The Value Perspective Podcast – with Ian Lance

JTR: Ian Lance, welcome to The Value Perspective podcast – it is a pleasure to have you here. How are you?

IL: I’m very good – very good. Thank you very much for having me.

JTR: For those who may not know you, please could you walk us briefly through your career?

IL: Certainly. I have been investing for about 35 years. In the 1990s, I worked at a UK pension fund company called Gartmore and then, in the early 2000s, at US bank Citi Group, on the asset management side. Then – and I suppose this is where it gets interesting – I moved to work at Schroders with some of your colleagues and I am sure we will discuss that later on. I also worked with a chap called Nick Purves and, in 2010, he and I moved to work at what at the time was called RWC– now Redwheel – and which was actually run by a young fellow called Peter Harrison, who I think you might know, given he is now your CEO! We have been there ever since and Nick and I have been running value strategies together for the last 15 years or so in total.

JTR: Well, welcome back to Schroders – as I say, it is a pleasure to have you here. Nick Purves is quite the legend in our team because he mentored both the co-heads, Nick Kirrage and Kevin Murphy. So, to honour the Value Team’s 10-year anniversary and acknowledge his strong reputation, let’s start by discussing your experience of working with Nick – and over such a significant period too.

IL: Exactly. It has been very good – I guess I had better say that because he might be listening! No, it really has been very good. We might talk about this in more detail later but one of the most important things about value investing is working with people who are ideologically aligned with you. And, when Nick and I first met, instantly we thought, We just see eye-to-eye on everything. We often get asked, What do you do if one of you wants to buy a stock and the other one doesn’t? And the honest answer is, That has never happened. And the reasons it has never happened is because, effectively, we are looking for the same things in stocks and we either evolve towards an answer or we don’t. So the partnership has worked really well.

JTR: Your presence here today is also very significant because Kevin Murphy told me a story about the very early days of The Value Perspective blog. Now, the blog preceded the podcast – indeed, the podcast would not exist, if it were not for the blog – and Kevin says the mastermind behind that was actually you. So could you tell us a little bit about the origins of The Value Perspective, please?

IL: Certainly. I have always enjoyed reading the investor letters of successful value investors and firms and I suppose I had an idea to try and do something along those lines. I should also give some credit to Schroders’ then head of sales, Robin Stoakley, as he wanted to do for value investing what M&G’s ‘Bond Vigilantes’ blog had done for fixed income. So he was very much behind the idea. I think the first one I ever wrote was called, What is value investing? – so the idea was to try to educate and inform existing and potential investors.

And that is really important because, as you will be well aware, value investing goes in and out of favour and, if your clients’ expectations are set correctly, they are much more likely to stay with you during the inevitable bad periods – and of course, it is crucial they stay with you through those bad periods. So you are absolutely right – I did kick the thing off. I only wrote maybe six letters but, at the time, the world was heading into the financial crisis so there were some quite interesting ones – and it has come on a long way since, hasn’t it?

JTR: Well, absolutely. And the blog is still alive – it is just that the podcast has become an extension of it as we now conduct the interviews and provide transcripts of those on the blog. Kevin also mentioned that, at the very beginning, the blog had a different name. Do you remember what it was?

IL: I think it was called ‘Far from the Madding Crowd’ – is that correct?

What has changed over 35 years – and what hasn’t?

JTR: That rings a bell! And thank you very much for starting it off because, without you, this episode – and the 92 before it – might never have happened. Ian, you started your career in 1988 so an obvious question would be, What has changed in investment over that time? Equally, what has not changed?

IL: As you say, this is 35 years we are talking about and so things have changed very dramatically – I mean, quite literally. Take the use of technology – the first fund management company I worked at, there was one TV set in the corner of the office and I think it had three screens showing share prices and you pressed M1, M2 or M3. When we dealt, we wrote down orders on carbon-copy paper, and handed them out to the dealers. Whereas, obviously, today we have AI that is basically able to go through and summarise a company’s results in nanoseconds. So technology has clearly changed the picture. The city was a very colourful place too 35 years ago and Nick and I will often tell stories about going to company lunches at places like Warburg’s, where you might be sitting down with the CEO of ICI or something like that – but only after you had had a couple of gin and tonics, white wine, red wine, brandy and cigars! So the city was very, very different then.

A really interesting point is that asset allocation has changed massively. When I was at Gartmore in the 1990s – and Nick at the same time was at Schroders – we were running balanced pension funds. Now, a balanced pension fund at that time would have 55% invested in UK equities –  and not 55% of its equity exposure but 55% of the entire portfolio. It might only have 10% in US equities and then it might have 10% in bonds and a couple of percent in emerging markets and so on. So that was very different. And the pension fund landscape at the time was dominated by four big firms. Schroders, where Nick was, Gartmore, where I was, and then there were two other firms – PDFM, which was a famous value fund manager, and Mercury, which obviously became Merrill Lynch and is now BlackRock today. So that ‘Big Four’ dominated the pension fund market.

JTR: As value houses or did they follow different strategies?

IL: Gartmore was probably more of a growth house. PDFM was very, very value. Schroders had a value bias. I am sure you will have heard of Jim Cox, who was head of UK equities – he was Nick Purves’s mentor, actually, and was a very well-known value fund manager. So it was a mix. What else has changed? Another thing, I would say, is that most asset managers had a bias towards fundamental research and valuations – even the big life companies, such as Legal & General and Scottish Widows. Most of the people investing in those places would have some sort of valuation filter they invested with, which is quite different from today.

As for what has stayed the same – because I have made it sound like an awful lot has changed – I would say the one thing that really hasn’t changed is that share prices are still set by human behavioural biases. The emotions of fear and greed are something human beings will probably never get rid of – and they still cause overreactions in share prices, above and below intrinsic value. That was definitely something I saw in the early days of my career and it is clearly something that is around today.

JTR: Do think the growth of passive and ETFs has led to the loss of price discovery?

IL: Yes. Maybe we will move onto this later but Nick and I often talk about the changing nature of market participants. There are now significant numbers of people who do not care about valuation because they are passive and so all they are interested in is the weight of a stock within the index – so valuation is completely and utterly irrelevant to them. Then there are other people for whom valuation sort of matters but it is not the primary driver – you know, price momentum might be the more important consideration or whether a company is going to beat or miss its earnings forecast is more important. And, when you add all those people up – I would actually like to get some numbers for this, but it feels like it is now probably the majority of the market and the percentage of people for whom valuation is their central tenet feels smaller and smaller today.

Protecting your process from the ‘sin’ of style drift

JTR: That actually leads me to my next question. Clearly, the last decade has been a tough market for value investors – in the UK or otherwise – so, from a process point of view, how have you and the team ensured you remain resilient over this time and avoided the ‘sin’ of style drift?

IL: That is a really good question – and the first point to make is about that word ‘process’. We have a very clearly defined process – at the end of the day, we spend pretty much all of our time just trying to figure out what individual companies are worth and then comparing that to the share price. That is basically what we have done throughout our entire investing careers. We know it does not always work but, over a long period of time, it has worked for us – so, to a certain extent, you then almost ask yourself, Why would you give up on that? So I guess that is point number one.

Point number two is experience – you know, Nick, and I have been through a few cycles, seeing value work and not work and so on but what life has taught us is it is absolutely fatal to give up on it – because the time you give up on value will be the time that it turns. Then, quite rightly, your clients really get angry if they have appointed you to be a value investor and you basically drift from doing that and value turns in your direction and you don’t do well. That is the point in time that people give up on you – and they should, by the way, if you have drifted. So that is another factor while a third factor, I would say, is having two of us.

So, for example, if I went to Nick and said, I think LVMH looks quite cheap – why don’t we have a look at that? – he would give me pretty short shrift. So I think having two of you definitely helps. And then the final thing is having a supportive firm and supportive clients. There will be more pressure on you to drift, if there is someone tapping you on the shoulder saying, Right, you have had two bad quarters, you had better not have a third one – and then, you know, your career-preservation instinct starts to kick in! So if you have a firm that doesn’t do that and clients that don’t do that, that is really important.

JTR: It is no surprise the culture of my team involves co-management. Every single portfolio is co-managed and that is probably because Nick and Kevin learned from the example of others. My own personal opinion is co-management is one of those things that either works very well or not at all. What is the secret behind you and Nick Purves co-managing for such a long time? And is there not a risk of this approach sometimes leading to confirmation bias?

IL: That is another really good question. The secret is what I mentioned earlier on – being ideologically aligned because, if you were not, that will inevitably lead to disagreements. Eventually, those will probably become quite unsettling – and, if you don’t see eye-to-eye, co-managing funds must be pretty difficult. Fortunately, Nick and I do see eye-to-eye. Your point about confirmation bias is a very good one, actually, because this is potentially one of the traps for value investors. You start off with a thesis, don’t you? That the market thinks this business is in structural decline – and you disagree with the market and you think the earnings are going to mean-revert upwards.

But maybe you get one profits wanting, then a second ... and I think there is a real risk in your always looking for data that supports your initial view that, no, this isn’t actually a structural decliner. So how do you look to cope with that? One thing we have started doing is, when we are looking at the investment thesis for a company, we write down the factors that would basically invalidate this thesis – and do that before the actual purchase. Then, if those things happen, you know you have said to yourself before the event, If this happens, it is probably a signal my thesis is wrong. So that is one way to guard against confirmation bias.

JTR: When that has happened in the past, is it an indication you need to exit the position? I mean, what you are building into your decision-making framework here is in essence a ‘Ulysses contract’ for what Michael Mauboussin has called a ‘man overboard’ moment – where if a particular situation occurs, you don’t ask any more questions, you just get out.

IL: That is exactly right because, if you don’t, inevitably that confirmation bias kicks in and you think, OK, the company might have had these bad figures but I still reckon it will come good in the fullness of time.

The hardest thing about being a value investor today

JTR: Ian, what is the most difficult thing about being a value investor in today’s market?

IL: As you know, Juan, being a value investor is hard at any time! Why? Because, as I am sure lots of your previous guests will have said, human beings are hardwired to run with crowds – we have evolved in that way over thousand and thousands of years. I think James Montier has described value investing as like repeatedly having your arm broken – so you are basically getting that pain again and again and again. And we all know that is why you get paid a premium in the end – because you are basically buying things other people are convinced you should not go anywhere near.

So being a value investor is hard anyway. What is really difficult today, however, is you went through all that pain, things ultimately worked out – so, in actual fact, over the last few years, our returns have been pretty good, particularly over the last three years – and investors are still deserting us in droves. That is hard because, historically, I suppose we used to accept the fact we would go through bad periods and, although we disagreed with people leaving at that point in time – because we always had the belief what we were doing would come back – we could kind of understand why they were throwing in the towel.

These days, however, people are not abandoning value investing because it has done badly, what they are doing in lots of cases is they have made a decision they are either going passive – so they just don’t care about value investing – or they are going UK to global. So they are basically selling down UK equities – and UK value in particular – to buy global equities. And, of course, today that means selling down, in our opinions, some very cheap equities and going and buying what look to us like some pretty expensive equities – in the US in particular. So while it kind of feels like it should be the time when people should be getting behind us, in actual fact – and for different reasons – people are going in the opposite direction. That is really frustrating.

JTR: We can definitely empathise with that frustration. Many investors nowadays strive to better understand human heuristics and build and execute on a process that helps them guard themselves against those biases – and maybe even take advantage of them. What, in your opinion, is the most difficult bias to fight against and how do you look to counter it at Redwheel?

IL: It is a tough one because, when we are explaining our investment philosophy, we always say we exploit behavioural biases in other people. So risk aversion, extrapolation, overreaction and so on – we think those are the things that move share prices by more than is warranted and more than the change in the underlying intrinsic value of a business. Yet Nick and I are humans too so we must have some behavioural biases too, mustn’t we? So, we touched on it earlier, but I think confirmation bias is probably one of the most difficult ones for us as value investors – always looking for the thing that is going to validate our thesis and perhaps not paying so much attention to the things that are going to invalidate it.

But it is a really tough one because there have been lots of situations in the past, where we bought something, it has had a couple of profits warnings, the share price has gone down, we have added to it and, ultimately, we have added to it successfully – so, actually, the decline in the share price ended up being a good thing. And, often, these were companies that were written off by the market – you know, a lot of retail was written off by market, wasn’t it? Because there was this view that, ultimately, Amazon was going to be the winner – or, rather, retail was going to be loser – so lots of retail businesses traded at very, very distressed valuations.

And, for a while, you know, lots of data actually would have told you those were structural decliners – but, as it happens, some of them have come back very, very strongly. Marks and Spencer is a really good example – that business has really turned the corner has done very well. So that is a long-winded way of answering your question but I suppose all I am saying is, sometimes several data points might have led you to the thought that, No, we have got this one wrong – and actually sticking with it ultimately did pay off. So it is really hard.

Has news of the UK’s death been exaggerated?

JTR: Changing tack a little bit, there has been a lot of talk that the UK market has become something of a ‘dead’ asset class in recent years – indeed, you referenced this in a previous answer, suggesting lots of investors have made the decision to allocate away from the UK towards markets that are more global in nature. What is your personal take on this idea – is it narrative or reality?

IL: Again, this is a really interesting subject so let’s break it down into different parts. I heard Schroders’ Duncan Lamont on the ‘Merryn Talks Money’ podcast recently and he was talking about the decline in the number of stocks within the UK market – and that is a factor you cannot ignore. Now, he did actually make the point this has happened in lots of other markets as well but that is a bad thing for UK investors – and it is probably a bad thing for the UK economy as well. And I think it is the sort of thing governments and other institutions need to work together on to try to solve because we should have a healthy capital market and we should have new businesses willing to list themselves on the UK stockmarket – and not always take the view, I am going to remain private or I am going to sell out to private equity or I am going to list in the US?

So that is factor number one. Factor number two is what we touched on earlier on – the fact that pension funds have gone from 50%-odd in UK equities to maybe 4%. That is not going to change – I don’t really see pension funds going back in the opposite direction – so that money has probably left these shores. I suppose the best you can say is we are now so close to zero, it can’t get much worse! Then again, a lot of the big wealth managers have done the same – they now look at market-cap weightings when they do their asset allocation and therefore they tend to have a very high weightings to the US and a low weighting to the UK. And, again, that is probably not going to change.

What is the positive case for the UK? It comes back to our old favourite: valuation. When we look at the UK’s valuation, we have a 50-year chart and, relative to the MSCI World index, it is at a 50-year low – on average, it has traded at about a 17% discount; today we are at about a 40% discount. And I always find it interesting – go and look at some global stocks because, even if you are very, very bearish on the UK economy, that is not really going to be a factor for a company like BP or Shell. Those just happen to be listed in London but have less than 10% of their profits coming from the UK – and yet they trade on about half the valuation of their US peers. So I still think the starting valuation of the UK market is going to be a positive factor in the future.

Of course, we have been pointing this out to people for a number of years – as I am sure you have – and we all sit there waiting for the question: what is going to be the catalyst? And, actually, we have started to see a catalyst – and it is the fact that companies have begun to accept there is not going to be a wall of money coming back in the opposite direction to drive up their valuations. So they can either get frustrated about this state of affairs or they can use it to their advantage – and using it to their advantage basically means buying back their own shares. So what we have seen in the last year is an increasing number of UK companies doing that. Again, we have a good chart looking at, by market, the percentage of companies that have bought back their stock in the last year and the UK is now the leader – about 50% of UK companies have bought back stock in that time. So now, not only can I see the low valuation, I can see the mechanism to the realisation of that undervaluation as well. So I think the outlook for the UK market is pretty attractive at the moment.

JTR: Would you say there is something more structural in the sense the UK, together with Europe, lacks the presence of one very important sector – information technology – which is pretty much what has driven valuations in some other places?

IL: That is absolutely right. And there are times that is a bad thing, and there are times that is a good thing – for example, if you looked at the performance of the US market post-2000, having a very low exposure to tech and information technology was a good thing! I am sure you will have heard lots of people talk about ‘potential regime change’ – and what they mean by that is we have been through 10 or 15 years in which interest rates just went in one direction, down to zero, quantitative easing and so on. And that was very good for long-duration assets – information technology stocks, quality growth stocks and so on.

There is a reasonable chance those days have gone and they are not coming back anytime soon – I personally don’t subscribe to the view that interest rates are back on their way to zero – and therefore maybe the stocks that do well in the next 10 years are a completely different set to those that did well in the last 10. So – a bit like post-2000, when the best place to be was tobacco, utilities ... the old economy stocks – maybe the best place to be in the next 10 years is not going to be in information technology and branded consumer staples and so on. Maybe it is going to be in energy or mining companies or financials, in which case, having a very low weighting to top technology stocks and a high weighting to these sectors could be a good thing.

And, if so, could share buybacks be the catalyst?

JTR: David Einhorn provoked a storm among value investors at the start of 2023 when he suggested value investing as a business – as opposed to a philosophy – was dead. I have discussed this with a number of value investors who run their own businesses and I am very curious to hear your own thoughts – especially given our earlier conversation about price discovery being lost.

IL: Absolutely. I actually wrote on this a few weeks ago because I thought it was really interesting. I would start by saying I think some people have been a little bit naughty and quoted him out of context – particularly people who are not value investors have leapt on that and said, Even David Einhorn has given up on value investing. So let’s look at what he actually said, which was: “The market is still dominated by investors that either will not (index funds), cannot (untrained novice investors) or chose to not (valuation indifferent professional investors) have valuation as a cornerstone of their investment process.” So that is what he was saying and it echoes what we were saying earlier on – that, when you look at market participants, the number of people who use valuation as a cornerstone of their investment process is getting smaller and smaller.

He then went on to say, effectively, that the way you realise value as a value investor is going to have to change, arguing: “It used to be we could buy something at a reasonably low multiple, whatever we thought it was, see the company do somewhat better, benefit from it doing somewhat better, and realise that other investors would see what we saw six months later or a year later and would re-rate the shares so you would buy something for 10x earnings, you would get another three points on the multiple and you would make 50% after three years. That isn’t happening anymore because there is nobody to notice what actually happened to these companies. Nobody knows what anything is worth” And I have to say – I completely agree with that.

And it really chimes with your first question on what has changed in the UK market over the last few decades. Back in 2000, you could buy something that was quite lowly valued and there often was a wall of money that would come in behind you. I mentioned how UK firms like PDFM were very big but there were very big US value firms too, such as Brandes, and they would come in too. And so, actually, often you would buy something and this wall of value money would come in behind it and would drive the valuation back up. Those days really are gone, I think – there just isn’t enough value money to do that and therefore it is incumbent on the companies to do that themselves, as we were discussing earlier on with share buybacks.

Just to finish this discussion, that is what David Einhorn went on to say – that, effectively, we have to invest in companies that can realise that value themselves and he used the example of a stock his firm was invested in called Dillard’s. And Dillard’s is a department store – so not a great business. There was very little growth but it basically generated cash and it just sat there every year, buying back stock, buying back stock and, as Einhorn said: “You got to the point where there was pretty much no stock left and they kind of bought it all back and after years and years of the stock underperforming, suddenly it went up 600%.” And it really did – it went up 600% in one year. And I subscribe to that view – you need to be invested in companies now that can be proactive about realising value. But, you know, buy companies where they have a good business, they have a good balance sheet, they are generating cash and they can use that excess cash to buy back their own stock.

At the risk of labouring the point, one of my favourite examples of this is retailer Next. Again, we wrote about this recently and the figures are just incredible – if you had invested £100 in Next in 2000, today it would be worth £1,800. That is about a 15% per-annum total return. Yet, in that = time, Next has only grown its top line at 4% per annum, which is in line with UK GDP. So how on earth do you get a company grossing a top line of 4% to give you a 15% per annum total return? Share buybacks. Lord Wolfson has bought back – believe it or not – two-thirds of the company’s shares in issue across that period of time. And therefore, even though the top line is only growing at 4%, the earning per share have compounded at about 15% per annum – and, of course, the dividends per share and so on. That, to my mind, is the poster child for the value investor today.

JTR: When you sit down with the management of companies and you bring up the topic of share buybacks as an active capital allocation decision, what reception do you get from them? Do they understand the need to look at capital allocation that way? Do they understand the price at which they are buying their own shares is important in that equation? How are they thinking about all this?

IL: It varies, as you can imagine – but like you, I am sure, we meet with lots of companies and often the CEO just looks so depressed. They are sat across the table from us, virtually with their head in their hands, saying, What is going on? My business is doing well – why are we on a P/E ratio of 5x and a dividend of 8x? And we say to them, Look, rather than getting frustrated, go and do something about it – buy back your stock. And I think, the longer companies are sat there with these very, very depressed share prices, the more the penny starts to drop with management – we need to start choosing share buybacks as a capital allocation decision.

You have to remember that a lot of CEOs will have spent a long period of time climbing the greasy pole to get to the top and they probably didn’t set out with the view that, When I arrive in the CEO’s office, I am going to sit there all day buying my own stock! They probably thought they were going to grow their business, either organically or by acquisition. So I think it is a cultural shift for some people – but it is also an important one. And the figures I quoted earlier on about the percentage of share buybacks in the UK market – that kind of supports the view, I think, that increasingly the penny is starting to drop.

A value classic as a book recommendation

JTR: That is really interesting. Ian, before we let you go, we always ask our guests for a book recommendation so what would be yours?

IL: My all-time favourite is Seth Klarman’s Margin of Safety – and, while there are lots of apocryphal stories about it selling on eBay for thousands of pounds, the book is available rather more cheaply, if you seek it out. I like it because Klarman sets things out in a very common-sense way – you know, he just continually rams home the point that value investing is basically about working out how much your business is worth and then paying a lot less for it than that. That is your ‘margin of safety’ –where the book gets its name. And he says it in a way I think even a lay investor could understand. It is very clear, very concise and very well put together.

JTR: Well, I am very happy you mention that book because it was my initiation into value investing. I became a value investor after reading that so thank you very much for that – and thank you very much for coming to Schroders and joining us on The Value Perspective podcast.

IL: A pleasure – I really enjoyed the conversation.