Commentary

The fund lagged the wider market as the relentless optimism among equity investors continued to confound the outlook portrayed in the bond market where the three-month to 10-year differential remains strongly negative. The much-trailed meeting of the world’s central bankers at Jackson Hole at the beginning of the last week in August contained little new news. On the last day of the month, the PCE Core Index showed inflation higher year on year in July versus June. The cost of money is working its way through the real economy. With mortgage rates at 20-year highs in the US, sales of existing homes have fallen to four million, just above the levels seen during the Great Financial Crisis. The uptick in inflation may prove a statistical quirk but the macro outlook remains opaque. The US bond market is priced for this while the US equity market is not.

At the stock level, the largest negative contributors to relative return in order of their impact were Citigroup (-12%, total return in local currency), Siemens (-10%), CK Hutchison (-11%), Alibaba (-7%), and Southwest Airlines (-7%).

Citigroup shares had been the standout this year within a troubled sector following the problems at the US regional banks but August saw the sector and Citi in particular fallback to leave Citi’s shares only just ahead of the S&P Bank sector year to-date. The regulatory framework among the smaller and regional banks in the US remains under review with capital requirements likely to rise. While Citigroup passed its stress test in June, the Fed increased its Stress Capital Buffer component of the minimum Core Tier 1 capital requirement of 12.3% from 4.0% to 4.3%, something that Citi had not expected. With the bond market remaining somewhat more cautious on its outlook for macro conditions in the US, it is perhaps unsurprising that the banking sector should face a higher risk premium before other sectors in the equity market. We think that Citi shares are priced for significant trouble, valued at just 7 times this year’s expected profits and just half of tangible book value. This level is attractive against both its own history, but also when compared to more than 9 times profit and 1.2 times tangible book for the other US mega banks.

Alibaba reported a solid set of results for its first fiscal quarter of its 2024 financial year. Revenue growth was 14% with the core Taobao and Tmall division growing 12%. Adjusted profit growth (including a one-off re-basing of share-based payments at Ant Group) was 43% (70% excluding this one-off adjustment). Alibaba is working on the finer detail of delineation and separation of the six business units that can be listed separately. The business is extremely lowly valued at just 10 times net profits. Adjusting this for the year-end net cash of US$48bn (market capitalisation is US$235bn), the valuation drops to just eight times net profits. The group is generating free cash flow of c.$24bn a year, a free cash flow yield of 10%. The company

Commentary

continues to repurchase shares, US$3bn worth last quarter with an outstanding buyback authorisation of US$16bn. With an expected return on equity this year of 13%, these buybacks are very accretive. Ant Group, the firm’s 30% associate, is offering to buy back its own stock at a valuation that is 22% above the value we assume for Ant Group in our sum-of-the-parts valuation. With the core business generating more than 100% of group operating profit, any value ascribed to the spin-offs of stakes in the other five divisions is going to make the valuation of the core group look even more compelling.

The largest positive contributors to relative return in order of their impact were NOV (+5%), Berkshire Hathaway (+2%), Fresenius (+4%), LG H&H (+9%) and Tesco (+3%).

NOV’s second quarter results were good. Revenue is up 21% year on year with operating profit up 170% year on year with orders healthy and book to bill ratios about 100% at the firm level. The company suffered significantly during COVID with key suppliers facing greater disruption than expected and some going bust. The company has worked hard to restructure their supply chain. With this supply chain now returning to more normal service levels the company has accumulated more inventory than required in the short-term. This has been a large drain on free cash flow this year and the company now expects to see only a break-even level at the cash level for the full year. Pre-COVID, NOV would normally consume working capital during expansion years and throw off large amounts of cash during downturns so it is interesting that they expect to be cash break-even this year given the growth being experienced.

Global oil demand is back at prior peaks of 103 million barrels per day. OPEC, and Saudi Arabia in particular, are restricting their output to keep demand and supply tight and the oil price at $85. While onshore drilling in the US has declined, this level for the oil price has incentivised the offshore market with drill ship rates now topping $500,000 a day. NOV’s offshore order book is particularly important since profit margins are higher offshore. The shares are valued at 14 times profit expected this year and 1.1 times sales. With the world continuing to under-invest in renewable energy sources, we expect demand for oil to remain high and we think NOV has the ability to grow earnings per share closer to $3 over the next 2-3 years, roughly double the level of earnings per share forecast for the current year.

The fund offers authentic contrarian value with a highly attractive weighted average upside on a two-year view of over 60%. This is on estimates and valuations for the individual holdings that we think are conservative, providing a good margin of safety. The strategy has a forward price to earnings ratio of less than ten times and a price to book multiple of just over one. This portfolio valuation is at a substantial discount to the MSCI World and the MSCI World Value indices.

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