PERSPECTIVE3-5 min to read

The Value Perspective Podcast episode – Meet the Manager, with Andrew Lyddon

In this latest episode in our Meet the Manager series, Arjun Murti returns to The Value Perspective to interview Andrew Lyddon of the Value Team. Arjun is a partner at Veriten, a knowledge and media platform with a focus on energy, technology and environmental trends, as well as a director on the board of ConocoPhillips, a senior adviser at Warburg Pincus, an advisory board member at Columbia University’s Centre on Global Energy Policy and the author of one of our favourite Substack offerings, Super-Spiked, on the energy transition. It is a delight to have Arjun back as he is a natural host on the pod. Andrew Lyddon is a co-founder of the Value Team – way back in 2013 – as well as a fund manager at Schroders. He started his investment career at Schroders in 2005, originally as part of the pan-European research team, with a focus on telecoms, construction and support service. On top of his CFA, Andrew has degrees in intellectual property law and chemistry. Here, Arjun and Andrew cover the debate between value and growth dynamics and what it really means to be a value investor; an argument for growth using recent examples of growth companies that could have been value, if one could accept their growth potential; the pros and cons of the energy sector; and, finally, Arjun plays devil’s advocate on the subject of energy around the position of oil majors in Europe, the war in Ukraine and the challenges of ESG in the context of investing. Enjoy!

02/10/2023
en

Authors

Andrew Lyddon
Fund Manager, Equity Value
Arjun Murti

AM: Andrew Lydon, welcome to The Value Perspective Podcast. I may not do as good a job is Juan but I am very happy to be the guest host today and to spend some time with you. Thank you for joining us.

AL: It is a pleasure to speak to you, Arjun.

AM: I believe you were one of the original founders of the Value Team at Schroders – is that right?

AL: That is right. It gives away my age a little bit but, back in 2013, when the value investors across the equities department of Schroders were formally brought together, there were five of us. I was the youngest one but I was one of those lucky people.

AM: Fantastic. Now, I would actually prefer to end with some of your personal background and, first, get into some questions about value itself as a strategy. When we think about making investments, we can appreciate people might invest in equities for a little more return or they might prefer more conservative assets, like fixed income. So there are many different types of investing but if we stick with something like large-cap equities, I have always struggled with these labels of ‘value’ versus ‘growth’. I think, because I have an energy background, I get labelled as a, quote, ‘value person’ – but I’ve never really understood why these labels are relevant. What does it mean to you to be a value investor?

AL: Well, to the extent they relate to sectors – and things like energy or utilities or whatever being called value stocks – I think those labels are pretty irrelevant, to be honest. One of the fund managers I worked with when I first joined here said, If you stay in the market long enough, you’ll see every company at every valuation. That very much applies to sectors as well, I think – and, as we have seen a lot over the past few years alone, different sectors can come in and out of favour very quickly.

For me, a value investment is simply one that looks cheap on the basis of its established economic fundamentals – so based on what it has historically delivered, rather on what we might hope it delivers 10 years in the future. So whether that is using a Graham & Dodd-type P/E [price/earnings] ratio, based on price to average earnings, or similar kinds of ratios for free cashflow or price to tangible book – you can pick the percentage but it is the cheapest, say, 20% or 25% of the market on that basis.

Those kinds of stocks, which include all kinds of companies across a range of sectors that people are avoiding for whatever reason – they don’t like the sector, say, or the company itself has screwed something up in an idiosyncratic kind of way and is just having a difficult time – are businesses people don’t like. They don’t want to be seen to own them by their clients and they don’t want to wear the underperformance they may bring them. And buying them creates an opportunity for people who are willing to be a bit more thick-skinned, perhaps, or have a longer time period than a lot of other investors in the market to come in and try and pick out the ones from those ‘problem children’, if you like, that are going to be able to grow up and flourish and benefit from the excess return that delivers. So I think those sector labels are pretty problematic and, basically, everything needs to be looked at on a company-by-company basis.

AM: Fantastic. We will get to energy in a moment but, in that sector, things tend to get labelled as ‘clean’ or ‘dirty’, ‘ESG-friendly’ or ‘not ESG-friendly’ – and these labels can sometimes be a bit limiting or arbitrary. When I think about ‘growth’, it often refers to a notion of ‘top line’ – that it is going to grow more rapidly and presumably grow into its valuation – whereas, as you articulated, value often refers to some inexpensive multiple, being out of favour and so forth. Still, are these the right perspectives? Could something that is growing rapidly today not actually be a value stock?

AL: That is where value falls into two different camps, I guess. And I am not sure of any better labels so I will use these: there is the traditional kind of Graham & Dodd value end of things and there is the more Warren Buffett end of the spectrum. The Graham & Dodd approach, which is more where the Schroder’s Value Team is, is kind of deep value and cheap based on historic performance – those kinds of things. It is what we sometimes call ‘statistical value’ in that you can screen for it relatively easily – and you pick out just the cheapest stocks on your chosen metrics in the market.

Where Buffett and some other value investors differ is – if they find a business they think has the barriers to entry or the ‘moat’, as they might call it, to deliver consistent and reliable earnings growth – they are willing to pay a slightly richer multiple perhaps for the growth that could come in the future. And they go out of their way, obviously, to try and pay less for it than they believe it is worth, but they put more emphasis perhaps on the franchise values or the barriers to entry the business has and how that will lead them to earn a premium return on capital, I suppose. Through both of those camps, however, you still have this contrarian angle because, whatever you might say about Warren Buffett’s value style, there is definitely a contrarian streak – more than a streak – that runs through all of that, even though it may differ in some ways from the more traditional Graham & Dodd approach.

Paradigm shifts v reversion to the mean

AM: I think you have introduced some great new concepts there. One is the idea of momentum or sticking with what is in favour, which does often get associated with growth. Also, almost by definition, every value investor is going to be a contrarian investor. The part I struggle with when I think about these labels and these investments is when you have paradigm shifts. Again, we will get to energy in a moment but, say, you have this long track record in a sector – and, while I am going to use energy, it could be industrials or any number of things – but something has happened. You have had a down-cycle or a recession or what have you – the area is out of favour – how do you think through when it is appropriate to use what has happened historically, to say we are going to see a reversion to the mean, versus the risk of a paradigm shift where, for whatever reason, the business has changed, the world has changed and that old way of doing it could be worse, it could be better? How do you build in this concept of paradigm shift as you evaluate historical performance and try and project it forward?

AL: It is one of the key questions we ask. We have our investment framework with seven questions we ask of every business we appraise and one of those is – because the screens we use are backward-looking in nature and typically use 10-year average historic numbers – are the last 10 years going to be a good reflection of the next 10 years? So that is an absolutely critical part of assessing a value investment – particularly when you have been using relatively simplistic screens to generate ideas.

So it is something you are always vulnerable to as a value investor because, as you alluded to in your question, to some degree you are betting, not necessarily on mean reversion but on some kind of movement back towards history. And obviously, at certain points in time, history does not repeat itself. There are genuinely new things and value investors, if they do not see a paradigm shift – and, by its nature, a paradigm shift is very hard to see – then they will fall foul of that and it will cost them. That is one of the things you just kind of have to take on the chin and wear as a value investor – that, every now and again, the implicit bet you are making on things being more like history than not, you get wrong.

Still, the thing that gives us some comfort there is looking at the returns of value over very long periods of time – you know, you can go back 150-odd years in the US looking at this stuff and, if you think of the number of paradigm shifts in the US or in global equity markets over that time, some incredible changes have gone on and an incredible number of companies have been destroyed, to put it bluntly, as a result of those changes – and yet the value factor still wins through. So I think it is a matter of not becoming too obsessed or too focused on any one paradigm shift and just backing the averages basically – that, by putting faith in history and by sticking to those core value principles, the historic track record of value still shines through.

AM: A great example of a company that, if you stick around long enough, you get to see as a growth and a value stock – and apologies for the US examples; I am based there! – is Microsoft. That started out as a rapid-growth company, inventing this revolutionary software that somehow, 30 years later, we are still using as Microsoft Excel, Word and so forth and also the operating systems. Then the tech bubble led it to become overvalued, as a classic growth stock often does, and it became what I think was a value stock. So is this the kind of company, thinking back to the mid-teens of the last decade, a value investor could have figured out, OK, something is changing. They have a new CEO, Satya Nadella and, in 2016, they are earning $2 a share. I believe they earned $10 a share in the last fiscal year – so they have quintupled earnings – so could one have viewed it as a value stock in 2016? Could someone have said some things have changed? And could one have stuck with it? Did it remain a value stock as it appreciated over the last five or six years? That is my example but you can use a different one.

AL: No, no – I am very grateful you picked Microsoft because it is one we have used as an example in some presentations. So you have landed on a very good one there! As you kind of alluded to, in that 2010s period, Microsoft traded at 30 bucks and you could buy it on a P/E ratio of 10x, with a big cashed-up balance sheet. Looking at it objectively, it might have been it was no longer considered – wrongly, as it turned out – to be at the cutting edge of technology or software but it was clearly still firmly embedded in basically every business on the planet. So, if you can buy those kinds of businesses on a P/E of 10x, you should do that all day. And so, even when we did not have a global fund to run, we owned Microsoft in some of our UK funds – as well as others of  what would now be considered ‘older-school’ tech stocks, such as HP and Intel and so on.

And, to your point, everyone got incredibly carried away with the valuation of Microsoft into the dotcom boom. And it is a great example of where you pay a really high price for something on the basis it is a brilliant business that can grow and generate cash – and it goes ahead and does all those things quite successfully – but, because you paid such a high price right at the beginning, you made absolutely no money out of it whatsoever. So the company delivered all the fundamentals really – relative to expectations – but a lot of investors still lost lots and lots of money. So I think it is always important to remember those dynamics – that it really is the price you pay that determines the outcome of the investment.

Then, as you alluded to, at the other end of that for Microsoft, the market fell in love with it again. And often what we are trying to do is buy a business when it is in that slightly depressed state, where the market does not even necessarily hate it but is perhaps just bored by it, and then the market comes back to view it in a normal way again and you make a bit of money – although, with Microsoft, it has obviously swung back to the other extreme, in that the market has completely fallen in love with it again. For our part – as often happens with value investors – we sold it far too early, if you look at it ex post. And yes, it has obviously performed incredibly, as you say, both in terms of fundamental delivery – which is the way we would think about it – but also from a share-price perspective as well.

Another good example from the US – because we owned a number of these at the same sort of time – were some of the pharma stocks. So we owned Eli Lilly at that point because it had a big patent cliff coming up – I can’t remember the share price but it was very depressed for a period of time in that similar 2010s period. You look at it 10 years later and see what the share price chart has done just by backing mean reversion and, again, it has not only got back to where you might have hoped it would – the share price has flown past that level and it is one of the most highly rated and loved large pharma businesses out there.

AM: If I go back to the Microsoft example, one of the things ... I would not say it frustrates me about the value approach, a lot of which I hold with, but I would question is the idea of ‘When to get off’. So, on the one hand, there is an impulse within value people that, When momentum comes in, I need to get out – that, if it is popular, it must be overbought or expensive or what have you. I think it still comes down to the fundamentals of the business. So, if a company like Microsoft has gone from $2 to $3 or $4 a share of earnings – again, hindsight is 20/20 – but, if one could have laid out how cloud infrastructure and all the things the company is getting into would lead to $10 per share of earnings in 2022, was it not still a de facto value stock along the way? And how do we guard against the psychology value people can have, which is instinctively to say, This is now popular. On current multiples, it is maybe 20x or 25x P/E, and therefore it is not a value stock anymore? How do you guard against the opposite of what momentum investors risk and jump out of a stock too soon? Or is that not a valid critique of value?

AL: No, I think that is a pretty valid critique – and again, to some degree, it is one of those things you just have to take on the chin as part of being a value investor. Almost by definition, you are going to be jumping out of stocks when people are starting to get really excited about them again – because it is by not owning them when people are really excited that you are able to add value and avoid the kind of value destruction the people who bought Microsoft in 1999 suffered, for example.

The momentum aspect is tricky and it is one we toy with a lot. We have done quite a lot of work thinking about the way value and momentum can interact – although we have not really got it boiled down to a perfect formula yet. And if we do, we probably won’t tell anyone – frankly, we will keep that to ourselves! But you almost have to resign yourself to the fact you are going to be getting out of these things – and then a number of them will continue to do very well. You can try and do things to mitigate that – you can try and average your way out in terms of selling the shares and so on.

To some degree, it comes back to that dichotomy between the different types of value investor – if that is not too crude a way to think about it That is to say, if you are at the more Buffett end of things and so are willing to look at a company like Microsoft and say, OK, its barriers to entry and return on capital profile and so on mean I am willing to pay 25x for it today, because I think it genuinely will deliver more growth than the market expects, and therefore I do consider it cheap today, despite it being on that multiple – that is where it diverges from the more Graham & Dodd end of things, which again is where we are as a team.

We just think that, if something gets to 20x earnings, the odds then tilt out of your favour in terms of actually going on to deliver what it must to justify the share price. So we do tend to be the people who are looking back at the Microsoft share price chart and thinking, Well, it would have been lovely if we had ridden that all the way up – but, in reality, we never would have done. And certainly, for us, it works better being the people who jump off a little bit too early than it does trying to pick the stocks that go on to be the darlings again.

AM: It is a great answer. When I think of my critique of the value approach, on the one hand I probably say that because, when I think of value investors – and this may be some personal bias – I think of people who have done a lot of the fundamental work, who really dig into the numbers and who care about profitability and free cashflow and do not fall in love with the dream, which can often get overhyped. The numbers actually have to pencil out. So I retain an optimism that a value investor can figure out that, for example, there has been a paradigm shift in cloud infrastructure, there is a new CEO and a new direction and we can pencil it out. So it is not about 20x current earnings being too expensive – it is about believing in that and actually having confidence in that. On the other hand, the pushback against what I am saying might be I am picking an obvious winner in hindsight here whereas you are expressing the discipline that, on average, when you look at companies that get to these kinds of valuations, yes, Microsoft was successful, but there are plenty of other examples I am not thinking of where the methodology or discipline holds –  and I assume that is part of the point.

AL: That’s right. The ones that go on to be massively successful with the vertical share price charts are always the ones that lodge in your brain – in the same way that, when we speak to clients, the stocks that have halved in price in three months are always the ones we get asked about most and not the big risers. Those things just stick in your brain and, as you just mentioned, we are trying to be a little bit more data-driven about it in terms of, OK, these are the things that have lodged themselves in my brain, to what extent are they representative of the reality of the world.

And we premise what we do on the fact that, with most businesses that trade on those multiples – and there are a number of studies that have shown this – the percentage actually that go on to deliver the earnings growth people expected or to deliver five years of consecutive earnings-per-share growth of above 5%, say, is very low. So that, I guess, is another part of how we try and nudge the odds in our favour of finding outperforming stocks.

AM: Let me try one other example – the even more extreme US company Tesla! In 2019, it lost $4 a share yet, at a $60bn equity market capitalisation – these are approximate numbers – it was still larger than Ford, GM and a whole bunch of other competitors, despite selling a fraction of the number of cars those businesses did. In those days, I think, Tesla’s sales were measured in tens of thousands – maybe 100,000 – but certainly well below today. Now, last year – which was actually a down year – it earned over $4 a share so it was a $19 stock in 2019 and, three years later, it earned $4 a share. So 19 divided by four strikes me as a low valuation and, of course, the stock ended up exploding to the upside. It went from $19 to $225, currently – that is a $700bn valuation. This is perfect hindsight, of course but, if you were able to model out Tesla and say, You know what? This is a fantastic car. I believe in electric vehicle sales for the luxury market and there will be policy incentives to support electric vehicles – we can debate the degree to which electric vehicles help climate or not but a lot of people believe they do – so here is a leading company that has created a new paradigm for how to get people to buy these electric vehicles. So, if we knew Tesla was going to earn $4 a share, if we pencilled it out and believed in all that I just said, could it have been a value stock in 2019?

AL: I suppose so, yes – if you knew you were buying it on that multiple! Unfortunately, however, back in 2019, we didn’t have you here to tell us that, which is unfortunate!

Could Tesla once have been a value stock?

AM: I am not claiming to be on the right side of this! I am really just challenging what it means to be a value investor – and are folks like ourselves too focused on what happened historically? And, again, maybe I am just picking two successful paradigm shifts here but there is something about Tesla that seems really emblematic of this bubble stockmarket we have had – it is often picked on and it is the focus of a lot of shorts. And I am neither a bull or bear on Tesla as a stock – personally, I love the car and I have driven one for eight years – but it just strikes me this is one neither the bulls nor the bears accurately manage to describe. Clearly I do not think Tesla is going to have an infinite market share going forward so there is some limit to how big this company can be – and $700bn does seem really, really large for what it is probably going to be! But I also think the bears have been completely wrong about this: at a $50bn valuation, I think it was a value stock – not at the time, but with the benefit of hindsight. So I am just trying to reconcile what can I learn from this, as someone who is more value-oriented? Am I just picking, again, the one-in-100 example of where the paradigm shifted happened or is there a lesson in here?

AL: I think it may be more a case of picking when the paradigm shift happened! And that could be for any number of reasons – it is a very high-profile business, it has a very high-profile person running it and it has done all kinds of exciting stuff away from cars as well. If you knew you were buying it on a P/E of 10x or whatever, three or four years ago, it would have been a value stock – because this equity market valuation was clearly much lower then than it is now.

There are some types of company, I guess, that value investors do tend not to own and certainly, the way we generate our ideas, Tesla tends to be difficult for us to own – purely by the way we screen and the way we think about stocks. So stocks without much of a record of financial delivery tend to be one of those types – because we are focused to some degree on historic cash-generation or profits, say, it is very difficult to get that from a start-up. Be it a biotech or a tech start-up or whatever, it is very difficult for us to apply value ‘techniques’ to that kind of business – and I think Tesla would probably have fallen into that category.

It is also quite difficult for us to be on the right side of paradigm shifts in that way, for a similar sort of reason. We can often find opportunities, identifying companies that are on the wrong side of the paradigm shift, where the market is overexaggerating how bad things are. So we often get opportunities that way from structural changes in markets but on the other side – particularly, again, the way we do it in the Value Team, we very rarely own those kinds of stocks. Also, on financial history, it is not necessarily the traditional stocks you might think of in terms of tech or biotech – it could be an insurance business or a mining business. And, if there is no reliable financial history we can look at, it does not mean we cannot develop a valuation case for it – but it does make it more challenging to do that.

AM: You are making some great points here – and I am picking two cases where we know the outcome, both were successful and both probably would have qualified as value with perfect hindsight. But there is just a discipline to this strategy and this approach and so, yes, we might miss a Tesla – perhaps – and we could probably still debate if it was a value stock in 2019. But for every Tesla, there are 99 – and probably 999 – other examples where the paradigm shift did not happen and that lack of historic delivery played out. So I am very respectful and appreciative of the discipline that comes with value investing. The last area I wanted to talk about in this context of what it means to be a value investor is the notion of volatility in earnings or revenues or cashflows – and what it means to you. This strikes me as another area where there is this big dichotomy where, quote, ‘growth’ investors always prefer the businesses where there is not a lot of volatility in their underlying earnings and cashflow – at least for a period of time – whereas, for value investors, it is actually that inherent volatility that might cause a sector to come out of favour. And energy and mining would be great examples. So what does volatility mean to you? I would love to hear how you think about it, in terms of your approach to investing, and what you think are the right metrics for volatility to be looking at?

AL: For me, volatility is just synonymous with opportunity. Certainly when we are talking about share prices, if there is volatility out there, it means people are getting nervous and are not sure what to think about particular issues. So, if you are willing to take a long-term view – we typically hold shares for three to five years – and to step back and say, OK, I have no idea where the share price will go in the meantime but in the medium term, the company should be worth X amount, then the volatility should be meaningless to you.

Now, there are issues around managing clients expectations about volatility of funds and that sort of thing but the way we try to think about it is, We are buying a stock today, we think it is worth something in the future and so – as long as we are broadly right about what it is worth and we make the return we hope to make – in terms of share price, we do not need to care too much about the route by which we get there. Again, that is part of what sets value investors apart and perhaps accounts for a bit of that value premium – value investors tend to be longer-term in their thinking and willing to hold difficult assets for longer. And lots of investors are not willing to do that – they come under pressure for the performance or just because they look stupid and they don’t like looking stupid. I am absolutely fine with looking stupid – there is not much I can do to avoid it, to be honest, in investment or otherwise! And, as a value investor, you have to be willing to do that.

In terms of volatility of cashflows and profits and so on, again, I think they can be great drivers of opportunity because, at some level, they tend to drive share prices as well – particularly, as you alluded to, with energy and so on. For cyclical businesses, there is some degree of predictability about the nature of the cycle – the timing of it may be difficult to call but you know there is going to be a capital-expenditure cycle over a period of time or a general economic cycle over a period of time. And the market does not like those cyclical companies when things are getting worse but, as long as they have the financial strength to make it through whatever the bad bit is that happens in between, that is where the value investor steps in.

The value investor takes the longer-term view and says, We are at a cyclical trough now and nobody wants to own this business because it has fallen a lot but we are willing to step in and buy it. And value investors are often painted as being miserable and penny-pinching and so on – and to be honest, most of the time, that is probably fair. We are pretty miserable and, by definition, we do have to watch every penny. But there are points in the economic cycle or the stockmarket cycle where we are the optimists – we are the people out there who can see through whatever the short-term noise is and we are the people who are thinking about a less miserable, more profitable future and so on. Yes, it is probably for the minority of the time but we are actually the optimists in the stockmarket, when everyone else is miserable.

AM: Andrew, I hope someone highlights this segment of the podcast because you make so many great points. I would like to emphasise a few of them. The first is that volatility should be meaningless to folks or at least – and I might rephrase it here – it should not be a negative variable. There is so much emphasis on smoothness – whether that be year-to-year revenues or earnings or what have you – and that can lead both investors and companies astray. And GE in the 1990s would be my example of a company that fell in love with trying to ensure smooth earnings from what were inherently unsmooth businesses and it led to some challenges. And this desire for smoothness causes investors to avoid cyclical sectors when, frankly, there is actually a lot of certainty in the volatility.

Things to love and hate about energy stocks

AM: We know energy is cyclical – it is going to have peaks and troughs. You can actually go back to 1870 – The Crude Chronicles has done a Substack on this – and chart the financial history and, while you may not get the exact year correct, the cycle is actually reasonably predictable. And within that can lie a lot of opportunities. So I sincerely love your answer and I do hope it will get cut out in some manner and highlighted as a great lesson on both the discipline and the opportunity – and the optimism, as you correctly highlight, that value investors do have! You have to be pretty optimistic to have wanted to buy energy in 2020, just after minus-$37 oil, the sector had collapsed and certainly no-one could have been a pessimist and wanted to buy energy in those times. Let me turn now to energy – and when Juan introduced me to you, he said this is a sector you do spend a lot of time looking at. So what do you – and forgive the Americanism – ‘love and hate’ about the energy sector?

AL: Going back a few years, it just happened – through coincidence – that a number of different threads in the world came together. Obviously around Covid, along with the negative oil price and so on, the oil and gas stocks started showing up in our screens – in our natural hunting ground, if you like. Some of them had been there for some time but they did so, seemingly, having reined in their capex quite a lot. So while we had looked hard at them in the prior five or even 10 years, we could never get our head around the fact they were on P/Es of 6x yet never generated any cashflow, because they were looking for oil elsewhere – I don’t need to tell you everything they were they were doing.

So they came onto our screens again and, this time, we had more faith that the paper profits they could generate might actually be turned into cashflow at some point in the future. We also took the view the level of oil price in the market at the time was clearly unsustainably low – the world would still be using oil and oil products in five years’ time so, while there may be structural trends going on, it wasn’t as though oil and gas demand and related products were going to disappear. So there was that contrarian part to it – the normal day-to-day value investor stuff going on. In addition, the sector started to get dragged into the ESG debate, which – as you will know from speaking to Juan and myself on this podcast towards the start of last year – is something, as value investors, we have thought a lot about and we perhaps push back against the more conventional – or simplistic – thinking here that still happens in the investment world a lot.

For me, then, it was not only a genuine value opportunity, like any other, it also had the ‘edge’ of embodying a lot of the way the world was moving at that point, in terms of the focus on quite a simplistic interpretation of ESG. It was very easy just to point to oil and gas companies and say, OK, these are inherently bad businesses and, because they were going through a difficult time and performance was poor, nobody really pushed back on that. Yet there is not a lot of scientific or logical basis to this idea they can be inherently evil. So the energy sector embodied all those different debates and opportunities – and it is one we have spent a lot of time looking at over the past few years.

AM: One observation I would make – and, over my career, I have focused on global energy companies with a strong US and Canadian bias so please correct me if I am wrong on this – but it does seem like Europe’s very largest energy companies, what we might call the ‘super-majors’, are under more pressure to transition into lower-carbon energy sources. I am being very generic here but it does seem like, in Europe, there is more of a broad-based societal buy-in to the need to transition in a more meaningful way – whereas, in the US, there is more debate about exactly what we should do and how we should do it. Yes, there is pressure on US companies to be thinking about ESG issues but there is far less pressure to get into low-carbon businesses and so forth. Can you offer any observations about why there is this different mindset? Is it just the basic societal point that Europeans generally – and I am including the UK here – are more in favour of stronger climate action? Or are there other reasons for the different pressures on big European companies versus their American peers?

AL: In Europe, as you will know, Germany is the prime example of a society that, rightly or wrongly, has embraced and invested a lot of money in putting renewable energy in place. So I think it is a natural flow forward from that – that governments and so on have tried to incentivise the companies to which they are very closely connected, whether via shareholdings directly or otherwise, to try and pursue those same aims. And, as a result, investors in those societies have put pressure on companies as well to change.

Going back to the 2020 period, it was very easy to do that because oil companies were not making any money and human-caused climate change is a genuine thing – so it was possible to put those two things together and say, OK, let’s make all the oil companies change. Fast-forward a couple of years and I think we are in a much more ... I’m not sure it is necessarily in a balanced place yet, but both sides of the argument are being represented to some degree – still acknowledging the need to transition and to clean up the way power is generated and so on.

On the other side, however – because of the sad practicalities of what has happened in Ukraine and the subsequent effect on oil and gas prices – it has actually been hammered home to people that oil and gas are pretty important and we only notice them when they go up in price a lot, or when their supply is threatened. And so there does need to be a pragmatic, rather than purely idealistic, debate about how we get from one place to another – and who the right people are to get us from one place to another.

I mean, it is just a personal view but I do not really see oil and gas companies as natural owners of windfarms – that does not seem logical to me. Some of the stuff ENI and others are doing with hydrogen and bio-refining and those kinds of things seems a lot more in the natural wheelhouse of an oil and gas company. So hopefully, having started from this naïve or idealistic place, the European oil and gas industry is gravitating towards something – and, again, this is my personal view – a bit more along the lines of common sense.

The other thing to observe, which also highlights some of the tensions that exist here, is BP was probably the European major that had set out the most wide-ranging plans to head towards renewables. And then the oil price goes to $100 and that stance changes and the company starts talking about transitioning at a slower pace and so on. It then becomes much more of a dilemma for shareholders as to, OK, if we made them spend the money on transitioning, they cannot pay us the dividends today.

The company is printing all this cash at the moment – as the head of BP perhaps foolishly but nonetheless accurately observed – and do people want that in their pocket as dividends? Do they want it reinvested in more oil and gas that can continue to generate cash for some period of time yet? Or do they want to own windfarms. I know which camp I am in – I would rather they sustained oil and gas supply and transitioned into things that are much more within their skill set, as well as returning cash to shareholders. So, yes, it started from a much more idealistic place in Europe than perhaps in the US – and I should add the caveat that my knowledge of that market is not comprehensive. Still it seems things have perhaps been driven a bit more by pragmatism in the US – both in terms of science and financially – than has been the case in Europe.

Could an energy major ‘pull off a Microsoft’?

AM: I happen to personally agree with your viewpoint – as I think you know and I have talked about with Juan on this very podcast. Still, let me play devil’s advocate and adapt my Microsoft example to the energy ‘super majors – either European or American. Microsoft had this legacy software business where you had to go to a store and buy the software and put it on a computer but they have now shifted Excel and Word to Office 365 – a much more modern way to sell software – and it has been good for their business. At the same time, after some fits and starts, they have transformed that legacy business to something newer and better today by virtue of having Office 365 instead of buying individual copies of the software – and now this cloud infrastructure and other related businesses are about the future of the world. And, as a result, they have done very well as a company – they have made more profits, returns on equity and free cashflow are excellent, earnings per share has quintupled and the multiple the stock trades at has gone from 10x at its trough to over 30x today. These are my estimates and based on consensus data – so listeners should check the figures themselves. But does that paradigm shift opportunity not exist for energy companies? Should the super-majors not think about the energy transition in that way or is there something that differentiates that from what Microsoft has shown can happen very successfully in the technology industry?

AL: Any business that has been around for a long time has to adapt to change. Pretty much whatever it is you do, if you have been around for 100 years, you must have adapted quite a lot along the way. So there is no reason the oil and gas majors cannot transition towards some of those areas we talked about, related to refining and so on – but the key is for these changes to happen at a sensible pace. Things like energy systems and electricity grids are profoundly complicated pieces of infrastructure that most people, me included, do not come anywhere close to understanding. And to change them quickly – and certainly as quickly as some people seem to want to do, without actually thinking about science and details and so on – it may be great to dream that sort of stuff but you cannot just make it happen.

So, certainly, the oil and gas companies can reinvent themselves but I cannot necessarily see the same parallels as Microsoft – for example, would refining hydrogen or whatever enable those businesses to be bigger in the future than they have been historically? I don’t know. There is certainly a future they can head towards that is viable – it is just that, as with all these things, it needs to be done at a sensible pace. And a lot of people seem to be in a hurry, which is not particularly helpful.

AM: My joking response to your very professional answer – which I do appreciate – is that, rather than get into wind or hydrogen or these kinds of things, perhaps they actually should get into cloud infrastructure or some of these other businesses where there are clear profits to be made and where you actually can transition much faster! But let’s keep this more serious at the moment. I think you offer an excellent critique of this idea that you can change these energy systems quickly. And I don’t know if we will have time to get into the fact there are the lucky one billion of us who live in the US, UK, Europe, Canada, Japan and then there are the other seven billion people – some of whom are gaining some luck, but many of whom, of course, do not even have access to any form of modern energy – and we are going to have to figure out how we solve for them. Through all that, however, is there a critique of the majors that comes from either climate activists or ESG advocates, in particular, that they do get right – where you say, You know what, energy companies should do better on this one or two or three things?

AL: There are definitely areas – and I know you have talked about, for example, the way oil and gas businesses should be more responsible for their methane output, among other things. And there are inevitably other environmental issues oil companies could – and should – address. So, to the extent they are not, it is reasonable for ESG advocates or the relevant government organisations or whomever to put pressure on them to do so. I mean, in an ideal world, shareholders would not have to do that at all – and the relevant authorities would take that up and fine people for not doing what was right.

So there are certainly valid places to criticise these businesses. However, if we take the voting-down of the Exxon motions in the US earlier this year as an example, I think the people pushing for such things would have a lot more success if they did not make them quite so extreme. If they pushed for votes that worked towards small steps in a particular direction, it would be much harder for a lot of other people – and the company – to object to them. Whereas, as it turns out, if you put something a bit more extreme on the agenda, then 80% of shareholders vote against it.

It comes back to this idea of certain people wanting to get things done as quickly as possible – and that is not really the best way to take anyone with you, be it company shareholders, the government or society more broadly. So they certainly do get some things right but they do not help themselves in the way they behave sometimes. And to come back to an earlier comment of yours, a lot of this is just imposing the values of privileged people, sat in nice offices in London, New York and so on, onto the rest of the world – and, as it happens, it was thinking about that and reading things people have written on that that really got me more interested in where a lot of this ESG stuff was going, because it seemed to be pretty scientifically and socially bankrupt in a lot of those regards.

AM: As someone who shares a lot of your perspectives on value and fundamentals and so forth, I am struck by the fact that, when I look at the outlook for any of the Europe or UK-based super majors and their earnings and cashflows – and I am speaking solely as an analyst here – I can debate whether some of the newer areas they heading into will be profitable or not. Yet I feel like I could write off a lot of those investments and still get to a core traditional energy business for the largest European and UK, oil and gas companies and conclude that – compared with Exxon, Chevron and the other large US companies – there is a pretty big valuation gap that is not simply explained by the greater pressure to invest in low carbon that does exist in Europe versus the US. That is kind of odd. Portfolio managers and other investors are often subject to investing within their jurisdiction so I am going to remove that from the equation and ask, If you are running one of these big companies and have a choice of where you can be headquartered, is it not a no-brainer decision to go to the US or Abu Dhabi or Dubai or somewhere else because you are going to face constant pressure in Europe and the UK? Or is this just a temporary thing and, ultimately, if I am maybe wrong about the valuation discount European oils are trading at, will it go away on its own? Or, putting aside whether that is geopolitically possible and so forth, do some of these companies need to consider moving out of Europe if they want to achieve a fuller valuation? Would you do it if you were one of these large companies?

AL: I guess there are two considerations there. There is the oil and gas sector-specific portion and there is the more general US market premium versus Europe, in terms of market multiples and so on. That is a reasonably well-observed situation in the UK at the moment and quite a lot of companies are taking their listing away from London and going to the US because multiples seem – for some time now – to have been structurally higher there. So, just on that general valuation differential argument, yes – I mean, you probably would pick up Shell and drop it in Houston or wherever. I am not sure the French government is going to let you take Total anywhere! But, yes, it would make sense.

Then there are what we might call ‘cultural’ differences in terms of approach to ESG and those sorts of things. And, again, there are two elements there. There is the pressure from governments as to where these companies spend their money; and there is the approach of investors as to whether they are willing to own those businesses or not – and, obviously, an increasing number of investors have just excluded them from their opportunity set.

Whereas in the US – and I have not seen any numbers; I am just basing this on what I read in the papers – the number of people excluding the oil and gas sector would appear to be considerably less. And, at least until very recently, the pressure from government on companies to direct cashflow into projects that may or may not make anything close to an acceptable return is considerably less. On that second part, in terms of the cultural differences, I think things in Europe are improving – particularly with the Ukraine situation making people focus a bit more on how energy security is important; how oil and gas supply is something that needs to be invested in and not just run down and ignored; and how maybe Germany burning more coal is a backward, not a forward, step.

And there are some businesses – ENI would be the one that springs to mind – that are doing a pretty good job of balancing investment of free cashflow in sustaining production; investment in some kind of options on the future – again, I may not have been particularly complimentary about the technologies or sectors they are directing that cashflow towards but they are at least giving themselves optionality for the ‘new world’; and also giving money back to shareholders. And I think – particularly when cashflows are as bumper as they are now – it does need to be a balance of those three things. And, as BP has done, hopefully companies are moving back to a more balanced approach and not just, Let’s throw all our money at windfarms.

Between two extremes and grounded in reality

AM: Andrew, as we wind down here, maybe I can just ask you to tell us a little bit about yourself. I heard the first podcast in this series, where one of your colleagues claimed he was a value person through and through – shopping at discount stores, buying stuff on eBay – does that describe you? Tell the audience a little bit about yourself and what you like to do for fun?

AL: I think that was Simon Adler – and I will hopefully distance myself as far from him as I possibly can in all of my comments! I like to run – that is the way I blow off steam or whatever and it is something that helps me think more clearly and mull over things. I see it as either time to think about something specific and in a lot of detail or to think about absolutely nothing – and both of those I find running very useful for. In terms of any value ‘proclivities’ outside investment, I like to think I run through the middle of the extremes of our team, of which Simon would definitely be one! And I will throw it out there because he might not listen to this! Nick Kirrage, one of the Value Team co-heads is probable at the non-value extreme – as a consumer!

Like a lot of our team, I had a relatively – inverted commas – ‘normal’ upbringing. And, again, quite an important part of being a value investor is, I think, to remain attached to reality and not get too swept up in the bubbles that inevitably envelop London or New York or any of these other financial centres. When you are looking every day at businesses that are going bust or going through very difficult times or where they are laying off thousands of people, hopefully that keeps you a bit more connected with the real world. And again, to come back to your point on the people who have ready access to energy and those who do not – I think it is easier to think about those other seven billion if you are less wrapped up in the bubble of the one billion.

AM: That is a great place to end: let’s stay grounded in reality; let’s not forget about the other seven billion people on Earth; and let’s try and avoid bubbles – especially as value-oriented people. Andrew, thank you so much for joining me today on The Value Perspective Podcast. It has been my honour and my pleasure to be a substitute host today in place of the esteemed Juan. And thank you for joining us.

AL: Well, I am sure you have got Juan pretty worried! Thank you very much for your questions – it has been a pleasure to speak to you.

AM: Thank you. Likewise.

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Andrew Lyddon
Fund Manager, Equity Value
Arjun Murti

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