Commentary
The year saw extreme outperformance by Growth, especially in the US, where the ‘Magnificent Seven’ (Alphabet, Apple, Meta, Microsoft, Amazon, Nvidia, Tesla) provided a total return of +107% pushing the S&P 500 to an all-time high at the end of the year. With the US market some 70% of MSCI World and 60% of MSCI All-Country World, it is perhaps unsurprising that our classic, contrarian value-driven strategy lagged these global benchmarks last year.
The strategy kept pace with MSCI World Value and MSCI ACWI Value in 2023. The largest detractor of performance relative to benchmark was LG H&H, the South Korean consumer goods company, which halved during the year (-51% total return in local currency terms). The other leading detractors were, in order of their impact on performance relative to MSCI ACWI Value: Bayer (-28%), Southwest Airlines (-12%), Alibaba (-11%) and NOV (-2%).
In the last week of October, LG H&H reported third quarter results that fell short of the market’s, and our, expectations. While they reported continued resilience of sales and profits in their Refreshment division (soft drinks) and the Home and Daily Beauty (HDB) division (combined 60% of profits for the last twelve months), their Beauty division (luxury skin care and cosmetics) reported weak sales and profit.
The Beauty division has been challenged since 2021 and is dominated by its luxury skincare range sold largely in China and Korea (to Chinese tourists). Sales to China, largely luxury skincare, fell 29% on the same period last year. Given some restructuring, rebranding expense and negative operating leverage, profit in beauty for the quarter was down almost 90%.
The problem in China is not unique to LG H&H. Other global skin care companies such as Estee Lauder and Beiersdorf have seen similar declines in their Asian travel business. In response they, like LG H&H, are working hard to return the industry to its pre-COVID structure by reducing exposure to resellers and reducing inventory in the channel – both tough decisions to take.
The results raise concerns that the problem is more than skin deep and that brand equity for these international players has been impaired, ceding market share to domestic Chinese players. The fact that global industry leaders like Estee Lauder are also suffering similar issues offers us some comfort. That said, after adjusting for the net cash on the balance sheet, the shares are now valued at 12.6 times the lowered consensus expectations for profit in 2024 (earnings which are based on Beauty operating profit which is just 20% of 2021 levels).
The extreme weakness in the share price and the slow recovery in Beauty are disappointing but we think the current valuation fails to recognise Beauty’s recovery potential, the strength and stability of HDB and Refreshment (60% of operating profit) and LG H&H’s strong cash generation and net cash balance sheet.
While LG H&H was painful, it is important to note that the strategy managed to keep up with global value indices because a majority of the stocks (16) in the strategy outperformed these indices. The largest positive contributors to the strategy’s performance in 2023 were, in order of their impact on the strategy, easyJet (+57%), Siemens (+35%), Samsung Electronics (+44%), Tesco (+35%) and Exor (+33%). The impact on the strategy was enhanced by the modest weakening of the US dollar against Sterling and the Euro during the year.
While easyJet’s shares started and finished the year strongly, the share price suffered significant turbulence during the year. In the second half of the fiscal year ending September 2023 the company flew 3% more miles than the year before Covid. Strong pricing, a growing package holiday business and welcome cost control helped the company deliver record second half profits. Despite concerns about a slowing economy and pressure on consumers the company continues to expect a robust demand environment and firm pricing. The company ended the year with a net cash balance sheet and the shares valued at just 7.5 times net income expected in 2024.
During the fourth quarter we bought two new holdings for the strategy – Middleby, the US-based, global catering equipment company, and Heineken Holdings, the holding company that owns 50.4% of Heineken, the Dutch-based global brewing company. These purchases were funded from reductions in the holdings of Sanofi, Berkshire Hathaway, Tesco and Siemens all of which were closing in on our estimates of their fair value.
Heineken is a global beer company that was founded in 1864 by Gerard Heineken. Heineken owns 300 brands with the largest being Heineken (c.20% of volume). The Heineken brand competes with AB Inbev’s Budweiser for the status of largest global brand outside of China. Other global brands the company owns include Amstel and Tiger.
Heineken owns 167 breweries with 14% share of the global beer market, second only to AB Inbev
(27%). A decade ago, Western Europe accounted for 44% of volumes, 50% of revenue and 36% of profit. Following a series of acquisitions across several of the largest emerging market countries, revenue from emerging markets now account for 53% of revenue and Europe accounts for 30% of volume, 35% of revenue and 25% of profit. With the brewing costs for all beers being very similar, the key to profitability is the focus on cultivating premium branded beers. For Heineken, premium brands now account for 40% of sales. Among these is the world’s leading zero alcohol beer, Heineken 0.0%, a new growth area for the business.
The last three years have created the opportunity in Heineken today. Cost pressures and Covid have seen gross margins fall from 50% to 44%. The competition has seen similar cost pressures that has meant that all operators have had to put through price rises not seen in a generation. Looking forward, we would expect pricing to hold but some of the costs to fall and this will help restore gross margins.
Today the Heineken family remains controlling shareholders of Heineken through their 53.7% holding of Heineken Holding which in turn owns 50.4% of the main Heineken listing. Heineken Holding shares had fallen to a valuation of 14 times price to 2024 earnings, a 17% discount to the valuation of the main listing, and we see a multiple in the high teens as fair.
Founded in 1888 as a manufacturer of baking ovens, Middleby Marshall Oven Company was acquired in 1983 by TMC Industries, a publicly traded company that changed its name in 1985 to The Middleby Corporation (“Middleby”). Today, Middleby has grown to more than 115 foodservice brands of commercial and residential kitchen equipment.
Over the last ten years, Middleby has grown revenue and earnings per share by 7% p.a. through a combination of acquisitions and organic growth. The business has strong brands, exposure to a resilient market and sticky customer relationships. The company has three divisions: Commercial Foodservice (c.60% of revenue), Food Processing (20%) and Residential Kitchen (20%). Revenue is primarily in North America (c.70%) and Europe (20%).
Middleby now trades at just 13 times earnings vs S&P 500 at 21 times. Middleby consistently traded at a premium to S&P 500 from 2010 to 2021. The discount is due to investor concerns around the company’s balance sheet and weak performance in the Residential Kitchen business. In our view, the balance sheet is acceptable with leverage (ratio of net debt to EBITDA) at 2.8 times against its covenant at 5.5 times. Following residential-related acquisitions made during the COVID years, the company is now focused on repaying debt and should be down at two times by the end of 2024. Whilst Residential Kitchen has indeed been weak, it represents just 10% of profit. The other 90% of profit from Commercial Foodservice and Food Processing is more resilient and the current trading is solid.
The strategy overall is valued at a price to expected earnings ratio of less than 10 times and a price to book ratio of 1.1 times. This compares with a price to expected earnings ratio of a little over 15 times and a price to book ratio of 2.0 times for the MSCI World Value index and a price to expected earnings of nearly 18 times and a price to book ratio of 3.1 times for the MSCI World benchmark. The weighted average upside for the portfolio ended the year at 54%, offering a prospective total return over the next couple of years of 60%, substantially ahead of its long-term average, providing an exciting outlook for the strategy in 2024.
Commentary
The year saw extreme outperformance by Growth, especially in the US, where the ‘Magnificent Seven’ (Alphabet, Apple, Meta, Microsoft, Amazon, Nvidia, Tesla) provided a total return of +107% pushing the S&P 500 to an all-time high at the end of the year. With the US market some 70% of MSCI World and 60% of MSCI All-Country World, it is perhaps unsurprising that our classic, contrarian value-driven strategy lagged these global benchmarks last year.
The strategy kept pace with MSCI World Value and MSCI ACWI Value in 2023. The largest detractor of performance relative to benchmark was LG H&H, the South Korean consumer goods company, which halved during the year (-51% total return in local currency terms). The other leading detractors were, in order of their impact on performance relative to MSCI ACWI Value: Bayer (-28%), Southwest Airlines (-12%), Alibaba (-11%) and NOV (-2%).
In the last week of October, LG H&H reported third quarter results that fell short of the market’s, and our, expectations. While they reported continued resilience of sales and profits in their Refreshment division (soft drinks) and the Home and Daily Beauty (HDB) division (combined 60% of profits for the last twelve months), their Beauty division (luxury skin care and cosmetics) reported weak sales and profit.
The Beauty division has been challenged since 2021 and is dominated by its luxury skincare range sold largely in China and Korea (to Chinese tourists). Sales to China, largely luxury skincare, fell 29% on the same period last year. Given some restructuring, rebranding expense and negative operating leverage, profit in beauty for the quarter was down almost 90%.
The problem in China is not unique to LG H&H. Other global skin care companies such as Estee Lauder and Beiersdorf have seen similar declines in their Asian travel business. In response they, like LG H&H, are working hard to return the industry to its pre-COVID structure by reducing exposure to resellers and reducing inventory in the channel – both tough decisions to take.
The results raise concerns that the problem is more than skin deep and that brand equity for these international players has been impaired, ceding market share to domestic Chinese players. The fact that global industry leaders like Estee Lauder are also suffering similar issues offers us some comfort. That said, after adjusting for the net cash on the balance sheet, the shares are now valued at 12.6 times the lowered consensus expectations for profit in 2024 (earnings which are based on Beauty operating profit which is just 20% of 2021 levels).
The extreme weakness in the share price and the slow recovery in Beauty are disappointing but we think the current valuation fails to recognise Beauty’s recovery potential, the strength and stability of HDB and Refreshment (60% of operating profit) and LG H&H’s strong cash generation and net cash balance sheet.
While LG H&H was painful, it is important to note that the strategy managed to keep up with global value indices because a majority of the stocks (16) in the strategy outperformed these indices. The largest positive contributors to the strategy’s performance in 2023 were, in order of their impact on the strategy, easyJet (+57%), Siemens (+35%), Samsung Electronics (+44%), Tesco (+35%) and Exor (+33%). The impact on the strategy was enhanced by the modest weakening of the US dollar against Sterling and the Euro during the year.
While easyJet’s shares started and finished the year strongly, the share price suffered significant turbulence during the year. In the second half of the fiscal year ending September 2023 the company flew 3% more miles than the year before Covid. Strong pricing, a growing package holiday business and welcome cost control helped the company deliver record second half profits. Despite concerns about a slowing economy and pressure on consumers the company continues to expect a robust demand environment and firm pricing. The company ended the year with a net cash balance sheet and the shares valued at just 7.5 times net income expected in 2024.
During the fourth quarter we bought two new holdings for the strategy – Middleby, the US-based, global catering equipment company, and Heineken Holdings, the holding company that owns 50.4% of Heineken, the Dutch-based global brewing company. These purchases were funded from reductions in the holdings of Sanofi, Berkshire Hathaway, Tesco and Siemens all of which were closing in on our estimates of their fair value.
Heineken is a global beer company that was founded in 1864 by Gerard Heineken. Heineken owns 300 brands with the largest being Heineken (c.20% of volume). The Heineken brand competes with AB Inbev’s Budweiser for the status of largest global brand outside of China. Other global brands the company owns include Amstel and Tiger.
Heineken owns 167 breweries with 14% share of the global beer market, second only to AB Inbev
(27%). A decade ago, Western Europe accounted for 44% of volumes, 50% of revenue and 36% of profit. Following a series of acquisitions across several of the largest emerging market countries, revenue from emerging markets now account for 53% of revenue and Europe accounts for 30% of volume, 35% of revenue and 25% of profit. With the brewing costs for all beers being very similar, the key to profitability is the focus on cultivating premium branded beers. For Heineken, premium brands now account for 40% of sales. Among these is the world’s leading zero alcohol beer, Heineken 0.0%, a new growth area for the business.
The last three years have created the opportunity in Heineken today. Cost pressures and Covid have seen gross margins fall from 50% to 44%. The competition has seen similar cost pressures that has meant that all operators have had to put through price rises not seen in a generation. Looking forward, we would expect pricing to hold but some of the costs to fall and this will help restore gross margins.
Today the Heineken family remains controlling shareholders of Heineken through their 53.7% holding of Heineken Holding which in turn owns 50.4% of the main Heineken listing. Heineken Holding shares had fallen to a valuation of 14 times price to 2024 earnings, a 17% discount to the valuation of the main listing, and we see a multiple in the high teens as fair.
Founded in 1888 as a manufacturer of baking ovens, Middleby Marshall Oven Company was acquired in 1983 by TMC Industries, a publicly traded company that changed its name in 1985 to The Middleby Corporation (“Middleby”). Today, Middleby has grown to more than 115 foodservice brands of commercial and residential kitchen equipment.
Over the last ten years, Middleby has grown revenue and earnings per share by 7% p.a. through a combination of acquisitions and organic growth. The business has strong brands, exposure to a resilient market and sticky customer relationships. The company has three divisions: Commercial Foodservice (c.60% of revenue), Food Processing (20%) and Residential Kitchen (20%). Revenue is primarily in North America (c.70%) and Europe (20%).
Middleby now trades at just 13 times earnings vs S&P 500 at 21 times. Middleby consistently traded at a premium to S&P 500 from 2010 to 2021. The discount is due to investor concerns around the company’s balance sheet and weak performance in the Residential Kitchen business. In our view, the balance sheet is acceptable with leverage (ratio of net debt to EBITDA) at 2.8 times against its covenant at 5.5 times. Following residential-related acquisitions made during the COVID years, the company is now focused on repaying debt and should be down at two times by the end of 2024. Whilst Residential Kitchen has indeed been weak, it represents just 10% of profit. The other 90% of profit from Commercial Foodservice and Food Processing is more resilient and the current trading is solid.
The strategy overall is valued at a price to expected earnings ratio of less than 10 times and a price to book ratio of 1.1 times. This compares with a price to expected earnings ratio of a little over 15 times and a price to book ratio of 2.0 times for the MSCI World Value index and a price to expected earnings of nearly 18 times and a price to book ratio of 3.1 times for the MSCI World benchmark. The weighted average upside for the portfolio ended the year at 54%, offering a prospective total return over the next couple of years of 60%, substantially ahead of its long-term average, providing an exciting outlook for the strategy in 2024.
Commentary
by two players – Arrow and Avnet – who together have c. 60% market share in North America and Europe.
Not unlike many other distributors, Arrow has low margins but generates attractive returns on tangible capital (15-year average ROTE exceeding 30%). Additionally, it benefits from increasing demand for semiconductor products as industries ranging from automotive to industrials to defence continue to digitalise. Total revenue growth (including acquisitions) has been c. 6% annualised over the last 15 years. We expect Arrow will continue to benefit from increasing demand for semiconductor products.
Not surprisingly, Arrow was a beneficiary of the semiconductor shortages in recent years, leading to revenue growth of 20% in 2021 and 8% in 2022. This ended abruptly in 2023 where revenues declined 11%. It was this slowdown in demand that created the opportunity to purchase the shares at an attractive valuation.
A key feature of Arrow’s business model is its counter-cyclical cash flows. During industry downturns, as the one we are currently experiencing, Arrow generates substantial free cash flow. This is because Arrow builds inventory when demand is strong and releases inventory when demand is weak. In 2021-22, when revenues were up 30%, Arrow generated free cash flow of c. $200 million. In 2019-20, when revenues declined 3%, Arrow generated free cash flow of nearly $2 billion. Arrow used the free cash flow in 2019-20 to pay off debt and repurchase shares. We believe the counter-cyclical cash flows is an important feature of Arrow’s business model and appears underestimated by the market.
Share repurchases is a key part of Arrow’s capital allocation. Over the last five years, Arrow has bought back shares worth $3.6 billion which is more than half of the current market capitalisation. An important part of the investment case is continued share repurchases which we consider to be very accretive at the current valuation.
At the time of purchase, Arrow had a market capitalisation of c. $6 billion. It generated net income of nearly $1 billion in 2023. The lowest net income over the last ten years is c. $600 million and the average c. $800 million. Consensus estimates net income for 2024 of c. $640 million which we expect to be the trough year. This would put Arrow on less than 10 times trough earnings. We think this is very attractive valuation for a business with significant competitive advantages and organic growth at attractive returns on capital.
Sales of Bayer and Citigroup
Our purchases of Reckitt Benckiser and Arrow were funded with the sales of Bayer and Citigroup respectively.
Bayer was held for a little over four and a half years and cost the strategy 5.8% of performance relative to MSCI World during the period. We sold because of the risk of further litigation. With an already levered balance sheet Bayer has limited ability to meet new litigation payments that may come from polychlorinated biphenyls (PCBs), new liabilities related to glyphosate as well as potential litigation in the US around the impact on biodiversity of its herbicides, fungicides and pesticides.
Citigroup, was held for almost 12 years and cost the strategy 1.9% of performance relative to MSCI World. For the first eight years, the shares outperformed the benchmark as the shares re-rated from around half of book to almost book value as the operational performance improved. We reduced the position by a third in Jan/Feb 2018 as the margin of safety had declined given the strong performance. Since 2021, the bank faced weaker end markets and higher costs from regulatory pressures. While the bank’s CEO, Jane Fraser, has laid out a plan to slash costs once more over the next three years, Citi’s strong share price recovery since October meant it was already discounting a successful execution of her plan.
Portfolio Management
We are excited to announce that Sam Ziff will join Nigel Waller and Andrew Goodwin as co-manager of our Global Equity strategy. Sam has been an integral part of the investment Team at OP for over ten years, contributing fully to idea generation for the Global Strategy and has been managing a Global Income Portfolio for nearly seven years. Since joining the global strategy as an Associate Manager last September, the dynamic has been working so well that it is clear Sam should now step up to be co-manager alongside Nigel and Andrew. We believe that this move will improve our process and, most importantly, lead to better outcomes for our clients over time as well as providing long-term thoughtful succession planning.
Sam previously was employed by J.P. Morgan Cazenove working in the UK Industrials Corporate Finance team. He graduated from Oxford University.
Juliet Marber retired at the beginning of April and we thank her for all she has done for the firm in her 11 years of service. We wish her well for her retirement.
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