From 'Mean-Reverting Heaven in High Quality' to 'Hard to Predict, Ugly and Cheap'
Johannes Visser, Analyst
19 May 2015
'In theory, there is no difference between theory and practice, but in practice there is.'
Since we established RECM more than ten years ago, we've consistently stated our preference for quality companies and demonstrated this preference in the assets we hold on behalf of our clients. As the broad characteristics of global markets have shifted, so has the composition of our portfolios. Stocks of companies generally seen to be of lesser quality have started appearing in our portfolios. This has led to some questions from investors as to whether we've changed our stripes.
This article clarifies how 'quality' fits into our investment process and investigates the composition of our global portfolios.
RECM is a valuation based investor with a preference for quality businesses
Our primary goal as investors is to maximise absolute returns after tax while minimising the risk of permanent capital loss.
We believe that investing in high quality businesses – ones that compound the value of their capital at a high rate – at a discount to intrinsic value is fundamental to achieving this outcome. The margin of safety – how far the asset is trading below our estimate of its intrinsic value – and our evaluation of the quality of a business ultimately determine how much capital we allocate to that business. Only high quality companies that are substantially undervalued will become large positions in our portfolios.
Theoretically the qualitative characteristics of a business is accounted for in its valuation estimate through the assumptions regarding the discount rate and growth rate assigned. If valuation estimates are accurate and the share prices revert to their intrinsic value over the same time period, the return earned from investing in a lower quality business at the same margin of safety to a higher quality business shouldn't differ materially. In fact, it'll be higher for the lower quality business because the return should reflect the higher risk or discount rate assumed in the valuation. It's from this standpoint – that quality or risk is accounted for in the valuation – that we emphasise the margin of safety and why RECM is, first and foremost, a 'value' investor.
Chart 1: Cumulative Return of Quality Businesses in the S&P 500 Relative to the S&P 500
As long term valuation based investors we're aware that no asset is so good that valuation doesn't matter. A prime example of this is the overvaluation of the 'Nifty Fifty' basket of blue chip companies during the early 1970s which led to horrendous returns for investors in the following decade. Although most of these businesses didn't go bust (some did) they didn't provide downside protection. Chart 1 provides evidence that quality – defined as companies in the S&P 500 index with high and stable profitability and low leverage – has in fact outperformed over the past 50 years. But the variation in the graph also show that quality as a subset doesn't outperform because it's divinely ordained to do so. It only outperforms when it's priced to do so – when it's undervalued at purchase.
If quality is accounted for in the valuation, why do we have a preference for it? Why not just focus on the margin of safety when weighting positions? Is it to manage career risk – in other words to invest in businesses that average opinion considers prudent? Or is it to beat the gun in an environment where yielding businesses are doing well in a low interest rate environment and 'quality' has become fashionable?
We believe that a focus on qualitative factors lends itself to a long-term bottom-up 'high conviction' approach – in other words is complimentary to a long-term valuation framework that invests in single businesses. This is RECM's approach. It also allows for a process that identifies the key characteristics in order to consistently inform opinions on weighting businesses.
Different investors have different definitions of quality. For readers who may be looking for more detail, please see the addendum to this article for a discussion of the characteristics of a business that ultimately inform RECM's quality call and position sizing.
All else being equal, quality increases our conviction. We typically have more conviction in the valuation of a highly profitable, stable, conservatively financed business with a long runway of investment opportunities and good capital allocators at the helm than for a business with the opposite characteristics. Understanding whether a business will be around ten years from today and what it may look like is easier for a business with a moat or a sustainable competitive advantage. Higher predictability means more conviction in the valuation. As a result we're likely to allocate more capital at a similar margin of safety to such a business than to a less predictable business.
When Charlie Munger was asked what he'd do if he was starting out again in the investment business he answered that he'd look to identify good management teams in smaller, quality businesses. Value investors are often criticised for missing out on high growth businesses as they are unwilling to pay high multiples. Great long-term investment track records – including those of Buffet and Munger – have been built on investing in great businesses at a fair price and holding on to them for a long time.
Valuation always has a range of potential outcomes. It appears wider on the downside for a poor quality business and wider on the upside for a high quality business. Realistically the valuation range cannot always be fully captured in a single value today. Certain businesses that have moats that compound capital at a high rate may have valuations with lower risk and more upside potential than our current valuation estimates may give them credit for. And as any investor knows one has to draw the line at some point with regards to forecasting high growth. To account for this practical element – that time is the friend of the good business and the enemy of the bad business – we may back a higher quality business at a lower margin of safety and require a much higher margin of safety for a poor quality business.
Strong moat, high return businesses can create tremendous value when they have reinvestment opportunities. In rare cases a business may be in the process of creating a moat and may well be worth significantly more than in its current form. These are the businesses one wants to identify, invest in and stay invested in. The valuation relies on understanding where a business may be ten years from now. When we see opportunities like these and management meet our investment criteria – as discussed in the addendum – we’re willing to back them at higher valuation multiples or lower margins of safety.
The investment opportunity set
The past six years has been a great time to invest globally. For most of the period, high quality equities have been available at low prices, particularly in developed markets like the US, Southern Europe and Japan. Low interest rates have chased up valuations of yielding assets, including high quality dividend paying companies, and investing has become increasingly difficult.
Chart 2: RECM Quantitative Screen – Percentage of Global Sectors at Discounts/Premiums to Quantitative Value
Source: Thomson Reuters DataStream, RECM analysis
Chart 2 shows the percentage of sectors in a global investment universe of approximately 7 000 businesses. Each bar shows the current discounts and premiums of each sector to quantitative valuations that are based on averages derived from a number of long-term valuation multiples. Broadly speaking the value opportunity set has shifted from 'mean-reverting heaven in high quality' to 'hard to predict, ugly and cheap'.
The information suggests opportunities in:
- metals and mining
- oil and gas
- software and hardware technology businesses
- electricity generators (although many of the undervalued assets are state owned with tightening regulation and a non-profit incentive)
- fixed line and mobile telecoms businesses (but growth and returns have slowed considerably suggesting lower multiples and valuations than the historic values indicated on the chart)
Chart 3: Food Producers, Tobacco, Personal Goods, Healthcare Equipment and Services, General Retail, REITS, Aerospace and Defence Price-to-Book Ratio
Source: Thomson Reuters DataStream, RECM analysis
Chart 4: Banks, Electricity, Mining, Industrial Metals and Mining, Oil and Gas Producers, Oil Services Price-to-Book Ratio
Source: Thomson Reuters DataStream, RECM analysis
Charts 3 and 4 show the combined price-to-book ratios (P/Bs) of a number of sectors currently perceived to be higher quality (Chart 3) and lower quality (Chart 4). While Chart 3 shows the most popular sectors trading around 50% higher than their previous highs, Chart 4 shows the combined P/Bs of the out of favour sectors trading near their 30-year lows.
The question is which one offers the best future investment return?
Bearing in mind that this analysis does not inform our intrinsic value calculations themselves, valuation filters such as this one – particularly at the industry level – have shown a direct relationship between low valuations and good future investment returns.
Our holdings are driven by bottom up idea generation, intrinsic valuations and portfolio construction
Table 1: Top 10 Holdings of the RECM Global Fund – March 2012 vs March 2015
Table 1 compares the top ten holdings of the RECM Global Fund as at March 2015 and March 2012. It shows that while most of the holdings in 2012 were what we'd consider quality companies, the holdings as at March 2015 reflect the current opportunity set – more cyclical companies with arguably less clear quality credentials.
The composition of our investment portfolios is driven by our idea generation, our estimates of intrinsic value, valuation asymmetry and portfolio construction that aim to capture diversified risk factors and generate the highest risk-adjusted return. As long-term value investors with a consistent investment process, RECM's relative performance has been – and will continue to be – influenced by the ebb and flow of the value investment style. As bottom up investors and part owners of the businesses we invest in, we rarely follow strategies purely based on quantitative value as described before. Our analysis and judgement bring both challenges and opportunities around idea generation and valuation, as well as buying and selling discipline. Broadly speaking we capture the value anomaly by investing where our bottom up process finds value and prefer quality businesses in this regard.
In the context of a wide investment opportunity set, filling a portfolio with around 30 high-quality businesses priced at an acceptable margin of safety seems conceivable. However, many of the more mature quality businesses we've identified are not trading at significant discounts to fair value. For the same reason many of our quality positions are also held at a lower weight in the portfolio than before. Nonetheless our research pipeline includes a number of higher quality businesses albeit generally at lower margins of safety, and we look forward to investing when the price is right.
What may be considered prudent investing in 'safe' high quality assets continues to become increasingly imprudent when such assets are priced for perfection. We're left with a choice between investing in high quality businesses at a smaller discount – where we may be potentially undervaluing a business – and lower quality at an enormous discount – where we may potentially be overvaluing the business. This is an important consideration and a tough balancing act in the current environment.
RECM remains a valuation based investor with a preference for high quality businesses. At the same margin of safety we prefer a higher quality business to a poor quality business. It's fair to say that our current portfolio reflects an aggressive move to non-quality businesses. Our position sizing in the top 10 implies that these businesses must be very attractively priced for us to invest such large amounts in them. We believe the current margins of safety in the non-quality businesses we have invested in more than compensate us for the risks and that this part of the investment universe therefore has a place in a global portfolio today.
Addendum: How RECM defines quality
When we evaluate the quality and size of a position in an asset we draw from our assessments around the following five factors.
1. Competitive position
When we evaluate the competitive position of a company, we look at it from the point of view of Porter's Five Forces – the framework developed by Harvard Professor Michael Porter that defines competitive forces within an industry. We focus most of our time on the first of these – namely the barriers to entry or competitive advantage the business may hold. In this regard we've borrowed much from Pat Dorsey and Morningstar's approach to assessing moats. This barrier or competitive advantage is what Warren Buffett has famously referred to as a moat. The basic principles of economics dictate that where a company earns excess returns on capital, other companies will enter the market and compete until abnormal profits are eroded. That is, unless the company has some advantage that allows it to sustain its higher profitability or at least delay the erosion for a long time.
What moats look like and why they work
Moats can be classified into four broad categories:
- Intangible assets – brands, patents and licences
Strong brands can confer instant recognition among consumers but not all popular brands are profitable. Brands have to be able to influence consumer behaviour to be valuable. If a brand can reduce the time a consumer has to spend on deciding on a particular product or if the brand commands pricing power, it is valuable.
Patents are typically less durable as they have a limited life and competition will arrive quickly once they expire. The competitive advantages conferred by patents often require an ongoing investment in research and development, where the outcome may be harder to predict.
As with patents, licenses can also expire and will differ depending on their type.The moats derived from licenses are typically strongest in cases where companies need regulatory approval to operate in a market but prices or capital investments aren't regulated.
- Cost advantages
A cost advantage can arise from a company's process, location, access to a superior resource or scale. Scale advantages – being considerably larger than the competition – can typically be found in businesses with large distribution networks, higher production volumes, a high number of subscribers or dominance in a niche market.
- Switching costs that lead to pricing power
Where there are costs to customers of switching from a particular product or service, that business often has pricing power.
- Network effects
The network effect is a kind of switching cost but is so powerful it can be considered separately. Certain businesses – such as social media companies – enjoy an exponential increase in value as more members are added to their network. A new network would have to replicate the existing network or at least come close before users see value in it. As a result, first movers may come to dominate, even though early on the network is subject to attack while consumer preferences are still being formed.
Porter's other four forces that may influence the returns a business generates include:
- the bargaining power of suppliers and customers (concentration, product differentiation, product cost as a percentage of the buyer's cost base, the product's quality impact on the buyer's product quality, the threat of backward integration by customers),
- the availability of substitutes (and the impact on pricing power), and
- the industry structure or level of competitiveness (such as the number of competitors and concentration, position relative to peers, industry growth, product differentiation, fixed cost or operating leverage, capacity increments, exit barriers and the presence of irrational competitors).
Even seemingly strong competitive advantages can become permanently eroded by things like rapid changes in technology and other changes in the competitive environment. Part of our analysis is specifically to identify the risks to these moats – what might make them disappear or weaken – and monitor developments in this arena.
An understanding of the competitive position within this framework allows us to form an opinion of the normal returns on capital and how long these are likely to last. This is considered together with the runway or reinvestment opportunities available to a company to inform our base valuation.
2. Earnings quality (cash is king)
Free cash flow may differ substantially from reported accounting earnings and this may influence our quality call and valuation. This often stems from the competitive position of the business and is evident in the capital requirements, net working capital requirements and other cash and non-cash items or the way the business accounts for these.
We investigate various factors to assess the quality of management. These include:
- past and current capital allocation decisions in the context of our understanding of the moat to form an opinion on management's skill,
- management's shareholding in the company and whether they've been buying or selling stock,
- the way management is incentivised
- a track record of integrity – are these people with whom we can partner long term?
4. Cyclicality and cycle call
We evaluate the stability and runway of earnings to establish whether the business is stable and growing, growing but cyclical or purely cyclical and this may inform the quality assessment.
Business risk – the risk of permanent damage to earnings power – is often highest at the top of the cycle and lower at the bottom. We evaluate the business cycle, including the indicators relevant to the business cycle of the particular business, where we are in the cycle, to what extent the cycle may affect long term business value, and how the business is priced at different points in the cycle.
5. Financial risk
We investigate the balance sheet and the financial risk represented by the ability of the company to fund itself.
These five qualitative factors generally inform our opinion on the risk and valuation of a business and ultimately an explicit quality call which together with the margin of safety determines the size of a position in a portfolio. Ultimately the quality call and size of a position may rely more heavily on certain of the five factors than others depending on the investment thesis and the interpretation by different portfolio managers.