Commentary
"There are decades where nothing happens; and there are weeks where decades happen.” – Vladimir Lenin
Overview
The strategy fell 28% in the month (40% year-to-date) with the two oil service companies (PGS and Oceaneering) down over 70% and the airlines (Dart Group and Spirit Airlines) down over 50%. Only three stocks were up: Draegerwerk (+94%), Zooplus (+24%) and Gaia (+5%). Draegerwerk, a German medical equipment company that makes ventilators, announced in the month that it would acquire the participation units that we hold; Zooplus, the European leader in online pet food retail, and Gaia, an online streaming company, are both benefitting from the current crisis.
The extraordinary measures needed to control the spread of COVID-19 have led to many of our businesses being forced to shut up shop for a period of time, while others are seeing their revenues drop dramatically. We have been through each position, stress testing them to see how long they can survive in the current climate. Having gone through this process, and taking into account the measures announced by governments globally, 5 of the 24 holdings (representing under 10% of the strategy by value) is at some risk of bankruptcy. In normal times we would not be content with one holding having a risk of bankruptcy, but these are not normal times. Even if all five of these companies do not make it through this crisis, which we think is extremely unlikely, the upside in the portfolio is 125% from the survivors alone.
Given the fall in equity markets and the even greater fall in the strategy, we thought it might be helpful to explain why we still believe in small cap value as a means for delivering superior returns.
Small Cap Value
In 1992, Eugene Fama and Kenneth French announced an improvement to the capital asset pricing model (CAPM) - a model that had been used by financial analysts since the 60’s to work out the expected return of an asset. CAPM had assumed only one factor contributed to returns: market risk; however, Fama and French noticed that there were two additional factors: market capitalisation and value (specifically price to book value) that, once added to the model, better explained stock market returns. They noticed that small caps and companies trading on low multiples of book value tended to do better than the market and this came to be known as the Fama-French Three-Factor model.
According to Ibbotson Associates, an investment consulting firm, small caps have increased in value by an average of more than 12% per year between 1927 and 2007, compared to 10% for large caps. There are many potential reasons for the small cap advantage including better alignment through large insider ownership, greater inefficiencies because of less analyst coverage, a liquidity premium and a greater potential to be acquired.
Value has been an even more consistent factor in outperforming growth, particularly over 10-year periods, where it has been ahead 84% of the time. The psychology of investors has meant that they tend to extrapolate good and poor results out into the future, leading to high growth companies being overpriced compared to low growth ones.
Even before COVID-19, the last ten years had been extremely unusual with both the value factor and the small-cap factor producing underperformance. Based on historic data, the odds of this happening would be about 5%. The recent sell off has resulted in small caps performing even worse with the MSCI Small Cap index down 30% year-to-date, while the large cap index is down just 21%.
Many of the largest companies in the world barely existed 20 years ago and have grown without the need for much capital so, despite having capitalisations of around $1tn, they have hardly any net assets after adjusting for their cash positions. They have dominant market positions and look set to continue to grow, leading many to argue that the predictive power of low price to book and smaller companies to outperform no longer stands up to scrutiny. We disagree. The ‘robber barons’ in the early 20th century or the ‘media barons’ in the late 20th century provide examples of monopolistic positions that looked unassailable. Eventually competition or government intervention reduced their dominance. We don’t know whether it will be regulation or competition this time, but history suggests profitability and returns will revert to the mean and small-cap value will have its day again.
In addition to smaller companies and low valuations, we look for companies that have high insider ownership (19% of portfolio holdings is owned by insiders), have limited analyst coverage, operate in attractive niches and have relatively strong balance sheets. These characteristics have proven to generate superior returns over the long run.
Activity
Following the announcement by the UK government that it would step in and pay 80% of the salaries of furloughed staff, we increased the strategy’s holdings in Dart Group and Wetherspoon. Philip Meeson (Dart Group) and Tim Martin (Wetherspoon) both founded their businesses with a core focus on providing the best possible value for their customers through service and low prices. They have built institutions that are loved across the UK. When the dust settles, the customers that have missed out on their Easter and perhaps Summer holidays will be looking to re-book their trip abroad and pubs will be bustling with activity again. We doubt we will get another opportunity to purchase these excellent franchises at such attractive valuations.
At the beginning of the month Zooplus was a 10% position which is the upper limit of what we can hold in any stock. With the stock increasing 24% and the rest of the portfolio down 30%, we had to reduce it. We invested the cash from these sales in a new holding, Shop Apotheke, the second largest European online Pharmacy run by its founder Stefan Feltans. Like Zooplus, Shop Apotheke stands to benefit from the current situation, as the move online accelerates.
Although we were more active in the month than usual, we were mindful that often doing nothing is a better course of action in market panics than the alternative. The cash position was reduced from 6.6% at the beginning of the month to 0.6% but the only sales made were due to requirements under UCITS rules for position sizing. Aside from the larger purchases of Dart and Wetherspoon, we also added to other parts of the portfolio that had been hit particularly hard. When the market recovers, we would expect these companies to recover fastest which is what we saw in the second half of March.
Liquidity
We do not hold any unquoted securities. A part of the reason behind small cap underperformance in market panics is liquidity: forced sellers must accept lower prices as spreads widen. One of the disadvantages of owning companies with large insider ownership is that, compared to companies of similar size, they often have less liquidity. This, of course, can work the other way during market recoveries. Although liquidity may impact the shareholders of some of the companies we hold, it is not an issue for this strategy. OP has an independent Risk Management Committee which took the opportunity in March to stress-test our assumptions around liquidity using the trading volumes seen in late February to mid-March. Their analysis showed that 98% of the portfolio can be liquidated within ten days.
Outlook
We believe, most of the strategy will not only survive this crisis but will come out stronger as competitors struggle. If we look beyond this year, we are seeing extraordinary valuations: for example Wetherspoon, the low cost pub retailer, trades on a 15% historic free cash flow yield and is backed by its freehold property; Dart Group, the owner of Jet2 with £1.5bn of cash on hand, is trading on four times earnings; CLS holdings, a property company with £260m of cash (having recently sold 15% of its property) is trading at 0.6x book; and the list goes on.
Every decade something comes along: a war, a debt crisis, a pandemic. At these times the outlook for businesses look terrible, yet it is precisely when it looks the worst that the opportunity to make good returns is often at its highest. We saw this in March 2009, but it was also true in October 1957, when the Asian flu crisis was at its worst. This crisis, like others before it, will pass and normality will return. This time the world is awash with cheap capital provided by governments/central banks and oil is the cheapest it has been for 20 years, so there are some reasons to be optimistic that it could be a sharp recovery.
We have adjusted our target prices to take into account the losses expected this year and, on the assumption that normality returns next year, we see upside of 145% - an unprecedented level. The price to ‘normal’ earnings is less than seven times and the price to book of the portfolio is just 0.8x. We are invested in a portfolio of companies that have excellent long-term prospects, run by able and aligned management at some of the most attractive valuations that we have seen.
Appendix
Operational resilience
These are difficult times for us all and we want to reassure you that at Oldfield Partners our staff are healthy, our systems and processes are resilient, and we are operating as close to normal as possible. The investment team are communicating with each other constantly and our weekly investment meeting takes place via video conference. Our research effort continues unaffected.
Counterparty risk
Our Risk Management Committee examines trade settlement risk as part of our wider risk management procedures. Considering recent events, we have re-assessed the creditworthiness of our executing counterparty.
In order to minimise this risk, OP settles all trades on a Delivery versus Payment (“DVP”) basis. This ensures that delivery occurs only if a payment occurs. It also reduces the chance that deliveries or payments would be withheld during periods of stress in the financial markets thereby reducing liquidity risk. We do not short stocks, use leverage or lend securities.
We execute all trades in equities through Northern Trust under an outsourced trading arrangement. Northern Trust is a custody bank with an A+ credit rating. Furthermore, actions by governments and central banks around the world are also helping to ensure sufficient liquidity in the financial system.
We remain comfortable with the risks associated with Northern Trust and that the risks associated with trade settlement are low.
Business continuity
We ran a full Business Continuity Plan (BCP) test in on the evening of 5th March, closing our office from Friday 6th March to the morning of Monday 9th March and asking all staff to work remotely, in preparation for a worsening of the situation in the UK. The test was a success – all staff were able to work remotely and securely, all business-critical systems functioned as expected and multiple communication methods worked well (email, instant messaging, voice and video conferencing).
The BCP was put into action indefinitely on Monday 16th March. Every single member of the firm is now working from home but keeping in contact through multiple channels of communication. All systems, controls and operational functions are working as expected.
Commentary
"There are decades where nothing happens; and there are weeks where decades happen.” – Vladimir Lenin
Overview
The strategy fell 28% in the month (40% year-to-date) with the two oil service companies (PGS and Oceaneering) down over 70% and the airlines (Dart Group and Spirit Airlines) down over 50%. Only three stocks were up: Draegerwerk (+94%), Zooplus (+24%) and Gaia (+5%). Draegerwerk, a German medical equipment company that makes ventilators, announced in the month that it would acquire the participation units that we hold; Zooplus, the European leader in online pet food retail, and Gaia, an online streaming company, are both benefitting from the current crisis.
The extraordinary measures needed to control the spread of COVID-19 have led to many of our businesses being forced to shut up shop for a period of time, while others are seeing their revenues drop dramatically. We have been through each position, stress testing them to see how long they can survive in the current climate. Having gone through this process, and taking into account the measures announced by governments globally, 5 of the 24 holdings (representing under 10% of the strategy by value) is at some risk of bankruptcy. In normal times we would not be content with one holding having a risk of bankruptcy, but these are not normal times. Even if all five of these companies do not make it through this crisis, which we think is extremely unlikely, the upside in the portfolio is 125% from the survivors alone.
Given the fall in equity markets and the even greater fall in the strategy, we thought it might be helpful to explain why we still believe in small cap value as a means for delivering superior returns.
Small Cap Value
In 1992, Eugene Fama and Kenneth French announced an improvement to the capital asset pricing model (CAPM) - a model that had been used by financial analysts since the 60’s to work out the expected return of an asset. CAPM had assumed only one factor contributed to returns: market risk; however, Fama and French noticed that there were two additional factors: market capitalisation and value (specifically price to book value) that, once added to the model, better explained stock market returns. They noticed that small caps and companies trading on low multiples of book value tended to do better than the market and this came to be known as the Fama-French Three-Factor model.
According to Ibbotson Associates, an investment consulting firm, small caps have increased in value by an average of more than 12% per year between 1927 and 2007, compared to 10% for large caps. There are many potential reasons for the small cap advantage including better alignment through large insider ownership, greater inefficiencies because of less analyst coverage, a liquidity premium and a greater potential to be acquired.
Value has been an even more consistent factor in outperforming growth, particularly over 10-year periods, where it has been ahead 84% of the time. The psychology of investors has meant that they tend to extrapolate good and poor results out into the future, leading to high growth companies being overpriced compared to low growth ones.
Even before COVID-19, the last ten years had been extremely unusual with both the value factor and the small-cap factor producing underperformance. Based on historic data, the odds of this happening would be about 5%. The recent sell off has resulted in small caps performing even worse with the MSCI Small Cap index down 30% year-to-date, while the large cap index is down just 21%.
Many of the largest companies in the world barely existed 20 years ago and have grown without the need for much capital so, despite having capitalisations of around $1tn, they have hardly any net assets after adjusting for their cash positions. They have dominant market positions and look set to continue to grow, leading many to argue that the predictive power of low price to book and smaller companies to outperform no longer stands up to scrutiny. We disagree. The ‘robber barons’ in the early 20th century or the ‘media barons’ in the late 20th century provide examples of monopolistic positions that looked unassailable. Eventually competition or government intervention reduced their dominance. We don’t know whether it will be regulation or competition this time, but history suggests profitability and returns will revert to the mean and small-cap value will have its day again.
In addition to smaller companies and low valuations, we look for companies that have high insider ownership (19% of portfolio holdings is owned by insiders), have limited analyst coverage, operate in attractive niches and have relatively strong balance sheets. These characteristics have proven to generate superior returns over the long run.
Activity
Following the announcement by the UK government that it would step in and pay 80% of the salaries of furloughed staff, we increased the strategy’s holdings in Dart Group and Wetherspoon. Philip Meeson (Dart Group) and Tim Martin (Wetherspoon) both founded their businesses with a core focus on providing the best possible value for their customers through service and low prices. They have built institutions that are loved across the UK. When the dust settles, the customers that have missed out on their Easter and perhaps Summer holidays will be looking to re-book their trip abroad and pubs will be bustling with activity again. We doubt we will get another opportunity to purchase these excellent franchises at such attractive valuations.
At the beginning of the month Zooplus was a 10% position which is the upper limit of what we can hold in any stock. With the stock increasing 24% and the rest of the portfolio down 30%, we had to reduce it. We invested the cash from these sales in a new holding, Shop Apotheke, the second largest European online Pharmacy run by its founder Stefan Feltans. Like Zooplus, Shop Apotheke stands to benefit from the current situation, as the move online accelerates.
Although we were more active in the month than usual, we were mindful that often doing nothing is a better course of action in market panics than the alternative. The cash position was reduced from 6.6% at the beginning of the month to 0.6% but the only sales made were due to requirements under UCITS rules for position sizing. Aside from the larger purchases of Dart and Wetherspoon, we also added to other parts of the portfolio that had been hit particularly hard. When the market recovers, we would expect these companies to recover fastest which is what we saw in the second half of March.
Liquidity
We do not hold any unquoted securities. A part of the reason behind small cap underperformance in market panics is liquidity: forced sellers must accept lower prices as spreads widen. One of the disadvantages of owning companies with large insider ownership is that, compared to companies of similar size, they often have less liquidity. This, of course, can work the other way during market recoveries. Although liquidity may impact the shareholders of some of the companies we hold, it is not an issue for this strategy. OP has an independent Risk Management Committee which took the opportunity in March to stress-test our assumptions around liquidity using the trading volumes seen in late February to mid-March. Their analysis showed that 98% of the portfolio can be liquidated within ten days.
Outlook
We believe, most of the strategy will not only survive this crisis but will come out stronger as competitors struggle. If we look beyond this year, we are seeing extraordinary valuations: for example Wetherspoon, the low cost pub retailer, trades on a 15% historic free cash flow yield and is backed by its freehold property; Dart Group, the owner of Jet2 with £1.5bn of cash on hand, is trading on four times earnings; CLS holdings, a property company with £260m of cash (having recently sold 15% of its property) is trading at 0.6x book; and the list goes on.
Every decade something comes along: a war, a debt crisis, a pandemic. At these times the outlook for businesses look terrible, yet it is precisely when it looks the worst that the opportunity to make good returns is often at its highest. We saw this in March 2009, but it was also true in October 1957, when the Asian flu crisis was at its worst. This crisis, like others before it, will pass and normality will return. This time the world is awash with cheap capital provided by governments/central banks and oil is the cheapest it has been for 20 years, so there are some reasons to be optimistic that it could be a sharp recovery.
We have adjusted our target prices to take into account the losses expected this year and, on the assumption that normality returns next year, we see upside of 145% - an unprecedented level. The price to ‘normal’ earnings is less than seven times and the price to book of the portfolio is just 0.8x. We are invested in a portfolio of companies that have excellent long-term prospects, run by able and aligned management at some of the most attractive valuations that we have seen.
Appendix
Operational resilience
These are difficult times for us all and we want to reassure you that at Oldfield Partners our staff are healthy, our systems and processes are resilient, and we are operating as close to normal as possible. The investment team are communicating with each other constantly and our weekly investment meeting takes place via video conference. Our research effort continues unaffected.
Counterparty risk
Our Risk Management Committee examines trade settlement risk as part of our wider risk management procedures. Considering recent events, we have re-assessed the creditworthiness of our executing counterparty.
In order to minimise this risk, OP settles all trades on a Delivery versus Payment (“DVP”) basis. This ensures that delivery occurs only if a payment occurs. It also reduces the chance that deliveries or payments would be withheld during periods of stress in the financial markets thereby reducing liquidity risk. We do not short stocks, use leverage or lend securities.
We execute all trades in equities through Northern Trust under an outsourced trading arrangement. Northern Trust is a custody bank with an A+ credit rating. Furthermore, actions by governments and central banks around the world are also helping to ensure sufficient liquidity in the financial system.
We remain comfortable with the risks associated with Northern Trust and that the risks associated with trade settlement are low.
Business continuity
We ran a full Business Continuity Plan (BCP) test in on the evening of 5th March, closing our office from Friday 6th March to the morning of Monday 9th March and asking all staff to work remotely, in preparation for a worsening of the situation in the UK. The test was a success – all staff were able to work remotely and securely, all business-critical systems functioned as expected and multiple communication methods worked well (email, instant messaging, voice and video conferencing).
The BCP was put into action indefinitely on Monday 16th March. Every single member of the firm is now working from home but keeping in contact through multiple channels of communication. All systems, controls and operational functions are working as expected.