Why there’s more to value than meets the eye
Why there’s more to value than meets the eye
Value investing is, largely, about mean reversion and exploiting the behavioural biases in markets that lead to stocks becoming mispriced. Stock markets are imperfect and, over time, some companies fall out of favour and become valued more cheaply than their intrinsic worth. When their valuation reverts to the mean, investors make money.
But what does the phrase “value stock” conjure up? Perhaps a bank or energy company: many of the businesses in these sectors are trading on lowly valuations. However, the opportunity set goes far beyond them. We see several different “flavours” of value hiding in plain sight in markets currently.
Hidden value in Japan
Japan’s slow economic growth and sometimes poor record on shareholder returns has led some investors to disregard the potential opportunities. But we’ve looked at a large number of companies in Japan and think there are some hidden gems that are unappreciated by the broader market. What’s more, the potential drivers of these stocks are independent of interest rate, inflation or other macroeconomic expectations.
In particular, we look for companies with solid balance sheets, scope for valuations to mean-revert, and whose management teams are acting to improve shareholder returns.
One such stock is Dentsu, a major global advertising agency. The advertising industry in general has had a torrid time as digital platforms like Facebook have grown in importance relative to conventional advertising channels. But this challenge can be overplayed and the agencies are adapting to the new digital world. For Dentsu specifically, we’d highlight that its head office is one of the most valuable buildings in Tokyo and worth around a third of the company’s whole market capitalisation.
Another example is Tokai Rika, a specialist in manufacturing seat belts and electronic displays for cars. That might sound rather dry and boring, given the enormous innovation going on in the automotive space, but cars will always require seatbelts and displays regardless of whether they are petrol or electric.
A third example is DeNA, operator of mobile and online services including games and e-commerce. The company has been struggling to come up with new game titles but the arrival of a new CEO may help change this. DeNA also has a license for Nintendo branded games. This is a clear example of a Japanese company with a focus on shareholder returns: DeNA bought back 13% of its outstanding shares last year, and is in the process of buying back another 8%.
Quality stocks are identifiable by traits such as reliable revenues and strong returns on capital. Sounds good right? But such stocks can also fall out of favour, for all manner of reasons, and become value opportunities.
Take the pharmaceutical companies. Sanofi, GlaxoSmithKline and Bristol Myers-Squibb are all facing patent cliffs (where patents expire, opening up competition and potentially leading to a sharp fall in revenues). However, they’ve followed the successful formula of other pharmaceutical companies by investing in the rebuilding of their product pipelines, changing their management teams, and employing world class scientists. It may take time but we believe they can discover decent new drugs.
Then there are quality companies where events have simply conspired against them. Brewers like Molson Coors are one such example. In Europe especially, beer tends to be consumed in communal spaces – bars, sporting events – and so the Covid-19 lockdowns saw a dramatic hit to demand which was not fully offset by an increase in home consumption. The lifting of restrictions should see demand recover.
And quality companies can make missteps. For example, Bayer is the owner of Monsanto which continues to face litigation over the weed-killer Roundup. From an investment perspective, the protracted legal proceedings are overshadowing the merits of the rest of the business. It takes time and patience for these issues to be resolved, but such historic issues do eventually fade.
Another overlooked segment of the market are the “slow and steady” companies like food retailers or telecommunications stocks. These won’t set the world alight with their growth rates but they could prove long-term winners. Both of these sectors have had a difficult decade. However, we think those who can make small improvements to their top line and profit margin growth, and who focus on shareholder returns, can be attractive prospects.
Another group is the businesses that have suffered a difficult period, again for a variety of reasons, but have taken matters into their own hands to resolve things. There are many attractive investment opportunities to be found in companies who are at differing stages of their recovery.
One that is fairly advanced along the recovery path is Royal Mail – a 500-year old business still operating in an era where the market’s focus has been on all things new and digital. The boom in parcel deliveries since the pandemic has undeniably been a welcome surprise. However, companies need to be in a position to take full advantage of such boosts when they come.
Royal Mail has transformed its relationship with its workforce recently. We think this can benefit other stakeholders (customers, shareholders) as better relations with employees are the key to unlocking efficiencies and potential profit growth.
Don’t write off “obvious” value
Last but certainly not least, we return to the “poster children” of value currently: namely banks and energy stocks. Banks have been out of favour since the Global Financial Crisis (GFC), leaving the sector generally looking attractively valued, in our view, even with interest rates at current levels.
Banks hold record high levels of capital, have spent a decade of reducing risk, and are part of the solution to the current crisis rather than the cause, as they were with the GFC. And if interest rates were to rise then that would be an enormous positive for the sector.
The second poster child for value is the energy sector. Oil companies face a well understood and significant structural threat from the need to decarbonise economies in the face of climate change.
Ironically, this has finally forced them to act in a shareholder friendly way. By and large, the energy companies are showing discipline on spending, focusing on costs, and returning capital to shareholders. This is a combination which, when considered alongside a potential spike in oil prices, could be very attractive for shareholders.
The above is hardly comprehensive but hopefully it demonstrates how investing in the value style can lead to a very diverse set of companies. A large number of these are idiosyncratic stories whose chances of success are independent of each other and of wider market variables such as the future path of inflation.
Clearly, value has had a difficult decade and the challenges facing sectors such as energy are well known. But, for investors prepared to look a little more closely, and exercise a degree of patience, we think there are exciting opportunities to be unearthed.
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