PERSPECTIVE3-5 min to read

The Value Perspective Podcast episode – Meet the Manager, with Simon Adler

Hi everyone and welcome to the TVP Pod. This year is our 10th birthday – not as a podcast but as a value franchise, here at Schroders. We wanted to celebrate this by throwing a ‘party’ with some of our longest-standing clients and past podcast guests – inviting them onto the pod and turning the tables. Usually, we interview people from all walks of life about their fields of expertise but, in this ‘Meet the Manager’ miniseries, some clients and guests will introduce us instead and finally ask any burning questions they have been harbouring over the last 10 years. We will continue to publish our regular podcasts as normal but hope you also enjoy this miniseries where we place the value franchise in the interviewee seat as a birthday treat.

20/06/2023
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Authors

Simon Adler
Fund Manager, Equity Value
Pete Drewienkiewicz
CIO of Global Assets, Redington

Hosting our first episode of Meet the Manager is Pete Drewienkiewicz, CIO of global assets at Redington. Pete advises wealth managers, insurance companies and public sector pension schemes with combined assets of more than £400bn. He also oversees Redington’s 25-person research platform across both manager and asset class research and is ultimately accountable for the asset class implementations recommended to clients. In this episode, he interviews Simon Adler, a portfolio manager on the value team, who joined Schroders 15 years ago. They discuss Simon’s journey to becoming a value investor; value investing’s landscape and current challenges; price discovery and the drivers of return; Simon’s often-used fashion statement analogies, such as ‘wearing a snorkel mask while cutting the grass’ as an example of a willingness to be different; and, finally, making money out of terrible businesses and a house analogy to understanding value. Enjoy!

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PD: Simon Adler, welcome to The Value Perspective Podcast. Lovely to be talking today. How did you get into value investing as a career – were you especially interested in the philosophy and pursued it as a route into investment or was it much more that you just ended up here by chance?

SA: Thanks for your time, Pete – and it is a good question. There are a range of factors but I think, deep down, at the core, I am a value investor. In my life, I live a kind of value investor lifestyle – you know, I have only just sold my 15-year-old Skoda. I buy everything second-hand. I just can’t help myself.

PD: I literally live on eBay. My wife thinks I’m like a surfing eBay king!

SA: Do you end up going, Well, we do need this, don’t we? Because it’s such a good deal – and it’s only a chest of drawers!

PD: Well, that is an actual problem and feels like something we should come back to in the context of investing.

SA: Yes – what to do with a surplus chest of drawers that is good value! But yes, for me, it is what I am, as it were. If I look at my family upbringing, there was never any kind of financial waste – it was always getting a deal, buying things cheap. So that is how I was brought up and how my kind of DNA is. Then, when I started at Schroders, I was in the very, very fortunate position that I started on a team that had growth investors – the likes of Richard Buxton; we had mid-cap investors, such as Andy Brough; and we had some core investors, like Sue Noffke and Andy Simpson.

And then we had the value team. At that point, it was Ian Lance, Nick Purvis, Nick Kirrage and Kevin Murphy. So I was able to look around at all of the styles, as I developed my career, and over time – but also quite early on – I was instinctively drawn to value. Then, having had that DNA aspect and the draw, and then reading the academic work that, in my view, is extremely persuasive towards value, it was extremely compelling to me.

PD: The stars aligned?

SA: Exactly.

PD: So it resonated and then you did the background work? I feel very similarly on those points but the problem with that is, something resonates – it seems very compelling – and then you can go through these long periods where it does not work or is very difficult. Has that dented your conviction at all?

SA: No. Having done the academic work, I think it is extremely clear that that is part-and-parcel of value – and one of the reasons why so few people would do it. I wasn’t a professional investor at the time but I grew up investing, you know, £50 I had saved up at the time of the dotcom bubble. So I was very aware of the dynamics of what was going on at that point – albeit in a very unsophisticated, pretty embarrassing way. So I think I always instinctively knew that was the case with value investing and then the academic work is very, very clear that the long-term returns are there but it comes with troughs – and that is part of why so few people are willing to do it.

I think it is also part of why, as I look at value investors, the ones who are able to remain true to it ... there are a number of criteria but one of them is a personal willingness to be a bit different. There are a number of ways in my personal life in which I might be a bit different – for example, when I cut the grass, I basically wear a scuba-diving outfit because I don’t like the grass getting up into my nose! My wife has some photos of me doing it on a hot day and effectively wearing swimming trunks and snorkelling gear. And I also use something called a ‘Nubrella’, which is – as I’m sure you must know! – an umbrella that straps to your back as a rucksack and flips backwards and forwards over your head so you don’t have to hold it with your hands.

PD: Those are some very strong visuals!

SA: Yet, for me, these are things that make life better. It makes life better if I cut the grass wearing my snorkelling gear. And it makes life better if I’m going shopping and I come back wearing my Nubrella rather than trying to balance an umbrella under my chin. I appreciate the fact it might make me look a bit weird – but I’m comfortable with that. So that willingness to say, I think this is the right course but I know that others may look at it and say, Yes, you’ve lost your marbles – that is part and parcel of it. You have to be willing to look wrong for a period of time.

Which factors have most challenged value as a strategy?

PD: We talked about this before but, if you think about those influences of the last decade or so – sustained, very low interest rates; very high levels of liquidity; cheap money washing around; meme stocks; retail investors coming in through the pandemic; and then, I guess, the relentless rise of passive investing, which comes with its own inbuilt momentum – where do you place most blame for the challenging environment or indeed the changes in investor behaviour?

SA: To some extent, those probably all play some part. Liam Nunn, one of our co-managers, always says – entirely aptly – that, with each bubble, there is a kernel of truth. There was a kernel of truth in the dotcom bubble – these companies were changing the world. And there was a kernel of truth with the low interest rate environment – the lower the interest rate went, the higher the multiple that could academically be applied to the higher-quality and higher-growth companies.

The problem with these kernels of truth is they get out of hand and become a bubble. And then the other aspects you mentioned – things like ETFs and the inbuilt momentum – I think what they did was extend the spring. I think the bubble was created with a kernel of truth – the lower interest rate environment. And we then, I think, went miles beyond that – partially through greed and fear, which is what always drives markets, but partially because of that flow of money that just went on and on. I mean, I did many, many meetings in 2019 and 2020 where people said, Value won’t come back – value is dead.

PD: Absolutely. We were having these conversations and it is almost self-reflective because you are sitting there saying, We think this stuff works because of behavioural reasons. And then you are having this extremely behavioural conversation yet you almost can’t step back from it far enough to say, Do you guys not see that the very fact we are having this behaviourally-driven conversation about value being broken and not working anymore – this is all part of why, over time, value works?

SA: I couldn’t agree with you more. I suspect you would have been holding out and arguing back but I feel like there was this whole portion of the market that just rolled over in those conversations.

PD: Yes. There were two aspects I woke up to from the momentum perspective. One was, every time someone fires a value manager and buys index; or fires a value manager and buys growth; or hell, fires a value manager and basically buys anything that isn’t value – they are effectively putting momentum into all the stuff that is working. And second – and I keep looking for someone to do a really amazing piece of work on this – is the amount of daily, weekly, monthly flow that invests in the market passively. Whether it is defined contribution funds, ISAs, Junior ISAs or whatever, it just feels like the market as a whole has become that much more of a momentum market, driven by those types of factors.

SA: Yes. I haven’t seen any work on that either but it would be very interesting. What I also find interesting is it still feels like people have two views as it stands. One is that the value bounce-back was a flash in the pan – you know, just a single flick back – and the other one is that, really, growth is still winning. Clearly, you can pick your timeframe to prove whatever you want – and value investors are probably as guilty of that as anyone else – but personally, over the last three years, it has felt to me that value has had some good quarters and some bad quarters but it kind of nets out. Yet, when you look at the numbers, value has absolutely smashed it – it has doubled the market and proper value managers have typically done much better. But even that hasn’t seemed to change the conversations and I guess one could take that two ways – if one wants to find encouragement as a value investor, it shows you how much more there might be to go. I hope that is right!

PD: Yes, if you look at, say, the long/short numbers that AQR puts out, they are saying, Sure, we are off the highs but we are still mid-90s in terms of percentiles of cheap-versus-expensive.

SA: Yes. We look at other bits of data that are indicating exactly the same sort of thing. If you track back to 2018/19, we got down to a point – pre-Covid – where we were about in line with the peak of the dotcom boom. Then Covid happened and we went down to levels that had never been recorded before. And now we are kind of back to where we were before Covid.

PD: So pretty much in line with the tech boom.

SA: Yet, three years on from the peak of the dotcom peak, I think the MSCI World Index was down 45% and value was up. And, five years later, MSCI World was still down and value was up significantly. Now, lightning doesn’t strike twice but, despite all that and the evidence being pretty clear cut, it still doesn’t feel like the overall market is persuaded. What does it sound like when you speak to people?

PD: The interesting thing we have – and, again, it is one of the perspectives that I think makes your job more challenging – is you are living this and this is kind of your shot, right? You are all-in – but that is not our style. We will absolutely have value managers, like yourself, but we will be partnering those up with managers who have more of a momentum-based approach and those who do quality-growth. And when you blend all that together – you know, you talked about the quarters up and quarters down, essentially it looks like it should: it looks like a relatively smooth ride that is adding value to the market through time. And that works nicely. Now, don’t get me wrong – we are still very much subject to what I call ‘line-item fascination’, which is where you are having a conversation with a client and nine out of 10 line items are up or in line and one is down 6% or something and they point to that one and go, Why is that happening? So we still have a lot of that. But I think our clients increasingly have seen that blend of styles working well. And we don’t really try to time styles. We are not trying to lean in and out of styles – we’re trying to say, We think these are all good things to have in balance.

SA: Ironically, I think that is what makes our job easier, actually. On the one hand, as you say, I have committed my career to value – as have the rest of the team – and we will live and die by how that does. On the other hand, however, we have worked very, very hard to ensure our client base have done exactly what you have done – and say, We will choose you for our value bit or you with a couple of others, and we will match you up with some quality and with some growth. And actually, that is critically important to us. We do not want to manage 100% of anyone’s money – we want to be part of a blend as that means we can focus day in, day out on trying to pick the best stocks.

Stick to where you have an ‘edge’

PD: So being the best implementation, effectively, of how you see value playing out. I do want to come to that in a few minutes but there is one more piece I just want to pick up on in regard to this last challenging period. You asked me how I feel about it and one of the things I get frustrated with is when managers take bets in areas where arguably they do not have an edge. I think we have seen that playing out over the last 10 or 12 years. You know, you have a situation where the US was persistently the most expensive market – I don’t have the exact numbers but I would guess, since the global financial crisis, the US grew from 50% or 55% to the mid or high-60s in terms of the global indices. So the ‘international value’ bet isn’t working and it gets worse and worse for people and value managers often end up making big country and sector bets – and those, of course, come with their own challenges. Currency is obviously something that just comes out of the country bet as you don’t tend to see a lot of people hedging currency. So how do you see that? Do you think those are areas you actually have an edge in? How do you try and contain those types of bets when the value appears to be there?

SA: It is one of the great challenges. And it is extremely difficult because, as you say, the US has been an unbelievably large part of the global benchmark. If we went onto the high street and asked people, if you were investing globally, what percentage of your assets would you want in any one market, no-one would say 65%. Yet that is where we stand – I don’t know what the number is today but it is somewhere around 65% or 70%. And at the same time, for much of that period, the US has in our view been an extremely overvalued market.

So the way we deal with that is, first, we try not to take a top-down view. I may have just said it but we don’t make decisions based on thinking the US is expensive while Japan is cheap or whatever we might have thought historically – I am not making a current view, obviously. What we are actually trying to do day in, day out is find cheap ideas around the world. When we screen the world for the cheapest ideas, we show which countries they are in and we look at what our portfolio looks like so we can say, OK, suddenly, in the cheapest part of the market, loads of ideas are flashing in this country but our portfolio has nothing there – let’s go and take a look.

So we try and ensure, from a bottom-up perspective, we are focusing on where the cheap areas are but the real challenge – and this is where we have been for the last number of years – is there are just not many ideas in the US. So we then go and look at the US ideas – because we don’t want to have a dramatic difference to what people would anticipate – but we can’t find many we like. That has been a real challenge for us and I think some people believe it impacted our performance – that we didn’t have much in the US and the US was doing well. I think the more sophisticated analysis showed that, actually, the cheapest part of the US wasn’t doing well either and, in fact, the US was doing well driven by five or 10 stocks ...

PD: The bottom quintiles just continued to cheapen up.

SA: Exactly. People ask us, why we didn’t go into the US more wholeheartedly or why we don’t have a benchmark weight in the US but, actually, the analysis we have done on whether we should have has shown it wouldn’t have helped us, really – because the cheapest bit of the US market didn’t do well. So those areas are extremely difficult but what we try and do is remain focused on the cheapest companies in the world: start with them and then do as much work as we can to try and filter out the dodgy ones – we won’t always get that right – and then end up with as broad a portfolio as possible.

And that is something we are, I think, doing better today than we were doing three or four years ago – trying to have as diversified a portfolio as possible within the cheapest bit of the market. I have started thinking about this in terms of a ‘domino rally’ – you know, what we don’t want is a ‘domino rally’ portfolio where you knock one domino over and everything goes. We want to have as many independent dominoes as possible. Now, you’re never going to get 40 or 50 independent dominoes but, psychologically and philosophically, the more independent the risks are, the better. That is how we think about that.

Dividends and other ways value is realised

PD: That makes me think about price discovery and how value is realised in the market. I listened to a David Einhorn podcast a few weeks ago, where he pointed out the number of people who are playing the market in your way and driving price discovery in cheaper stocks has really fallen – and we see that as well. The point he was making is your thesis cannot be built around, say, this company trades on a P/E of 5x, it does pretty well for a little while and it just re-values to a PE of 10x. You need to have more catalysts – more ways for that value to actually accrue to you as an investor. And, to me, that feels like another positive form of diversification across the portfolio. Do buy that you have to have to think about that differently now?

SA: I’m not sure I totally buy that. I haven’t seen any proper evidence of that though, clearly, there are anecdotal examples one could use on either side. If I think of large parts of our portfolio that have done pretty well over the last few years, lots of that has come through old-school price discovery. Having said that ...

PD: But the flipside is, I guess, if you look at the expensive side of the market, maybe that was where the price discovery became equally zero – because you had this kind of meme-stock silliness and retail investors chasing certain things.

SA: That’s a fair point. But what I was going to say is, if we just zoom out all the way back and look at the long-term sources of return in stockmarkets, we both know very well a very substantial portion of the return is the dividend yield you receive – and the reinvestment of that dividend yield. So I think, in that respect, David Einhorn was absolutely right – that is an important part of what the long-term returns for clients are. And if you are buying stocks in the cheapest part of the market, you get a big yield; and if you’re buying stocks in the most expensive part of the market, you’re lucky to get any yield at all.

So we absolutely subscribe to the view that that is an important part of the return – because that has always been an important part of the return and we consider it. But what we don’t do is become beholden to it, as it were – that we will only buy stocks with this level of yield or this level of cover or this level of free cashflow. What we do every time we look at a stock is consider a number of valuation metrics. So we might look at it on EV/NOPAT [enterprise value/net operating profit after tax], price-to-book and free cashflow yield – because we know that free cashflow yield is very important. And is that free cashflow yield going to go on acquisitions, which is bad news? Or dividends, which is great news? Or buying back shares, which is only good news if the shares are cheap?

Now, if we own a stock, we would like to think it is cheap – but only if its balance sheet can justify it. And so the use of that free cashflow is also as important, in many respects, as the level of free cashflow. And again, I’d come back to the diversification point – we don’t want to have a portfolio where the only source of return will be dividend or, equally, the only source of return will be the P/E going from 5x to 10x. We want to have a blend of different ways in which we will generate returns for our clients, with different risks as well, and we hope that – across the mix and over time – they deliver

PD: The dividend conversation is interesting. We always kick this around a lot with clients – you know, is income investing a thing? Should you just be able to take a share of your price return, deliver that back to yourself as income and it not make any difference? And, of course, the other interesting point is that, if you were a really good capital allocator, then there is a strong argument – as Warren Buffett has made over time – that you shouldn’t pay dividends. The argument goes that the best use of my capital is to reinvest it in the business as I am going to find better ideas than you do. Is there not a risk, then, that businesses with good dividend yields are almost predetermined to be bad capital allocators?

SA: I think it varies. We own a business, which I’m not allowed to name on here, which is the world leader at what it does. What it does is not hugely exciting but it is something that is absolutely critical and everyone will use over time. Now, it has never paid a dividend in its history but we own the business and, you know, we think our return will come from getting paid through the free cashflow – and, more specifically, the fact the company invests it at high levels of return and sometimes buys back its shares. Equally, we own banks – and we could have a huge session just on that – and I think the return there is going to come from the yield. Those yields are very high and they are very attractive and we want that to be a source of return.

We also manage an income fund as a team and, on that, we say we want three types of return here: we want capital return; we want the yield today; and we want growth in that yield per unit – because that is what the end-client actually cares about. What we don’t say is every single stock we own has to offer each of those types of return – some stocks can offer the capital return; some can offer the income returns. So I don’t think a high dividend yield stock is necessarily a poor capital allocator – however, if you have a stock that has a very high yield but could generate much higher returns by investing in its core business, we would be the first to encourage the company to drop the dividend and invest in the core business because, echoing Buffett’s point, that should generate a better long-term return.

Extreme honesty in managing client expectations

PD: Interesting. And I guess because, as you say, you have pockets of money doing different things, you could effectively do that and still maintain your investment objectives. Let’s now turn to the question of long-only versus long/short in value. Part of the return we saw over the last 12 or 18 months from some of our managers that run long/short books was more driven by the very, very expensive stocks cheapening up, of course – so how do you feel about that? Do you not feel like you’re operating with one hand tied behind your back because you can’t go out and short those crazy expensive stocks?

SA: No, I don’t feel like that. The big challenge for value investors looking to short expensive stocks is what we saw over the last decade – you can be wrong for a long, long time and that can be longer than you can remain liquid. Whereas if you were long-only – you were not levered but investing long-only in shares you thought were undervalued – through most of that period, you actually generated a positive return being a value investor ... it just wasn’t nearly as positive as it was being in the market.

So that has been a source of some comfort for us. Not a huge amount, but some comfort that, over most of that period, we have done a reasonable job – just not as good a job as the market. Whereas if you were short the expensive stuff and you were continuously having to post margin – and then how much longer can you continue doing that? – you were hugely exaggerating the peaks and troughs of value. I think there is a place to go short – I’m not against people doing that – I just don’t think I’m personally well set out to do it.

PD: That brings us nicely to client expectations – how long clients hold patience. What is your expectation for how long the average client will stick around? And do you find that frustrating?

SA: There are a lot of interesting elements in that question. The first thing I’d say – and I know everyone says this – is we are genuinely fortunate with our clients. We have a really good client base that understands what we do and why we do it – and that comes from the sales team at Schroders, who do a really good job of ensuring the people who buy our funds are buying them for the right reasons. We work pretty hard to try and keep that the case – but that doesn’t mean every client has stuck with us. And we did lose some at the trough, which is very, very disappointing because that money-weighted return is poor. We did also win some then.

PD: What is challenging there is that, behaviourally, they will probably be the ones who struggle to come back.

SA: Yes – or they come back at the worst time. Whereas the clients you win then really have got great circumstances. So I think getting the right clients is absolutely crucial. Then it is a case of delivering on the expectations. If we are having a difficult time because the cheapest bit of the market is having a difficult time, I think most clients are willing to understand that. If we are having a difficult time because we have had a very prolonged period of poor stock decisions – so, within the cheapest bit of the market, we have made lots of mistakes and far more than you can ascribe to bad luck or timing – then I think you can’t expect clients to stick around for that long. So it does depend on why you are having a difficult time.

But it also comes back to the policy – which we try and pursue – of extreme honesty and extreme openness with clients, explaining, This is where we have done well; this is where we have done badly. Over time, we have had a number of clients say to us, We have never had conversations like we have with you in terms of your openness about mistakes. Now, I don’t really know what that is about, in terms of what they have with other managers, but from our perspective, we just want to have that very open, very honest relationship because then, when things become difficult, you have the greatest chance of keeping the clients when they could generate the best returns by staying.

‘Genuine’ value and other manifestations of the style

PD: Yes. It is a nice thing that comes out of a negative, in some ways – because, of course, that experience is only won by having the mistakes to talk about! Looking around, do you get the sense there is – what’s the right word? – just less competition around in your space? I mean, something we are really interested in is the concept of the ‘boutique premium’ – we think boutiques are a great way to invest. Yet, if you look at boutique formation, you have seen almost no boutique formation in Japan and very, very little boutique formation in value investing. Does that make what you do easier or harder? What do you see when you look at the value landscape?

SA: In terms of the landscape, I think you will have a better idea than me, actually. Still, as we see it, we would totally agree with what you say – it appears there are fewer people doing what I would call ‘genuine value’. There has been a lot of style-drift, which you alluded to earlier, and the number of people left doing genuine value is pretty limited now.

PD: You mean a lot of people have maybe drifted more into what they call ‘GAAP’ [growth at a reasonable price]?

SA: Yes. ‘Quality value’ or ‘benchmark value’ or ‘GAAP’ – there are all kinds of different manifestations. Or else they have left the industry or their firms closed their funds or forced them to drift or the flows have gone against them so badly – whatever the reasons, there are very few people left doing genuine value. Does that make it easier or harder ...?

PD: It has to make it easier to raise money, hasn’t it?

SA: Maybe it makes it easier to raise money! Maybe it makes it harder to generate the returns – if David Einhorn’s right. I hope he’s not. But I think it’s remarkable, really – 10 or 15 years ago, no-one would even have a conversation as to what the definition of ‘value’ was. Everyone understood, it was crystal-clear and there were lots of different people doing it. Whereas now, I think, you can count on one hand the number of people in the UK doing genuine value. I think that’s extraordinary. So how do you see it?

PD: Well, I promised I wouldn’t talk about that – to myself, not to you! I promised I wouldn’t talk about the whole kind of, you know, value of IP, valuing intangibles and how do you calculate value? Because, actually, I think the market has come to something of a consensus – albeit probably a slightly fuzzy consensus – which is that value is a thing and you can calculate it but, as with lots of investment concepts, such as risk measures, for example, you need to use multiple lenses. You still have lots of people referring only to ‘VaR’ [value at risk] in the context of risk but, if you isolate your definition of risk to one measure, then I think you are always going to have a difficult time. I think it is the same with value, right? So, to me, it has got to be about more than, say, price-to-book – it has got to be about a broader set of understanding of what value is. But how people particularly weight those different factors and what methodologies people use ... you know, some people have amazing approaches – we will go back and attribute IP and intangibles across every balance sheet back to 1926 or whatever. I mean, it is wonderful to see that kind of diligence in people’s process. So I think there has maybe been something of a steadying around the philosophy.

SA: Yes That is an important area that I think we would say has changed over the last 20 or 30 years. You know, 20 or 30 years ago, there weren’t that many businesses with huge value that wasn’t reflected on their balance sheet, outside of branded businesses – Warren Buffett obviously did very well. Whereas now it is an important part of the market. When we look at various bits of academic work on, for example, value versus growth, it is clear there is a big difference between the price-to-book of the most expensive and cheapest stocks – so then you think, Oh, golly, I can understand why that would be a difference because of what you just described so well.

But if you then say, Well, let’s ignore that and just look at free cashflow yield or P/E or any one of a number of fundamental metrics that cut across those accounting differences, it still looks as extreme. So, if we were in a place where it only looked extreme on price-to-book, I think you could pretty credibly say that opportunity has passed or is more limited. But the work I have seen and the work we have done does not suggest that is the case today.

PD: But, again, that is just good diversification, right? You diversify your signals, diversify the portfolio, diversify the catalysts and diversify the way that value is going to return to you. That to me, I think, is something we see and we are pleased by. We do see processes evolving in the market and people being more thoughtful. And then, to your point about clients and conversations, we would probably agree that some of our most thoughtful conversations over the past five years have been with those parties that are having the most challenging performance. And that is great – you know, it is very good to see people being self-reflective and able to discuss mistakes and challenges in the market. I think, through time, that really sets you up to have a longstanding and successful relationship.

SA: Yes. And hopefully it also gives you a chance of being the best you can be. If you try and get better over time – and try and do that on data and evidence – that gives you your best shot of ending your career having done as good a job as possible. Whereas I think, if one ever risks complacency, it is by not trying to learn, not trying to get better, not trying to develop. Working to avoid that is a very core culture among successful people around the world.

Buying the worst house on the worst street

PD: Yes – 100%. One final thing to touch on because we mentioned the drift to GAAP – and I won’t get into my feelings on GAAP because, again, I promised myself I wouldn’t! – is when you’re fishing in the deepest value stocks. That, as some of the market proponents have advocated, is probably where the most clear value appears to be at the moment – the bottom quintile looks cheaper than it usually is versus other quintiles that are not so cheap. Screening for quality in some way – protecting yourself against real deep ‘trash’ – has therefore got to be more on your mind. How do you try and put some kind of quality screen over things without turning your process into what people would call GAAP?

SA: I think the biggest protection you can have is ensuring you remain in the cheapest bit of the market – because then, whatever your process is adding to the equation, you are always in the cheapest bit of the market. You’re not risking becoming GAAP or ‘QAAP’ or whatever.

PD: So dismiss businesses through analysis but just make sure you do not drift up into the higher quintiles essentially?

SA: Yes. That is, I think, the best way – and then have lots of different ideas. I mean, no-one likes to hear it but one of the stocks we made the most money out of over the last year has been the worst company I have ever come across! I’m not allowed to name on it here but it is absolutely awful, has done multiple rights issues and has gone bust over and over again. I mean, it is a total disaster! It had a rights issue, failed and the investment banks got caught on the hook with it – so they had underwritten it and had to take it up.

And the shares kept falling. Here I will make up some numbers but let’s say to 80 cents – it was euro-denominated. So we rang up the investment banks and offered to buy at 50 cents. The banks told us where to go. The shares fell to 70 cents so we rang them up again and offered to buy at 50 cents. No. The shares fell to 60 – and we offered to buy at 50 cents. And we bought at a price the public share price never actually even got to – direct off the investment banks. It is a horrendous business – and it has more than doubled since then.

PD: Wow! And have you now got out of that?

SA: Yes – we had a very conservative ‘fair value’ estimate on it! But people don’t like hearing that you can make money out of terrible businesses. You can – but you have to be paying a penny in the pound for it. The other analogy I give is, I used to live in Peckham in London and, when I moved there, it was a value play – I mean, Peckham had one place to go to eat at the time. And I often say to people, if you take the area where you live, go to the worst street there and then look at the worst row of houses in that street – and you know each one is worth £100,000. And then there is one in the middle that has dead rats, graffiti, needles, red light outside – and you can buy that for £1,000.

So you know every other house on that row is worth £100,000 – and, as you are also a builder and a surveyor, you know, it is going to cost you £2,000 to fix it and repaint it and put in new carpets. Would you do it? Everyone says yes, if they have £2,000 spare – and yet you have just bought the worst house on the worst street in the worst part of wherever. So, for us, the critical thing is knowing the quality. We say very, very firmly as one of the seven questions we ask about every company, You have to know the quality – because, if it is rubbish, you have to make sure you are paying a penny in the pound.

PD: Basically, it is having that price discipline. To your example, you stuck to your guns with that ‘terrible company’ and said, We will take it at this price. You weren’t trying to mess around or chiselling the price as it went down. You stand ready to buy at the price you believe – but you have that price discipline in the first place.

SA: Exactly. And you have to stay firm on that. Today, though, when we look at our portfolios, actually, there are not many of those really bad businesses in there because we do think quality does have an influence – it is important. But the most important thing is price – and paying a low price.

PD: Super. Well, just before we wrap up, I am going to say, Thank you very much for all the investing advice. I might not linger so much on the house-buying advice! Still, there is something in there for everyone! It was really nice chatting to you, Simon.

SA: Thank you very much, Pete – and you won’t be the first person to have turned down my property advice!

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Authors

Simon Adler
Fund Manager, Equity Value
Pete Drewienkiewicz
CIO of Global Assets, Redington

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