Commentary
With world stock markets making new highs this month, we have seen the switch back to value, that started in mid-August, blunted once again as momentum and growth take the lead once more. Overall, this has been a difficult year for value investors, especially those who provide, as one consultant described us recently, “proper value”.
As stock-driven, bottom-up investors we ignore the make-up of the indices to which our performance is often compared. Most commonly this comparator is either MSCI World or MSCI All Country World, and more often in North America, style comparators such as MSCI World/ACWI Value. MSCI’s index construction method means that country weights for its Value and Growth versions of its indices are similar no matter whether one market like the US, is historically expensive or not.
The chart below lists the top 20 stocks in the MSCI ACWI Value index. The first take-away is that all but one of them are from the US.
Figure 1: MSCI ACWI @ 29th Nov 2019. Source: MSCI & Bloomberg. One year forward metrics using Bloomberg consensus. Stocks shown in BOLD are held in OP’s Global Equity strategy.
The combination of the desire to have equal market sizes of the value and growth portions of the index at a country level and the relative lack of earnings growth at companies like Procter & Gamble (yet still valued at 25 times one year forward earnings!), Walt Disney (28 times), Coca-Cola (25 times) sees them assigned to the value index. Looking through this list one is struck by how high the valuation multiples of many of these stocks are with seven of them having one-year forward price earnings ratios of more than 20 times and seven with price to book ratios of more than four times. When value is out of favour, these ‘value’ stocks will tend to perform better than ”proper” value companies on much lower valuations.
The evolution of Warren Buffett’s investment style away from his mentor Benjamin Graham towards that of his business partner, Charlie Munger, led to a broadening of the ‘church’ of value investing. We are aware that the last decade of poor relative performance for value has stretched the breadth of the value ‘church’ more widely still. We have not altered our views on what constitutes value, looking for essentially sound companies valued lowly in absolute terms and relative to their own histories where expectations are already low. We accept that much of the time, because of the mix of stocks in the portfolio, the return on equity of the portfolio will tend to be a bit lower than that of MSCI World. The reasons for this vary by stock but we are often attracted to companies that are under-earning after a problem or mis-step and are now in recovery mode while others, like many of our Japanese holdings past and present, have inefficient balance sheets so chocked full of underappreciated assets such as developable land or holdings in listed companies, that their reported returns on equity are low despite acceptable returns on equity from their operating businesses. Back over time our portfolio ROE has varied reflecting which areas of the market were cheap – in 2006 our portfolio was characterised by high ROE companies because they were unusually cheap while today they patently are not.
In a tough month for value, the biggest negative contributors to performance, in order of impact, were BT (-6% total return in local currency), Mitsubishi Heavy Industries (-5%), Tesco (-2%), Hewlett Packard Enterprise (-4%) and Barrick Gold (-3%).
Shares of BT suffered for two reasons. Firstly, Virgin Mobile announced that it would be switching its traffic away from EE’s network to that of Vodafone from late 2021 implying a £150m hit to profit and cashflow for BT of c.6 per cent. Ten days later, the UK’s Labour party announced, mid-campaign ahead of the December 12th general election, that they would nationalise Openreach, BT’s physical infrastructure division, and provide free broadband for all. Labour had previously denied any interest in doing this, both publicly and to BT’s chief executive as recently as this summer. While Labour have not laid out any detail on this it would not be a simple thing to do despite the functional separation forced on BT and Openreach over the last couple of years. There are also questions raised about competitors like Virgin (Liberty Global), TalkTalk, Sky and the up and coming alternative fibre network providers. The opinion polls are still suggesting a Conservative victory which would provide a material boost to BT’s shares given the central role that it plays in the Conservative’s plans to see an acceleration in the roll-out of fibre to the premises in the UK. The shares yield 8 per cent and are valued at eight times earnings.
The largest positive contributors to performance were Siemens (+13% total return in local currency), Nomura (+13%), Viacom (+12%), Lloyds Bank (+8%) and Korea Electric Power (+10%).
Siemens’ share price had done nothing this year through to early July as investors fretted over the outlook for the global economy and China in particular, despite it being just 10 per cent of sales. Investors had ignored the bold move announced in May that Siemens would spin out its power businesses to lay bare the profitability and structural growth within Digital Industries (DI). Third fiscal quarter (to end June) results showed a slowing of new orders within DI, and the shares plummeted, touching €85 in mid-August. At that point, our sum of the parts work inferred a valuation multiple for DI of less than three times on an enterprise value to earnings before depreciation and amortisation basis. Since then the market has come to its senses and the shares have not looked back rising 38% to the end of November. We maintain our fair value of €137 in a little over a year’s time.
The portfolio has an attractive weighted average upside of 35 per cent and is attractively valued on a price to earnings ratio of 12 times, six times cash flow and one times book value.
Commentary
With world stock markets making new highs this month, we have seen the switch back to value, that started in mid-August, blunted once again as momentum and growth take the lead once more. Overall, this has been a difficult year for value investors, especially those who provide, as one consultant described us recently, “proper value”.
As stock-driven, bottom-up investors we ignore the make-up of the indices to which our performance is often compared. Most commonly this comparator is either MSCI World or MSCI All Country World, and more often in North America, style comparators such as MSCI World/ACWI Value. MSCI’s index construction method means that country weights for its Value and Growth versions of its indices are similar no matter whether one market like the US, is historically expensive or not.
The chart below lists the top 20 stocks in the MSCI ACWI Value index. The first take-away is that all but one of them are from the US.
Figure 1: MSCI ACWI @ 29th Nov 2019. Source: MSCI & Bloomberg. One year forward metrics using Bloomberg consensus. Stocks shown in BOLD are held in OP’s Global Equity strategy.
The combination of the desire to have equal market sizes of the value and growth portions of the index at a country level and the relative lack of earnings growth at companies like Procter & Gamble (yet still valued at 25 times one year forward earnings!), Walt Disney (28 times), Coca-Cola (25 times) sees them assigned to the value index. Looking through this list one is struck by how high the valuation multiples of many of these stocks are with seven of them having one-year forward price earnings ratios of more than 20 times and seven with price to book ratios of more than four times. When value is out of favour, these ‘value’ stocks will tend to perform better than ”proper” value companies on much lower valuations.
The evolution of Warren Buffett’s investment style away from his mentor Benjamin Graham towards that of his business partner, Charlie Munger, led to a broadening of the ‘church’ of value investing. We are aware that the last decade of poor relative performance for value has stretched the breadth of the value ‘church’ more widely still. We have not altered our views on what constitutes value, looking for essentially sound companies valued lowly in absolute terms and relative to their own histories where expectations are already low. We accept that much of the time, because of the mix of stocks in the portfolio, the return on equity of the portfolio will tend to be a bit lower than that of MSCI World. The reasons for this vary by stock but we are often attracted to companies that are under-earning after a problem or mis-step and are now in recovery mode while others, like many of our Japanese holdings past and present, have inefficient balance sheets so chocked full of underappreciated assets such as developable land or holdings in listed companies, that their reported returns on equity are low despite acceptable returns on equity from their operating businesses. Back over time our portfolio ROE has varied reflecting which areas of the market were cheap – in 2006 our portfolio was characterised by high ROE companies because they were unusually cheap while today they patently are not.
In a tough month for value, the biggest negative contributors to performance, in order of impact, were BT (-6% total return in local currency), Mitsubishi Heavy Industries (-5%), Tesco (-2%), Hewlett Packard Enterprise (-4%) and Barrick Gold (-3%).
Shares of BT suffered for two reasons. Firstly, Virgin Mobile announced that it would be switching its traffic away from EE’s network to that of Vodafone from late 2021 implying a £150m hit to profit and cashflow for BT of c.6 per cent. Ten days later, the UK’s Labour party announced, mid-campaign ahead of the December 12th general election, that they would nationalise Openreach, BT’s physical infrastructure division, and provide free broadband for all. Labour had previously denied any interest in doing this, both publicly and to BT’s chief executive as recently as this summer. While Labour have not laid out any detail on this it would not be a simple thing to do despite the functional separation forced on BT and Openreach over the last couple of years. There are also questions raised about competitors like Virgin (Liberty Global), TalkTalk, Sky and the up and coming alternative fibre network providers. The opinion polls are still suggesting a Conservative victory which would provide a material boost to BT’s shares given the central role that it plays in the Conservative’s plans to see an acceleration in the roll-out of fibre to the premises in the UK. The shares yield 8 per cent and are valued at eight times earnings.
The largest positive contributors to performance were Siemens (+13% total return in local currency), Nomura (+13%), Viacom (+12%), Lloyds Bank (+8%) and Korea Electric Power (+10%).
Siemens’ share price had done nothing this year through to early July as investors fretted over the outlook for the global economy and China in particular, despite it being just 10 per cent of sales. Investors had ignored the bold move announced in May that Siemens would spin out its power businesses to lay bare the profitability and structural growth within Digital Industries (DI). Third fiscal quarter (to end June) results showed a slowing of new orders within DI, and the shares plummeted, touching €85 in mid-August. At that point, our sum of the parts work inferred a valuation multiple for DI of less than three times on an enterprise value to earnings before depreciation and amortisation basis. Since then the market has come to its senses and the shares have not looked back rising 38% to the end of November. We maintain our fair value of €137 in a little over a year’s time.
The portfolio has an attractive weighted average upside of 35 per cent and is attractively valued on a price to earnings ratio of 12 times, six times cash flow and one times book value.