Value Perspective Quarterly Letter – Q3 2021 - Global

This quarterly note covers the Global perspective. Read the UK note here. Read the Europe note here. 

What just happened?

As we write this quarter’s investment outlook the MSCI World index stands at 3,006 points. This is almost 1000 points higher than was 2 years ago on the 30 September 2019. Starting from the March 23^rd 2020 nadir the index has almost doubled; it’s up 92%.

It’s somewhat surprising that the backdrop for this is:

• The rise of one of the world’s deadliest pandemics
• The greatest fall in Global GDP in seven decades
• The largest and most coordinated Global stimulus package ever instigated

The extreme nature of what’s been going on was summed up by a recent cartoon we saw. A man is watching TV with yet another extreme headline emblazoned across the screen. The man turns to his partner and says “wouldn’t it be nice to live in precedented times again?”.

For many observers, this has felt like an environment where it’s taken a lot of hard work for businesses to go nowhere. Large swathes of the global economy have been closed for the best part of a year, but behind the scenes companies have been working extremely hard and, in many cases, these companies are unrecognisable from the businesses we knew prior to the 2020 recession.

Operational improvements abound

There is an old expression “never waste a good crisis”. And few management team’s will not have seen a crisis as sharp or severe as the one we have experienced over the last 18 months. The best teams have used this challenging period to fundamentally restructure and reposition their businesses for the future. A good example is Rolls Royce.

Rolls Royce was a renowned engineering success story. Operating in the large, growing, market for air travel, Rolls Royce was one of only a handful of suppliers of Tier 1 jet engines. Barriers to entry in this market are extremely high. It’s not easy to replicate decades of expertise, huge amounts of investment in people and production and the long-term trust built up with global airlines. Rolls Royce operates a so-called “razor blade” model, where engines are supplied for low prices (and wafer-thin profit margins) but then provide a multi-decade stream of higher margin aftersales and servicing revenues. There was a lot to like about Rolls Royce.

Beneath the surface, however, Rolls was struggling with antiquated business practices, a fragmented production base and a huge legacy workforce. The Covid crisis and the impact on Rolls Royce has been severe, forcing them into a rights issue and to sell a number of non-core businesses. But on the flip side, it has also presented them with the opportunity to streamline their company for the future. Management have grabbed this opportunity with both hands. The fact that over the next 12 months Rolls Royce will reduce their production footprint from three factories to one, but still be able to produce the same number of engines is reveals just what they have been able to achieve. 

The road ahead will be hard and there is still much work to be done. Moreover, their has been a considerable cost –  financial and  human terms as they have mad significant redundancies. However, these steps should allow them to be a better employer and more profitable steward of capital over the coming years.

Can shares in a 500 year old business go up 3 fold in a year?

Rolls Royce aren’t the only business using the crisis to make fundamental changes to their business model. The UK’s Royal Mail has been a business under pressure for many years. A structural shift away from letters has put pressure on their revenues. A large, unionised, labour force made it hard to cut costs. And a universal service obligation necessitating when they deliver mail and at what price, made the business a political football with little pricing power. The light at the end of the tunnel has always been parcels. Online markets have been growing for a while now, but the onset of Covid saw an explosion in parcel growth rates; to which the constant ringing of our doorbells during our enforced work from home attests. This increased speed of transition – from letters to parcels – has fundamentally shifted the dynamics of Royal Mail in a more positive direction.

However, it’s the uncertainty and fear caused by Covid which has really allowed Royal Mail to change its future. Faced with an almost existential crisis, the management and unions have come together to work in a much more constructive way. This has allowed the company to alter it’s out-of-date businesses practices so they are fit for today’s new reality. Parcels do not need the same sorting machines, delivery patterns or post boxes as letters. But they do need other things which Royal Mail have in spades, such as a dense, highly evolved, final-mile logistics network.

As with Rolls Royce, there are many years of hard work ahead for the company and the path is unlikely to run smoothly. However, the very significant improvement in both near-term and long-term earnings expectations for this business have driven a very significant rally in the shares. It’s a measure of how cheap this business got, that despite a rise of nearly 300% from its trough, we still see considerable upside to fair value for the business today.

Rolls Royce and Royal Mail aren’t the only businesses in our portfolio where long-term profits expectations are improving and we’ve seen significant upgrades from a number of companies which have been struggling over recent years. Japanese imaging business Nikon and French advertiser Publicis are two such examples, however, more broadly we’ve been struck by how many of the companies held in portfolios are coming out of the downturn in much better shape.

What happens next?

So what does the future hold from here? Sadly we don’t have a crystal ball. However, despite extended valuations in many markets around the world at the aggregate level, we continue to find pockets of deep-value where there is significant upside on offer. More than that, many of the stocks that we own have taken advantage of the last 18 months to fundamentally put their houses in order. We remain cautious as we look at the world given the shock we have been through and the huge stimulus that is still ongoing. But we remain confident, when we look at your portfolio, that we can continue to generate positive longer term return for you, our clients.