecedented speed which has included the fastest ever declines in global stock markets. We are very sorry to report such painful results for the year to date but at times of great dislocation in markets, great opportunities are presented to the long-term and disciplined investor. Given the turmoil in markets this month’s newsletter offers a brief overview of our thoughts and is somewhat longer than is usual.
Summary
The OP Global investment approach
Our approach is contrarian and value-focussed where we seek to invest in sound companies that are lowly valued in absolute terms and relative to their own history. We select investments through a bottom-up, research driven approach, searching for companies which have attractive business attributes and are trading at prices well below our view of their fair value. Our rigorous approach and discipline around valuation means that when we set our valuation targets these tend not to be based on market levels and thus driven ever higher as a bull market progresses. This may mean that we sell holdings that continue to re-rate, but this gives us assessments of fair value which are more consistent and robust. History suggests to us that these valuation levels have for the most part delivered over the long-term.
We are contrarian in our thinking, looking for investment opportunities in those areas of the market that are unloved and out of favour. Poor sentiment towards such companies from most market participants is completely normal and essential our proposition. The portfolio is concentrated – typically 20-30 holdings – and diversified across countries and sectors. Finally, and importantly, we are patient investors with a long-term mind-set. Our average holding period is 4-5 years which enables us to focus on long-term value.
This strategy, like everything we do at Oldfield Partners, is an equity strategy. There are two reasons that we run our equity strategies largely fully invested. The first is that this is what we tell all our clients we will do: our strategies are for investors who want to be invested in equities over the long term. The second is that, even in dire times, times of great uncertainty and great volatility, we remain convinced in the long-term returns from equity investment.
Positioning going into this crisis
We have always stressed caution over combining high levels of operational and financial leverage in an investment. Where we do take on such exposure in a single investment, we are always doing so in the context of a portfolio that, overall, does not combine excessive financial leverage with operational leverage. The few companies where we have higher levels of financial leverage are business models well suited to it, namely utilities: E.ON, Kansai Electric Power and KEPCO. The leverage of the overall portfolio excluding utilities is around one times operating cash flow, which is around half that of the benchmark. We do this to reduce the risk of the permanent loss of value for equity holders. The top five holdings in the portfolio are currently E.ON, Tesco, Siemens, Sanofi and BT Group. These are all very defensive businesses with strong cash flows, well placed given the challenging set of circumstances the world economy now faces. Siemens is a more cyclical business, but it has no financial debt at the industrial level and the underlying customers to its financial services business are largely utilities.
Performance
So far, the current crisis has proved a challenging one for markets and for the portfolio. Value as a class has underperformed growth with the MSCI EAFE Growth index down -9% versus -18% for the MSCI EAFE Value index in US dollars. The EAFE Equity strategy was down -17% for the month.
The largest positive contributors to performance in the month in order of attribution were Kansai Electric (+6%, in local currency terms), Tesco (+0%), Nomura (-5%), Sanofi (-5%) and East Japan Railway (-1%). Kansai Electric was positive for the monthly given its defensive characteristics as an integrated utility and it also resolved the issues around corporate governance and is moving to a much better corporate governance structure, something which we have lobbied for. Tesco, the UK’s largest food retailer, is our third largest holding and was a strong performer in the month and year to date due to the defensive nature of its business and the fact that it should benefit from consumers’ enforced switch to in-home dining. It has hired 20,000 extra employees (an increase of 10%) to deal with extra demand. 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. Our second largest holding is Sanofi, the French pharmaceutical group, which also held up well in the current environment. Sanofi is one of the four major players in the global vaccines industry that together account for c.90% of the market, split quite evenly between them. It also owns 21.5% of Regeneron, a leading bio-pharmaceutical company. Sanofi and Regeneron have one of the more promising treatments for the Coronavirus – their arthritis drug Kevzara which they began testing on COVID-19 patients in New York last week.
The largest negative contributors to performance in the month were Carnival (-71%, in local currency terms), Embraer (-51%), Lloyds Bank (-36%), Exor (-27%) and Porsche (-32%). The Travel and Leisure sector has been hit hard with all non-essential travel severely curtailed, if not stopped all together, with low visibility over when it will restart. The cruise industry has been at the forefront of this and we exited the small position in Carnival which we had recently started to build. The risk to shareholder’s equity is now too great given that the company is currently operating at a significant loss and must pay some $7 billion for new ships they are legally contracted to take this year. The stress on the balance sheet means that shareholders will be significantly impaired, if not wiped out altogether. Embraer, the Brazilian aircraft manufacturer is facing a near total freeze in the global aviation industry. It has a substantial order book of $16 billion but this is facing the prospect of deferrals as the airlines fight for survival. The deal with Boeing for the bulk of its regional jet business is under pressure, although both sides are committed and there has been no mention of price renegotiation. Much depends on the fate of Boeing, which has its own financial pressures, but Embraer could survive as a standalone entity if needed. It has no liquidity issues in this year. Embraer is an object of national pride and the Brazilian defence champion. The Brazilian government would come to its aid in the worst case. Embraer suffered given the fears over a downturn in the aviation industry given the grounding of flights. Our holding in Lloyds was very weak with financial stocks hit hard given the monetary stimulus enacted globally will put further pressure on net interest income and the provisioning cycle will now turn against them.
What have we been doing?
We have been exceptionally busy appraising both the existing holdings in our portfolio and several new investment opportunities. With the huge uncertainty surrounding the path of this crisis, we have been assessing stocks firstly for how we expect they might navigate it and to ensure shareholders’ equity will not be impaired. A re-focus on near-term balance sheets and cashflows has been key here. Secondarily we are assessing how the medium-term outlook for the companies may have changed. As investors with an average holding period of 4-5 years, we remain calm, making changes to the portfolio gradually with the aim of enhancing the prospective returns as we navigate this crisis.
With the proceeds from the sale of Carnival we have added to existing holdings that have suffered significantly in share price terms and where we do not have concerns about their balance sheets and liquidity. These include Bayer, ENI, EXOR, Lloyds Bank, Mitsubishi Heavy and Nokia. The share prices of banks have been hit hard in recent weeks and whilst earnings will come under severe pressure, many banks are in much better shape than when they entered the Global Financial Crisis in 2008. On our recent call, they highlighted the need for additional provisioning of £1.4bn under their own severe downside scenario but clearly provisioning may well be in excess of this. By way of contrast they incurred a charge of £2.2bn for the mis-selling of PPI (payment protection insurance) in the previous year and this should not recur. Under the Bank of England’s most adverse stress tests which involve a significant deterioration in the underlying economic conditions, Lloyds is seen as still maintaining a Common Equity Tier 1 ratio of 8.5%. Lloyds is seen as having a strong capital position going into the current crisis. Chastened in 2008, it has spent the last ten years building up its Core Tier One Equity Ratio to one of the highest levels in Europe. It has simplified its business model, focused on UK retail banking and it has a loan to value ratio on its mortgage book of 43%, giving it protection even if there are significant defaults and property price falls in the UK. It currently trades on around half book value. Using a multiple of book value is one of the ways we assess value in banks and given this we are relatively agnostic to dividend payouts. If capital is not paid out in dividends it will be retained to build book value, and so the recent moves by central banks to curtail dividends and share buybacks does not impact our investment thesis for our holdings in the banking sector.
In addition to adding to our existing holdings we have made one new purchase in recent weeks, EasyJet. We have been interested in EasyJet for a long time, but we have been patient, waiting for a better entry point which has now presented itself. EasyJet has a superior, low-cost business model amongst the airlines which means that it should continue to gain share from the incumbents and competitors that may fail. It has one of the youngest fleets unencumbered by debt and best balance sheets in the sector. It has taken action to furlough staff and reduce costs and has access to significant liquidity which means even if it does not fly for a year, we do not expect shareholder value to be permanently impaired.
Outlook
The economic fallout from the outbreak of the COVID-19 virus will be significant, with significant declines in global GDP leading to increased levels of unemployment perhaps not seen since 2009. The global fiscal and monetary support enacted by governments around the world is also immense in size, QE4 has begun. The swift and decisive action being taken by governments around the world should help mitigate the worst of the financial damage that might otherwise have occurred from bringing large parts of the global economy to a halt. The UK’s stimulus package is about 15% of the UK’s GDP. On the clinical side, South Korea shows that the virus can be contained, but the net economic impact on the global economy of the measures taken to date to protect lives is still far from clear.
We have faith in the long-term efficacy of investing in the equity markets. One of the main questions we have been asked in recent years is what will make the fortunes for the value style of investment turn. We believe the virus and the measures taken to arrest it will be the catalyst for a return to value investing. What was certainly required was a change in momentum and market leadership. Once the crowded momentum trades that have driven the underperformance of value start to unwind, value should deliver. Among Warren Buffet’s pearls of wisdom is his famous quote “you only find out who is swimming naked when the tide goes out”. The tide has now certainly turned. We believe investors will once again start to focus on valuations as a key driver of returns and the ability of companies to generate near-term cash flows. The upside to our target valuations for the strategy is now at levels, previously only reached in early 2009 and February 2016, both of which were followed by periods of exceptionally strong returns for our investors.
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.