Commentary
MHI has seen a marked transformation in its fortunes since the depths of Covid. The share price of this once out of favour Japanese heavy industrial is now up c.93% year to date. In the month, it announced the results for the second quarter which highlighted continued progress in a difficult operating environment with stronger than expected orders, up 40% year on year. Full year guidance was raised for orders and sales but there was no change to the target for business profit target of Yen 200bn. In the quarter energy orders were up 82%, led by increased demand for gas turbines and for its services to nuclear power plants. Whilst the fundamental improvement is coming through the stock price is close to our view of intrinsic value and we have been using this share price strength to reduce our holding.
The confirmation of President Xi Jinping as the leader of China for an unprecedented third term at the CCP congress this month was widely anticipated. However, international investors were spooked by his appointment of loyalist Li Qiang, who was responsible for the protracted and chaotic Covid lockdown in Shanghai, and the seemingly very public removal of the former Chinese leader Hu Jintao signalling Xi’s dominance. This led to collapses in the share prices of Chinese shares. The Hang Seng (the Hong Kong index which contains many listings for mainland China) fell back to levels not seen since 2009. From 2009 China’s nominal GDP in US dollars has grown by 3.5 times. The share price of Alibaba fell to a five year low of $63 in the month, having traded at over $300 just two years before. The value of the company has now fallen to c.$168bn, with net cash, short-term investments and marketable securities accounting for over $100bn. The company has been free cash flow positive every year over the last ten and is forecast to generate free cash flow of $13bn this year to March 2023 and $18bn the year after. Whilst we acknowledge the current concerns and risks in holding an investment in China, by having a limited exposure in a diversified global portfolio to the world’s second largest economy by GDP in the largest online business which remains fundamentally sound, growing and with such a strong balance sheet remains a compelling opportunity valued at a free cash flow yield (excluding the cash and securities) of nearly 20%.
Fresenius, the German healthcare conglomerate has been very weak this year. It is suffering from difficulty in hiring nurses and a gap between ongoing cost inflation and the rise in the Medicare reimbursement rate for the dialysis business in the US which was hit hard by Covid and there is a delay in its ability to pass on increased costs in its European hospital business, Helios. The CEO has recently been replaced with Michael Sen, who we regard highly given his role in the transformation of Siemens. The fact that this global company is listed in Germany has not helped given the selloff in the German market but it is also a complex business with financial leverage. However, one of the attributes that attracted us was the defensive nature of its cash flows and asset backing. The company’s conglomerate nature is ripe for a breakup and it has now attracted the interest of activist investors from the US. The shares trade on a forward price to earnings of just 7 times which is well below historical levels. The hospital business remains very attractive and it continues to see recovery with strong organic sales growth of 6% year on year (with utilisation rates still below pre-Covid levels), which is somewhat offsetting the weakness in the US dialysis business.
As we noted earlier, our relatively low weighting in the US market means we have relatively more exposure to the absolutely and relatively cheap markets of the UK, Europe, Japan, South Korea and China. While the energy situation in Europe is not trivial it is certainly reflected in the valuations of UK and European shares where we see investors pricing in a likely recession in 2023 which is why these markets trade at multi-decade lows in valuation terms. By contrast the US market looks relatively expensive and we find it surprising that US investors seem not to assume a recession in 2023 for the US economy, something we suspect is very likely given the rapid rise in interest rates there too. Chairman Powell stated that it would seem unlikely that pain in the US economy can be avoided if they are to stamp out inflationary expectations.
Our portfolio has a weighted average upside of c.70% which is among the highest since we started. We have found this a useful guide to the portfolio potential when it gets to such extreme levels. We do not think that this is the time to capitulate and sell the absolutely cheap markets and stocks to buy the relatively expensive US market and the historically expensive US dollar. In fact, the US money manager, GMO, recently quipped that by focussing now on markets outside the US with currencies that are both historically cheap, it offers investors “two ways to win” and we couldn’t agree more.
Commentary
The fund started the year well, benefiting from the return to Value. Since the war in the Ukraine began, there has been a violent swing by investors to the US and the US dollar, as a ‘flight to safety’ and the fund has suffered given its relative underweight to the US and resulting additional exposure to the UK and Europe. This means that as at the end of October the fund is down 20.3% year to date with MSCI World Index down 20.1%. For October the Fund is up +7.7% versus the MSCI World at +7.2%. In 2022, we are seeing the long-awaited return to Value outperforming Growth and believe that Value leadership is here to stay. It is therefore frustrating that, after the very positive start to the year for the strategy against MSCI World Value, the strategy has lagged this benchmark since the outbreak of war in Ukraine with MSCI World Value now down only 10.6% year to date. The difference in the currency exposure explains almost the entire difference in performance versus Value. Indices are created ‘top-down’ and hence the MSCI World Value has a full c.70% weighting to the US, despite the relatively high valuation of the US market (MSCI US Value 2.7x price to book, vs 1.0x price to book for MSCI EAFE Value index). We believe the fall in price for the vast majority of our holdings does not reflect a fall in their intrinsic value and that many are seeing improving fundamentals even in this difficult environment. We are excited by the weighted average upside in the Strategy today, at over 70%, it is close to the highest levels we have seen since we began measuring it in March 2009.
The share price of NOV, the US offshore service company is up c.65% year to date. In the month, NOV delivered a set of results that showed that its recovery is gaining momentum. NOV’s consolidated revenue for the third quarter of 2022 was up 41% year over year, and up 9% sequentially. We first invested in NOV, a leading offshore services player in the first quarter of 2020 when the Energy sector was almost deemed un-investable given concerns around demand, stranded assets and ESG issues. NOV attracted us because of its valuation, strong balance sheet, highly regarded management team and the fact that it did not rely on long-life assets. It is taking time for the recovery in energy prices to feed through to the services industry but as Clay Williams the CEO of NOV said, “You can cannibalize idle equipment and deplete your stores of consumables and kick the can down the road for a little while, but rigs, drill pipe, pump, coiled tubing units, you name it, all of the things NOV makes are essential to getting the commodities out of the ground.” Given their position within the oil and gas value chain, NOV plays an important role in reducing the industry’s carbon footprint through facilitating the reduction in emissions, during this process. To date, they have focussed on providing more efficient products that reduce the energy intensity of drilling which is seen by the IEA as a first-order priority. NOV has also repositioned itself as a leading supplier to the offshore wind industry with its installation technology. We believe that NOV is at the start of a multi-year recovery in the end demand for its services after a drought that has lasted more than six years. The share price performance has led to NOV becoming the largest holding in the portfolio but our outlook remains as bullish as ever. As a significant shareholder, engagement on their transition to net zero is a priority for us.
Commentary
MHI has seen a marked transformation in its fortunes since the depths of Covid. The share price of this once out of favour Japanese heavy industrial is now up c.93% year to date. In the month, it announced the results for the second quarter which highlighted continued progress in a difficult operating environment with stronger than expected orders, up 40% year on year. Full year guidance was raised for orders and sales but there was no change to the target for business profit target of Yen 200bn. In the quarter energy orders were up 82%, led by increased demand for gas turbines and for its services to nuclear power plants. Whilst the fundamental improvement is coming through the stock price is close to our view of intrinsic value and we have been using this share price strength to reduce our holding.
The confirmation of President Xi Jinping as the leader of China for an unprecedented third term at the CCP congress this month was widely anticipated. However, international investors were spooked by his appointment of loyalist Li Qiang, who was responsible for the protracted and chaotic Covid lockdown in Shanghai, and the seemingly very public removal of the former Chinese leader Hu Jintao signalling Xi’s dominance. This led to collapses in the share prices of Chinese shares. The Hang Seng (the Hong Kong index which contains many listings for mainland China) fell back to levels not seen since 2009. From 2009 China’s nominal GDP in US dollars has grown by 3.5 times. The share price of Alibaba fell to a five year low of $63 in the month, having traded at over $300 just two years before. The value of the company has now fallen to c.$168bn, with net cash, short-term investments and marketable securities accounting for over $100bn. The company has been free cash flow positive every year over the last ten and is forecast to generate free cash flow of $13bn this year to March 2023 and $18bn the year after. Whilst we acknowledge the current concerns and risks in holding an investment in China, by having a limited exposure in a diversified global portfolio to the world’s second largest economy by GDP in the largest online business which remains fundamentally sound, growing and with such a strong balance sheet remains a compelling opportunity valued at a free cash flow yield (excluding the cash and securities) of nearly 20%.
Fresenius, the German healthcare conglomerate has been very weak this year. It is suffering from difficulty in hiring nurses and a gap between ongoing cost inflation and the rise in the Medicare reimbursement rate for the dialysis business in the US which was hit hard by Covid and there is a delay in its ability to pass on increased costs in its European hospital business, Helios. The CEO has recently been replaced with Michael Sen, who we regard highly given his role in the transformation of Siemens. The fact that this global company is listed in Germany has not helped given the selloff in the German market but it is also a complex business with financial leverage. However, one of the attributes that attracted us was the defensive nature of its cash flows and asset backing. The company’s conglomerate nature is ripe for a breakup and it has now attracted the interest of activist investors from the US. The shares trade on a forward price to earnings of just 7 times which is well below historical levels. The hospital business remains very attractive and it continues to see recovery with strong organic sales growth of 6% year on year (with utilisation rates still below pre-Covid levels), which is somewhat offsetting the weakness in the US dialysis business.
As we noted earlier, our relatively low weighting in the US market means we have relatively more exposure to the absolutely and relatively cheap markets of the UK, Europe, Japan, South Korea and China. While the energy situation in Europe is not trivial it is certainly reflected in the valuations of UK and European shares where we see investors pricing in a likely recession in 2023 which is why these markets trade at multi-decade lows in valuation terms. By contrast the US market looks relatively expensive and we find it surprising that US investors seem not to assume a recession in 2023 for the US economy, something we suspect is very likely given the rapid rise in interest rates there too. Chairman Powell stated that it would seem unlikely that pain in the US economy can be avoided if they are to stamp out inflationary expectations.
Our portfolio has a weighted average upside of c.70% which is among the highest since we started. We have found this a useful guide to the portfolio potential when it gets to such extreme levels. We do not think that this is the time to capitulate and sell the absolutely cheap markets and stocks to buy the relatively expensive US market and the historically expensive US dollar. In fact, the US money manager, GMO, recently quipped that by focussing now on markets outside the US with currencies that are both historically cheap, it offers investors “two ways to win” and we couldn’t agree more.
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