Value First

Value Investor Digest readers can enjoy this recent interview with Oldfield Partners' Andrew Goodwin and Nigel Waller from the most recent issue of Value Investor Insight. You can access the full February issue with more great content by registering for a free trial. There is no obligation and no payment required. The trial subscription will also include the upcoming March issue of VII, as well as our regular Bonus Content e-mails. To register, click here.




In the understated fashion of a traditional value investor, Oldfield Partners' Andrew Goodwin, co-manager with Chief Investment Officer Nigel Waller of the firm's global-equity strategy, doesn't make any grand claims about his investment edge. "We generally believe share prices become too low after a run of bad news and too high after a run of good news," he says. "From there we want to bring to bear a great dollop of common sense."


With that no-nonsense approach, Oldfield's $3 billion (assets) global strategy since inception in 2000 has earned a net annualized 6.7%, vs. 3.8% for the MSCI World Index. Today the two managers see mispriced value inside Europe and out, in such areas as telecom services, banking, diversified industrials and power generation.


One could categorize your investment strategy as rather "old-school" when it comes to discerning value. Would you agree with that?

Nigel Waller: We consider ourselves to be classic, contrarian value investors, so to the extent that we regard a share price that has gone down as cheaper and more interesting, that's probably fair. We focus on areas of the market where other investors aren't, where sentiment is poor and where valuations are historically low in absolute terms and relative to history.


We're essentially trying to take advantage of what we consider two key inefficiencies in modern markets, the short-termism of most market participants and the tendency of many investment managers to hug indices. We think those who can take a medium- to long-term view and disregard the index composition will have an advantage. 


Just as the market can extrapolate unduly to create share prices that are too high after good news, we're looking for the opposite cases, where the market lurches down in a knee-jerk reaction after bad news. To give one example, when voters in the U.K. in 2016 voted to leave the European Union, U.K. bank stocks bore the initial brunt of the negative reaction. We had already started looking at banks like Lloyds [London: LLOY] and Royal Bank of Scotland [London: RBS], stress-testing their balance sheets and cash flows against the worst-ever historical periods in the property, commercial and personal lending markets. When we did that, we concluded in both cases that with a reasonable time horizon the market was overreacting to the threat of Brexit. The lowering of their valuations due to the threat is what gave us the opportunity we ended up taking in Lloyds.


We're fully aware that a low valuation in itself tells you nothing about whether a stock is a bargain. When the shares of BP [BP] fell after the Macondo oil spill in 2010 we looked at it and decided very quickly that the stock price had come nowhere close to discounting the potential costs of the disaster. We looked last year at General Electric [GE] and couldn't get comfortable with its hugely complex balance-sheet liabilities. 


We also last year spent considerable time on PG&E [PCG], the California utility that has been very much in the news. The fundamentals of delivering power to power-hungry consumers in the state were attractive to us. On the surface, the regulatory framework was improving, with a compromise reached with regulators in the middle of last year that seemed to clarify the company's risk of liability in the event of wildfires. We eventually concluded the compromise didn't go far enough and the threat of bankruptcy if there was a big fire was too high. When the outcomes are binary, we try to steer clear. 


Kudos on missing those potential "opportunities." As an example of something that did made the cut, explain what attracted you to a traditional media company like Viacom [VIA].

Andrew Goodwin: Clearly the way people consume media is changing, which has led to a tremendous amount of uncertainty in the media sector. There's been an increasing polarization between those perceived as the winners, like Netflix, and the losers, of which Viacom appears to be counted. When there's this kind of polarization, investors can become enamored with the new and disregard the old. In Viacom's case that meant a stock that historically had traded at a P/E of around 18x was trading in early 2017 at a P/E of 6-7x. As contrarians, we'll look at that to see whether its yesterday's story or a potential bargain.


If we find a stock that appears statistically cheap, our research focuses on fully understanding why that is. We want to know what specifically is concerning the market and whether those concerns are appropriate. If we think the market is wrong – that the problems can be fixed or won't be as bad as expected – we'll then try to figure out what the shares could reasonably be worth.


In Viacom's case, there were a number of issues. The company was paralyzed by a very public boardroom battle at a time when the prospects for the pay-TV ecosystem in the U.S. were threatened. Its Paramount movie studio, historically a Hollywood leader, was losing hundreds of millions of dollars. The dividend had been cut in half.


Our investment case was – and is – that Paramount could be fixed and its value would again be recognized. While the decline in the pay-TV ecosystem is real, content is as valuable as ever and Viacom can not only make its way as the industry evolves, but also due to the contractual nature of its relationships with pay-TV providers should have more stable cash flows than the market seems to expect. We also expected the wrangling over corporate governance to be resolved in the best interests of the company, and that in the meantime it was in good hands with new CEO Bob Bakish, who had a credible plan for an operational turnaround.


If you first started buying in early 2017, you've so far been early. Is your thesis still intact?

AG: There have been some bumps along the way, particularly around negotiations with cable and satellite service providers, but we believe the turnaround is starting to gain momentum. Paramount is very much on the mend. Certain key properties like MTV are putting up better viewership numbers and the Media Networks business remains highly profitable and cash-generative – its operating margins are around 33% and it generates a mid-teens free-cash-flow yield. We took our second bite of the stock on weakness in the first half of last year, and we still think the turnaround is on track and will eventually result in the stock re-rating toward peer multiples. [Note: At a recent $34, Viacom shares trade at 8x consensus 2019 earnings estimates.] 


You spoke about dodging bullets in GE and PG&E, but more generally, how do you try to avoid the permanent value destruction that value traps bring?

AG: One of the biggest criticisms of value investing is the existence of value traps. It's an occupational hazard and one you will never eliminate entirely. But the fact of the matter is that they are necessary for the whole proposition of value investing to work. If it weren't for value traps, investing would be rather simple, you could just buy statistically cheap companies. But that wouldn't last as the opportunity would very quickly be arbitraged away. Value traps are essential for value investing to work. 


The fact of the matter is that value traps are necessary for the whole proposition of value investing to work.


The primary key to mitigating value traps is the quality of your own fundamental research. We're very wary of companies that combine financial leverage with operating leverage, which is often a prime contributor to value leakage over time. That was a big issue for us with GE. As Nigel mentioned with PG&E, we also try to avoid binary potential outcomes, where the downside is too extreme. 


NW: A lot of it, as you might expect, also comes down to valuation. If you're disciplined in requiring a large margin of safety, you can have some slippage on the original investment thesis and still generate an attractive capital return. Our minimum hurdle is that our estimate of fair value on a stock two to three years out gives us at least a 25% return from today's share price. In practice, the average weighted upside has been around 30% since we started the fund. That number today is closer to 40%.


From a portfolio perspective, we come at each idea from a bottom-up perspective and while we run a concentrated book – usually with 20 to 25 names – we care very much about diversification. We know if we're lucky or smart we're only going to be right 60% of the time, so it is very dangerous to start with a top-down view that permeates every aspect of the portfolio.


We have some general rules of diversification. We can't have more than 40% of the global portfolio in any market other than the U.S. Our broad sector limit is 33%, and for sub-sectors like autos or utilities that have idiosyncratic risks and influences, we limit those to no more than one-eighth of the portfolio. A typical position size for us is 5%, and if something gets to 7% or so we're usually in taking-profits mode. 


You mentioned taking a second "bite" out of Viacom. How do you think through averaging-down scenarios?

AG: If we buy something and the share price falls, as long as we can still see the requisite gap between the price and our view of intrinsic worth, we will take a second bite. But we'll only do so after a review of our investment case, if the share price has fallen by more than 20% and, ideally, if at least six months have passed since we took our first bite.


We will also take a third bite if, again, the required gap between price and value remains. But this time a full review is done by a new analyst who doesn't have the potential baggage of wanting to defend the earlier decision. The price has to be down at least 40% from the original purchase price and we limit ourselves to investing no more than 10% at cost of our capital in a single idea like this. After three bites, that's it. We won't take another.


Can you describe how your experience with supermarket chain Tesco [London: TSCO] – one of the more ubiquitous traps we've seen value investors fall into in recent years – has played out?

NW: We've been invested in Tesco since 2011, and many of the guidelines Andrew just described reflect our trying to learn from our mistakes with it and with other value traps we have fallen into over time. 


When we first invested in the company we knew it was operationally levered because it's a supermarket chain with a lot of fixed costs. What we didn't appreciate, in retrospect, was how rapidly its fundamental business was deteriorating and the extent to which that deterioration would make it more financially leveraged than we thought. As we mentioned earlier, that's a route to value leakage. 


We generally try to meet with management, but also want our analysis of the available information to drive our decision-making more than any subjective view of the CEO or others in leadership. In this case we made a fatal error in judgement in discounting our own analysis in favor of management's "explanations" for why the business was really in better shape than it looked.


You still own Tesco shares. What's the story today?

NW: If there's still a big gap between price and value, we will hold on. When margins collapsed we spent a lot of time on what margins should be in a business like this. Forget what they'd done in the past, what evidence did we have from comparable retailers in the world to support an estimate? We came away with a strong view that an operating margin somewhere between 3% and 4% was a reasonable expectation for a large food-retail business like this. The company had rebased to 0% margins and the general long-term expectation was only 1% to 1.5%. The company came out targeting 3-4% and we believe they're on track to doing that. We've stuck with it because we think from today there are still handsome returns to be made. 


One idea in which you chose not to take an additional bite last year was Russian energy giant Lukoil [London ADR: LKOD]. Why not? 

NW: We run primarily a developed-market portfolio, but when we invest in a name like this one important consideration is the additional discount we require because of country-specific risk that comes with investing in a place like Russia. When we originally invested, we required an additional 20% discount, but as Mr. Putin seemed to be pursuing ever more ambitious goals from a geopolitical perspective, we decided early last year to increase that discount to 30%. That reduced the upside to a level where we decided to cut our position in half. As the shares came back somewhat in the fourth quarter, they reached our fair-value target and we sold the rest.


While you passed on GE last year, you did establish a new position in German conglomerate Siemens [Xetra: SIE]. What attracted you to it instead? 

NW: The stock had come down a long way and it was appearing on our poor-performer screens. But the main impetus was actually our looking into GE and seeing potentially unrecognized value in its jet-engine, healthcare and even power-equipment businesses. Siemens had some of those same types of businesses, but didn't have the balance sheet issues GE did. That prompted us to think this might be a much better opportunity, with far less risk and complexity than GE.


We made an error by favoring management's "explanations" for why the business was in better shape than it looked.


If you look at the operating-margin history of Siemens, before around 2001 the story was awful. The company had an overly diverse set of businesses that didn't fit together and in many cases weren't very well run. Overall margins were maybe 1.5% to 3.5%. From 2001 on, however, there's been a persistent slant up and to the right for operating margins as a series of management teams have continued to restructure, focus and optimize the portfolio of businesses. But even with that improvement in the business, if you look at a valuation chart for the stock, it looks today exactly as it did in the 1990s. The returns have improved but the valuation hasn't. That's also something that will attract our attention.


The company's latest "Vision 2020" plan to improve margins and return on equity has fallen short of targets so far. Is that a concern? 

NW: Most of the divisions are very much on track with the Vision 2020 goals, but that's been shrouded by the massive decline in the power-turbine business, where Siemens is one of three major global players along with GE and Japan's Mitsubishi Heavy Industries. After a demand bubble in that business burst, new orders have fallen to a 30-year low, which has resulted in turbines going from 31% of Siemens' group profit in 2014 to less than 2% in the year just ended.


While wind and solar are likely going to drive investment in power-generating capacity over the next 15 years, the power-turbine business for Siemens is not going away and we think is poised to have another cycle up that is not at all priced into the shares. Natural gas will continue to replace coal to generate electricity, which will help drive demand for new gas-fired turbines. I'd add that Siemens is also a leader on the renewables side, where its publicly listed joint venture with Spain's Gamesa, Siemens Gamesa [Madrid: SGRE], holds the #1 global position in wind turbines.


Among other businesses of note, the company sold part of its medical-equipment business, Siemens Healthineers [Xetra: SHL], to the public last year, and it continues to generate excellent growth with high profitability. We also see tremendous potential in the "digital factory" business, where the company is a leader in cutting-edge industrial-automation equipment and software systems across industries. That business is growing at a mid-teens annual rate, with EBIT margins of around 20%. 


With the shares trading recently at around €96.70, how are you looking at valuation?

NW: A key part of the valuation work centers on the digital-factory unit, where the growth potential and integrated hardware/software nature of the business makes it much more valuable than a typical industrial enterprise. We think applying a 15x EV/EBIT multiple is justified in arriving at a value for it, which combined with the market values of the Siemens Gamesa and Siemens Healthineers stakes accounts for the parent company's entire current enterprise value.


That leaves us with zero ascribed value to businesses with total annual revenue of €49 billion. That includes the traditional power-generation business, where we aren't counting on revenue growth but do expect operating margins to get back to around 8%, mostly as a result of a headcount-reduction program already announced and being implemented. Overall, we value all the remaining businesses at 10x EV/EBIT on our 2020 estimates, which yields a sum-of-the-parts fair value of around €148 per share. 


In addition to Lloyds, which you mentioned earlier, you're finding opportunity in a number of large banks. Describe your investment case for one of them, Japan's Mitsubishi UFJ Financial [Tokyo: 8306]. 

AG: Low interest rates and the flattening of yield curves is clearly bad news for banks, but valuations that were modest to begin with have in some cases gotten to levels we consider unreasonable. The banks we own all have credible paths to improving returns on equity, have healthy balance sheets, and are returning surplus capital to their shareholders through dividends and stock buybacks. But their shares discount extremely negative prospects, trading at significant discounts to tangible book value. Lloyds is currently trading at around 80% of tangible book. Citigroup is at around 70%. For Mitsubishi UFJ, which is the largest bank by assets in the world outside of China, that number is only 45%. 


The Japanese macroeconomic environment, to put it mildly, has been inhospitable to banks like MUFG. The government's zero-interest-rate policy continues to dampen returns on assets and net interest margins. In MUFG's case, net interest income in Japan has been halved over the past 10 years. 


But the company has hardly been standing still and has built an impressive growth platform outside its home market. It bought a 23% stake in U.S. investment bank Morgan Stanley at the height of the financial crisis, and the two companies now collaborate on a variety of fronts. It owns Union Bank of California, the 13th-largest bank in the U.S. It also owns Thailand's fifth-largest bank, and this year will build to a nearly 75% stake in the fifth-largest bank in Indonesia. Just last month, MUFG bought the global supply-chain financing business of General Electric. Overall, roughly 40% of total loans now come from overseas.


Are those efforts driving the improved return on equity you see coming? 

NW: The bank today earns a return on equity of 6%, which is low compared to global peers, lower than the 8% or so they've earned over time, and lower still than the 9-10% target ROE management has set. Part of that should come from incremental, more-profitable growth outside Japan. Part of it will come from a fairly aggressive program of share buybacks. There's also a significant self-help aspect, from reducing the cost base of the Japanese bank through an announced plan to cut the number of branches by 50% and decrease headcount by upgrading technology and systems. The goal is to reduce the bank's cost/income ratio from 68-69% today to 60%. In general, any progress toward improving ROE would help drive a re-rating of the shares.


How are you looking at upside in the shares from today's price of around ¥580? 

AG: To value the listed operating holdings – the Morgan Stanley stake being the largest – and the large portfolio of listed Japanese equities MUFG owns, we're assuming these are worth their current market values. For the main banking business, given our expectation that ROE can improve at least part of the way toward management's goal, we value it at 0.6x tangible book value. All in, that gives us a price target of around ¥925. We don't assume any benefits from an improving macro environment in Japan – that would be optionality on the upside.


You don't appear to see the same potential in continental-European banks that you see in something like MUFG. Why? 

NW: If you study the behavior of banking-sector regulators since the financial crisis, the responses in places like the U.K. and the U.S. have been starkly different to what we've seen in the rest of Europe. Generally speaking, in the U.S. and the U.K. regulators took an aggressive stance toward recapitalizing the sector. That just hasn't happened in Europe, with the result that most European banks have been very slow to repair their balance sheets, the sector is less healthy and, as a result, economic growth has been weaker. That makes us very wary as investors, especially when we can find opportunities elsewhere with equally distressed share prices, but far healthier balance sheets.


Staying in Japan, what do you think the market is missing in Kansai Electric Power [Tokyo: 9503]? 

AG: This will give you a feel for how we approach things. Kansai Electric is a Japanese electric utility whose business had been dramatically impacted by the government's decision following the 2011 Fukushima nuclear disaster to switch off all of the country's nuclear reactors. The company owned and operated 11 reactors at the time and was forced to find alternative fuel sources to meet customer demand. As a result, its annual spending on fuel went from around ¥350 billion pre-Fukushima to around ¥1.2 trillion in 2015, when we first decided to take a look.


Our interest stemmed from indications that regulators in Japan were set to start bringing nuclear capacity back on line. In a country with no indigenous energy sources, there were strategic, military and financial reasons that nuclear had to play a role in supporting the country's electric grid. The utilities themselves were spending heavily to comply with new safety measures and get reactors ready to return to service, but analysts were reluctant to build that into their models for companies like Kansai. There were still significant legislative and judicial hurdles to clear for anything to happen, and most investors in the sector seemed to have given up. 


Our thesis at the time was relatively simple. With even a modest return to service of some subset of Kansai's nuclear capacity – which we believed would happen – heavy losses would turn into profits and the stock, then trading as cheaply as any utility in the world relative to assets, had considerable upside.


Looking at the stock price, it's been a rocky road, but so far so good. Update us on your thesis today.

AG: The simple initial thesis has been complicated by judicial decisions that have delayed certain restarts, and by the impact of deregulation of electricity markets in Japan that has brought increased competition to Kansai at a time when it has been more vulnerable because of its inflated cost base.


But the basic investment thesis is still intact. Four of the company's seven viable reactors are back on line, with the remaining three expected to restart by 2022. Given the significant reduction in fuel costs accompanying that, with all seven reactors functioning the company estimates that annual operating profits, expected to be around ¥200 billion this year, could come in at closer to ¥325 billion. We think that's reasonable, especially given the company's opportunity to gain share as it again becomes the lost-cost producer in most of its markets.


How do you see that impacting the share price, now at around ¥1,680?

AG: Looking out three years, our estimates assume seven reactors are up and running and that the operating-profit impact of that is roughly what the company envisions. On those 2022 estimates we apply an 8x EV/EBITDA multiple, which is the average sector valuation for utilities worldwide. That could result in a share price north of ¥2,500. 


Turning to your home market, describe why you're high on the prospects for telecom provider BT Group [BT].

AG: BT Group is the leading operator in both the broadband and mobile services markets in the United Kingdom. With around 10 million broadband subscribers, it has over a 45% market share of the installed base. In mobile it has about 30 million subscribers and also has leading market share.


It wasn't that long ago that BT was the highest rated of the European telecoms, but the company's share price has been cut in half over the last three years. A number of things have contributed to that, including lack of regulatory visibility around new investment in fiber-to-the-home infrastructure, heightened competitive pressures in the U.K. consumer segment, heavy spending to acquire sports broadcasting rights, and demands on corporate cash from a large pension deficit and a big dividend.


The fiber-to-home effort is a huge capital commitment, expected to cost BT something like $6 billion over the next eight years. Politicians in the U.K. are keen to see this happen – the U.K. has been a laggard on this front – but it's still unclear exactly the return BT will be allowed on the investment it has already started to make. That understandably worries the market, but our view is that this type of improvement in the country's communications infrastructure won't ultimately be discouraged by overly tight regulation of the only operator who can deliver at scale. These types of things are clearly difficult to predict, but we generally feel the regulatory relationship is past its worst point and is likely to improve.


There have been concerns about new broadband service providers rising up to challenge BT, but most of those alternatives are struggling to raise funding. The company has been aggressive in announcing discounts on its new fiber products, taking further steam out of competing efforts. We also think it's a huge win that BT finally came to an agreement with Sky, the satellite-TV provider, for the companies to show each other's content. The more content there is that doesn't require a satellite dish to access, the better for broadband providers like BT.


How worried are you about cash-flow constraints?

NW: We've looked at a number of different scenarios, and while there's a possibility the company may have to delay somewhat the pace of the fiber rollout, we generally believe the cash-flow generation will cover expected calls on it to fund the dividend, the pension and the capital spending for fiber. 


How cheap do you consider the shares at today's £2.15 price?

NW: The P/E today on our March 2019 adjusted EPS estimate of 27 pence is right around 8x, and the current dividend yield is over 6.5%. As the fiber-to-home rollout continues and the growth profile improves, we think it's reasonable to assume the shares could re-rate from their depressed level. At even a 12x P/E – quite conservative relative to history – on our March 2021 estimates the share price would be around £3.20. 


One potential backstop for valuation in this case is that Deutsche Telecom [Xetra: DTE] owns 12% of the company. It has expressed interest in the past in acquiring BT, and if the valuation gets any lower we wouldn't be surprised to see it renew its interest. 


You published an essay last November titled "Value Investing in an Age of Disruption," in which you defended value investors against the charge of being "disruption deniers." What prompted that? 

AG: We've had a long period since the financial crisis when value has lagged from a performance standpoint, which has prompted questions from investors, and more specifically consultants, that imply that value investing has become less relevant when rampant business disruption is increasing the likelihood of value traps. 


Our point is that disruption has always been a normal part of investment life, creating opportunity and threat for companies of all shapes and sizes. History provides us with a long list of examples of companies that failed to meet a disruptive threat and disappeared. But history is also littered with speculative periods where growth investors made and then lost fortunes as they overestimated the prospects of disrupters, how quickly the benefits of disruption would come, or simply got carried away with the valuations accorded to the shiny and new.


Many of our peers have drifted in response to the commercial pressures of keeping up with growth-led markets.


The challenge for us hasn't changed. We're on the search for bargains and have to fully understand disruptive threats and judge whether they are being correctly priced by the market or not. We're sticking firmly with the time-tested theory that low valuations are the single most important determinant of future returns. We'll dispense with that only if the company's prospects are indeed permanently disrupted and if that disruption doesn't appear to be priced into the shares. That has always been the case.


NW: While value in general as a style has been questioned, so has our specific contrarian, valuation-first approach. Questioners include more references to "quality," suggesting that we could have done better by focusing more on higher-quality growth companies. We believe the era of quantitative easing has led to significant distortions in asset markets of all types, raising valuations across the board. That's led to investors flocking to anything they perceive to have sustainable growth, with less regard for valuation. 


Of course, company quality and growth rates are important attributes in a stock, but we contend that many of our peers have drifted in response to the commercial pressures of keeping up with growth-led markets. In 2016, the only year in the last ten when value outperformed growth, our global equity strategy was the number one performer among large-cap global equity managers in the InterSec universe. Critically, 94% of investment managers underperformed the MSCI World Value Index in that year. We saw similar patterns at the end of 2018 too.


Over the long term, we know that the traditional value style outperforms growth. As quantitative easing subsides, we're as confident as ever that a classic, contrarian, valuation-first investing approach will deliver.


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