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 Global strategy returned 16.4% (up 4.6% in December), a respectable return in absolute terms but lagging the MSCI World index return of 27.7% (up 3.0% in December). The MSCI ACWI Value index was up 20.6% (up 3.5% 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 World fell by 13% and the OP Global Strategy fell by 9%. While 2019 was poor for value overall, this obscures the fact that value enjoyed a recovery relative to growth from the end of August to year end. The MSCI ACWI Value index is up +11.7% and the MSCI ACWI Growth index is up 10.9%. As we saw in 2016, when the Value style does well, the OP Global strategy does very well, and the OP Global strategy is up 15.8% over this period.
The moves by the US Federal Reserve in lowering interest rates stoked the liquidity fueled rally in 2019, making this one of the best years on record for US stocks and rounding out a decade long global stock market rally. The main driver of the global stock market performance for the year was again the US technology laden Nasdaq index which delivered a 36.7% return thus continuing a trend we have seen over recent years. Over the last five years the OP Global Strategy has delivered a return of 41.1% versus 34.3% for the MSCI ACWI Value index but still lagging the MSCI World index which is up 52.0%. After yet another year led by US growth stocks (certainly the first eight months of 2019), investors quite rightly question the efficacy of Value investing. Even the MSCI Global Value benchmark contains within its largest constituents such companies as Procter & Gamble, Coca Cola and Walt Disney - all maybe great companies but these trade on forward price to earnings ratios in excess of 25 times. These do not appear very ‘value’ to us. 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 this discipline the long history of empirical evidence shows that this is the best way to generate long-term capital growth.
After our holding in Tesco (+38% total return in local currency), Allergan (+30% since purchase) was our second-best contributor to our overall strategy performance in 2019. We purchased our holding in Allergan, a US pharmaceutical stock, at the end of April 2019. Allergan has two main lines of business: the traditional branded pharmaceutical business and an aesthetics business. The global aesthetics market is very attractive and Allergan’s Botox franchise is a market leader and has growing applications for various therapeutic uses. Our analysis highlighted the significant free cash flow generation, even allowing for investment in R&D and acquisitions, that would allow it to reduce its financial leverage substantially. The shares were trading on a free cash flow yield in excess of 10%. This was attractive both in absolute terms and relative to its own history and peers. We noted that in 2016, Pfizer had bid $363 a share, and this showed that industry participants saw significant value in the business. In June of 2019, Allergan received a take-over approach from the US drug maker AbbVie. The agreed deal will be made up of $120 in the form of cash and the rest in stock which valued Allergan at $188 on the date of the announcement. This was below our target price of $210 per share, but clearly our target price is set two years out. This offer valued Allergan at a 45% premium to its closing price a day earlier.
In 2019 we also purchased the German company Bayer, a leading agrochemical and pharmaceutical company which was our third 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 forecasted 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.
The share price of Nomura had fallen by around 43% since 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 over four 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. Since the end of June 2019, the share price is up by 49%, making this our fourth best contributor to performance in the year (up 39% in local currency terms in 2019) and highlighting the efficacy of our sum of the parts methodology. We continue to hold the shares and the company is at last showing signs of progress in its operational turnaround.
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 hold 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 26%. The portfolio is valued on a forward price to earnings ratio of less than 11 times and one times price to book value compared to 17 times price to earnings and 2.6 times price to book value for the MSCI World 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 Global strategy returned 16.4% (up 4.6% in December), a respectable return in absolute terms but lagging the MSCI World index return of 27.7% (up 3.0% in December). The MSCI ACWI Value index was up 20.6% (up 3.5% 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 World fell by 13% and the OP Global Strategy fell by 9%. While 2019 was poor for value overall, this obscures the fact that value enjoyed a recovery relative to growth from the end of August to year end. The MSCI ACWI Value index is up +11.7% and the MSCI ACWI Growth index is up 10.9%. As we saw in 2016, when the Value style does well, the OP Global strategy does very well, and the OP Global strategy is up 15.8% over this period.
The moves by the US Federal Reserve in lowering interest rates stoked the liquidity fueled rally in 2019, making this one of the best years on record for US stocks and rounding out a decade long global stock market rally. The main driver of the global stock market performance for the year was again the US technology laden Nasdaq index which delivered a 36.7% return thus continuing a trend we have seen over recent years. Over the last five years the OP Global Strategy has delivered a return of 41.1% versus 34.3% for the MSCI ACWI Value index but still lagging the MSCI World index which is up 52.0%. After yet another year led by US growth stocks (certainly the first eight months of 2019), investors quite rightly question the efficacy of Value investing. Even the MSCI Global Value benchmark contains within its largest constituents such companies as Procter & Gamble, Coca Cola and Walt Disney - all maybe great companies but these trade on forward price to earnings ratios in excess of 25 times. These do not appear very ‘value’ to us. 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 this discipline the long history of empirical evidence shows that this is the best way to generate long-term capital growth.
After our holding in Tesco (+38% total return in local currency), Allergan (+30% since purchase) was our second-best contributor to our overall strategy performance in 2019. We purchased our holding in Allergan, a US pharmaceutical stock, at the end of April 2019. Allergan has two main lines of business: the traditional branded pharmaceutical business and an aesthetics business. The global aesthetics market is very attractive and Allergan’s Botox franchise is a market leader and has growing applications for various therapeutic uses. Our analysis highlighted the significant free cash flow generation, even allowing for investment in R&D and acquisitions, that would allow it to reduce its financial leverage substantially. The shares were trading on a free cash flow yield in excess of 10%. This was attractive both in absolute terms and relative to its own history and peers. We noted that in 2016, Pfizer had bid $363 a share, and this showed that industry participants saw significant value in the business. In June of 2019, Allergan received a take-over approach from the US drug maker AbbVie. The agreed deal will be made up of $120 in the form of cash and the rest in stock which valued Allergan at $188 on the date of the announcement. This was below our target price of $210 per share, but clearly our target price is set two years out. This offer valued Allergan at a 45% premium to its closing price a day earlier.
In 2019 we also purchased the German company Bayer, a leading agrochemical and pharmaceutical company which was our third 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 forecasted 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.
The share price of Nomura had fallen by around 43% since 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 over four 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. Since the end of June 2019, the share price is up by 49%, making this our fourth best contributor to performance in the year (up 39% in local currency terms in 2019) and highlighting the efficacy of our sum of the parts methodology. We continue to hold the shares and the company is at last showing signs of progress in its operational turnaround.
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 hold 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 26%. The portfolio is valued on a forward price to earnings ratio of less than 11 times and one times price to book value compared to 17 times price to earnings and 2.6 times price to book value for the MSCI World Index.