This week Robert Swift takes a look at one of his favourite subjects of the last twelve months, – the land of the rising sun – and delves into a market of misunderstood problems and opportunities.
We have argued for a while that Japan has not ‘suffered from’ deflation at all, but has actually benefitted from deflation in goods and services prices which has made the economy much more competitive. We have also argued that this widespread mistaken idea that the ‘problematic’ Japanese deflation needs to be avoided elsewhere, has caused terrible policy errors by central banks worldwide. In response to what they falsely believe is the root cause of Japan’ low nominal GDP, these central bankers now try to obtain inflation, and positive inflation expectations. It is hubris for them to believe that they could precisely land, or settle, on the right number for, and the right kind of, inflation. They can’t and never could.
We now have the nasty problem of deliberately inflated asset values with which to contend as a result of this terrible and prolonged policy mistake of ultra low interest rates. In a mistaken belief in the need to get goods and services inflation, we have been delivered an asset bubble in certain assets.Deflation, which makes export prices more competitive, is no different from currency depreciation, which likewise makes export prices more competitive. No one thinks competitive depreciation is to be avoided at all costs?! Sometimes it can be useful. Just so with price deflation as long as it is not manifested in the collapse of asset bubbles but confined to goods and services. Deflation in goods prices makes companies invest to keep production costs down and to create new products. It is this private investment that creates wealth and real jobs, not government spending.
Actually the primary reason for low Japanese nominal GDP growth is the demographic aging of the working population. It really has nothing to do with deflation. Adjust for this demography and you have a very productive workforce and an increasingly wealthy economy. Japan has outperformed almost everywhere else on a per capita inflation adjusted basis. This is evident but widely overlooked by many investors. GDP can be as misleading as revealing.
So why has the stock market languished, until recently at least? As investors who focus upon stock specific risk, we think the market is very attractive. The spread of valuations and business prospects in Japan is very wide and will reward good stock selection. We also note that some Japanese companies are beginning to treat shareholders with more respect; are increasing dividends; and reducing wasteful expenditure on unnecessary plant and equipment. This will be good for shareholders. Not all Japanese companies will reward shareholders with change, but those that do will far outperform those that don’t.
We also agree that there have been, and still are, some poor policies adopted both by the government (which don’t look like changing) and by companies, some of which do look like they are in the midst of change. It is the growing evidence of corporate change that we think will drive the market higher. We think the stock market is in the process of being rerated and that we are on a multi-year period of Japanese outperformance. For those that actually have the experience of watching a Japanese equity bull market, this will be an opportunity.
Stay long or overweight.
Here are the reasons why; the evidence that corporate Japan finally ‘gets it’; and some stocks to ponder.
Japanese companies have been incentivised to overinvest and to skimp on dividends. This is changing. Higher dividends will improve corporate capital allocation, raise return on equity, and make Japanese equities more attractive.
Generous depreciation allowances encourage Japanese companies to invest too heavily. Appropriate for a time when Japan had a need to refurbish plant and equipment and prepare for an export drive, these overly generous depreciation allowances are no longer needed. Given their shareholders’ aging demography, Japanese companies should be investing less, and distributing more cashflow as dividends. They are – or some are.
In aggregate it takes about twice as much capital investment in Japan to generate a unit of growth as it does in the USA. One probably underinvests and the other overinvests, but Japan is a conspicuous outlier compared to all the other countries too. This relationship is known as the Incremental Capital Output Ration or ICOR. At the company level it means that there is a lot of ‘crapex’ or wasteful expenditure, driven by the desire to reduce the visibility of corporate profits and thus reduce taxes. It means you you can probably eat off the factory floor when you visit the company as an analyst, since it is so frequently refurbished to an incredible standard, but the flip side is that Japanese shareholding retirees are starved of dividends which they could use to spend and pay their (healthcare) bills.
Check out this chart for different ICOR for the G5 from Andrew Smithers. He is the first to have shown the worldwide misplaced obsession with nominal GDP in Japan with the root cause not as deflation, but as demography.
Japanese companies should be distributing more cash as dividends and reinvesting less. There are signs they are – finally.
They have a long way to go. Check out these two charts from Credit Lyonnais.
Source: Credit Lyonnais
Japanese companies are asset and cash rich. Japanese overall debt is high but owned by the Japanese themselves.
Japan is still a Net Creditor nation and generating current account surpluses. It will matter more what the Japanese think of your bond market before it matters what you think of theirs! Do not be too alarmed by comments about Japanese gross debt figures. It is the net debt figure that matters. In this regard Japan is ok. To be sure, there are some poor and wasteful policies, but fundamentally much of the corporate sector is possessed of good products, globally competitive, with a productive workforce.
The sum of corporate Japan’s profits is equal to the government’s budget deficit. Put another way, the government is mistakenly spending money to boost the economy and run up budget deficits, when all they have to do is remove the depreciation incentives for the private sector to over invest and consequently collect some more corporate tax, as the true profits are revealed. In other words the Japanese government budget deficits are huge but needless and more than matched by the corporate surplus. Under PM Abe. Japanese corporate margins are up by 50% from where they were. The pendulum has swung too far toward corporate profit RETENTION and too far away from dividends and wages. Rising dividends often mean higher share prices. More than 50% companies are net cash in Japan vs 19% in USA and cash to market cap is 23% versus 9% for USA.
From the IMF, the Net International Investment Position of:
Japan +63.8% of GDP
Germany +54.4% of GDP
Australia – 55.6% of GDP
Guess which country needs more inward capital from abroad to balance the books? This inward capital can also become outward.
Governance and Board reform is underway and will improve dividends and shareholder treatment.
Japan has had its fair share of accounting scandals (eg Olympus Optical) in recent years and its boardroom policies and board member selection positively antediluvian. This is however changing, and the Nikkei company and the Tokyo Stock Exchange, launched an index about 4 years ago, the Nikkei 400, to specifically include and weight companies based upon governance metrics, return on capital and profitability. Many Japanese listed companies are clamouring to be included in this new index, because some of the largest investment pools, such as the Government Pension Investment Fund, explicitly use this as a benchmark in preference to the other indices such as the Topix or Nikkei 225 which are not weighted toward ‘good governance’.
We attach the construction rules here:-
Quantitatively
3-year average ROE: 40%
3-year cumulative operating profit: 40%
Market capitalization on the base date for selection: 20% Qualitatively
Appointment of Independent Outside Directors (at least one-third or a minimum of three. If one-third of the total number of directors is less than two, at least two.)
Adoption or Scheduled Adoption of IFRS
Disclosure of English Earnings Information via TDnet (Company Announcements Distribution Service in English
Better governance is strongly associated with better share price performance and dividends and fewer accounting shocks. We saw this trend in Europe and now expect this to occur in Japan. See that charts below comparing the payout ratio and board composition for Japan and Europe. It is quite possible that Japan follows Europe to the benefit of shareholders.
So what to buy?Stocks we like come from the globally competitive and often overlooked hardware technology sector where Japanese companies such as Disco, Hoya, Nidec and Tokyo Electron are the equal of USA and Taiwanese companies. Not all technology emanates from the USA and to solely focus on the USA stocks is a mistake. We also like Autos where exposure to emerging markets (Suzuki) and increasing respect for shareholders (Honda which has just declared it has a dividend policy with a resulting share price pop) will likely result in increasing revenue and dividends. Even the financial sector is attractive where Orix, a capital equipment leasing company (with a global fund management business in there as well) is likely to benefit from increased global investment in preparation for the One Belt One Road (OBOR) in China, and what we hope will be a “refreshment” of dilapidated USA infrastructure.
As we write this, the Japanese market has gone to 25 year highs. There may be an event known as ‘reculer pour mieux sauter” but use this as a chance to get further invested. We will be.
This week the TAMIM Australian Equity Small Cap team review some of the more interesting take aways from the November AGM season as it relates to their portfolio.
Konekt Limited (KKT.ASX)
Market cap: $52m AGM date: 16 November 2017
Workplace services provider Konekt (KKT) held its AGM during November. At the AGM, KKT confirmed forecast revenue growth of more than 70% and underlying EBITDA growth (excluding one-off items) of greater than 70%.
A key focus of the AGM was therefore on updating the market on its recent Mission Providence acquisition – pleasingly, KKT noted that there have been no surprises following completion and that the business was tracking to expectations. The acquisition diversifies KKT’s existing revenue streams, and enhances its ability to provide return-to-work (RTW) employment services, to complement its existing core offering of delivering RTW injury management programs (essentially managing the process of rehabilitating injured workers and getting them back into jobs – and where it is the current national market leader).
KKT noted the acquisition also provides KKT the capacity to enter new or underserviced markets. The logical potential new market here is providing RTW disability employment services – an attractive opportunity with the Federal Government’s 2017 budget highlighting an additional investment of over $3 billion in disability employment services to help people with disabilities get and keep long-term jobs.
A private equity fund has recently bought a majority shareholding in one of KKT’s key competitors – APM, the largest provider of disability employment services to the Federal Government (see here). Apart from this transaction, there has been growing private equity interest in the sector – possibly driven by the potential to capture some of the increasing amount of government funding committed to the disability sector.
KKT continues to trade on a PE multiple of less than 10x, with EPS growth (excluding amortization, abnormals and potential cost synergies) of 15% – 20% forecast over the next two years – a powerful combination of value and growth.
There would also appear to be little upside priced into KKT’s current share price to reflect the further growth available to KKT from the larger scale opportunities it is looking to capture, as the business transitions from its injury management focus to a larger, diverse, more integrated employment services company, operating in multi-billion dollar markets.
Joyce Corporation Limited (JYC.ASX)
Market cap: $48m AGM date: 30 November 2017
Diversified investment company Joyce Corporation reported a strong trading update at its AGM in respect of each of its businesses lines:
Lloyds online auctions – revenue growth for Q1 of FY18 of 61%
KWB Kitchens – revenue growth for Q1 of FY18 of 13%
Bedshed network – revenue growth for Q1 of FY18 of 5%
Investment properties – both now generating external rent with revaluation gains expected.
JYC continues to invest in the intellectual property and development of each business unit to ensure long term sustainable growth. JYC reiterated that on the whole, its businesses are resilient to economic cycles and are unlikely to face any significant threat from Amazon.
To summarise our investment case here, JYC has interests in:
The fastest growing, and one of the largest, online auction sites in Australia (FY17 revenue growth of 56%, and YTD growth of 61%);
The largest specialist kitchen renovation business in Australia;
A large bedding and furniture franchise business; and
Approximately $20m of recently refurbished real estate.
We view the sum of each of these equity interests to be significantly higher than JYC’s current $48m market cap.
Blackwall Limited (BWF.ASX)
Market cap: $52m AGM date: 17 November 2017
Blackwall Limited (BWF) – fund manager, property manager and manager/developer of the Wotso shared workspace business, held its AGM during November. BWF highlighted that by locating its Wotso workspaces in city fringe and suburban sites, it is able to achieve industry leading margins of 25% to 30%. This is because it incurs significantly lower rental expenses but is still able to charge similar rates for its spaces as city-based co-working spaces.
Wotso is a very fast growing business – during FY17, Wotso grew its revenue by 84% and operating profit by 93%. It manages the largest number of coworking sites in Australia, together with a Singaporean business, and is currently looking at New Zealand opportunities.
At the end of November, BWF confirmed that following the uplift in value of a fund that it manages, it had generated performance fees of approximately $11m. This fee will be converted into units in the fund – providing BWF with an ongoing income stream and the potential to benefit from further capital gains in the fund. This is an $11m asset that BWF did not have this time last year – and is quite material in the context of a $52m market cap company.
In addition to this ‘new’ asset, BWF has a number of other ‘surplus’ investment assets on its balance sheet – we estimate BWF’s net assets to be worth approximately $35m in total.
Deducting the value of these net assets from BWF’s market cap of $52m implies that BWF’s three operating businesses (the fast growing Wotso business, and BWF’s fund and property management businesses) are being valued at just $17m. The fund management business has generated performance fees of $14m in the last 6 months alone! To provide an indication of sector values for larger co-working companies, we note that WeWork, the world’s largest co-working company and Wotso’s largest Australian competitor, is currently valued at an incredible 20x its forecast
annual sales. (Wotso’s annual sales are currently tracking at approximately
$8m).
Paragon Care Limited (PGC.ASX)
Market cap: $138m AGM date: 22 November 2017
Healthcare equipment and consumables supplier, Paragon provided revenue and EBITDA guidance at its AGM which was in-line with market expectations and translates to ~10% organic EPS growth for the year (pre any acquisitions).
A number of growth drivers for PGC were articulated in the AGM
presentation:
– A growing demand for the provision of preventative equipment service and maintenance throughout the medical, scientific and allied health industries, with these recurring service revenues now expected to contribute ~10% of PGC’s FY18 revenues;
– Extending PGC’s geographic footprint – i.e. the rolling out of a new South Australian warehouse and logistics site in January 2018. Queensland and New Zealand are areas that remain underserviced
by PGC;
– PGC continues to benefit from increasing demand in the aged care sector with these revenues increasing 20% to $14m for FY17
– PGC’s e-health offering Midas, a web reporting software platform, is making strong progress towards contributing profit; and
– Strong pipeline of value accretive M&A to add to PGC’s product range, service and maintenance offering and geographical footprint are being reviewed.
Despite these positive developments the PGC share price continues to be weak. We believe the weakness can be explained by the following:
An upcoming CEO transition – short term in nature;
The market expecting a capital raise at some point to fund a potential large acquisition – again short term in nature if it happens;
Seasonality of the business becoming more pronounced as hospitals buying increasingly trends to the third and fourth quarters of the financial year (structural – but can be mitigated through increased service and maintenance and consumable revenues).
Whilst the current share price is disappointing, we expect the PGC share price to be materially higher this time next year. PGC have stated some aggressive financial targets (revenue of $250m and EBITDA of $37.5m) – and have an excellent track record in achieving its targets.
Guy Carson, manager of the TAMIM Australian All Cap Value portfolio, has had an excellent year to date. This success has come from not only picking good stocks but also from managing the portfolio risk when he occasionally picks the wrong stock. This week, to illustrate how to minimise losses and maximise gains, Guy takes a look at one of his recent mistakes alongside some of his better picks.
One of the most common questions we have received in recent months is why do we hold so much cash (currently c. 37%). The answer to this is that it is a result of our bottom up process and is a function of two things: Firstly the number of stock ideas that we have at any given time and secondly the amount of exposure we are willing to take in each position. At the moment we hold 20 companies; this is the highest number we have for some time but our cash level remains elevated as the average position size is smaller. This is a function of us having less overall conviction in the current ideas due to either high valuations or greater risk in the business models.
As stock pickers we are aware that we are not going to get 100% of our calls right and hence we need to manage the risk within the portfolio. The key for us here is trying to minimise the downside from those we get wrong and maximise the upside from those that we get right. This is the key reason behind why we vary the weights of the stocks in the portfolio. In order to explore this concept further we wish to take a look at some of the calls we have either got wrong or right this year and how we have managed those positions over time.
One we got wrong: minimising losses
Recently we wrote about a company that we like called Inabox (IAB.ASX). For those who don’t follow the company, the company has since our write-up downgraded earnings on the back of a recent acquisition.
“It must be pointed out that this is a very small company with a little bit of debt so an investment is certainly not without risk. Whilst it may not be our largest position, we believe it is worthy investment for part of our capital.”
– Guy Carson, Telcos: Thinking outside of the box
Whilst we liked the story and believed the market was undervaluing the business, we were hesitant to place too much of our capital into the stock (taking a position of just 2%). When investing in small and micro-cap companies it is always important to remember that scale provides a form of protection. Things can go wrong very quickly and very easily for a small company and that was the case for Inabox through their acquisition of Hostworks.
Hostworks is a cloud services business that had achieved revenue of $22m and EBITDA of $0.6m in FY16. On acquisition, Inabox believed that they could achieve $2.9m of cost synergies primarily through reducing staff and rent costs. This meant the business would add meaningfully to EBITDA in FY18. The problem though comes when we look at the spread of its revenue across clients. The largest client represents over $3m of revenue (as you can see below); if this client was to leave then the profitability of the business is more or less wiped out.
Source: Company filings
This is the key risk with businesses of this size. One contract or client can make a big difference both on the downside and on the upside if gaining new clients. In the instance of Hostworks, revenue is now expected to be $15m in FY18 suggesting the loss of multiple clients.
As a result of this risk, these positions in our portfolio are always going to be small, they will grow if the story plays out and the company grows. In the case of Inabox, the story has not played out as we envisaged and our small weighting has limited our downside. Our initial weighting in the stock was 2%, the price had rallied since we bought it and the weighting stood at 2.2% at the time of the downgrade.
From our initial 2% position, Inabox has cost us approximately 0.8%. Despite this we still remain in positive territory for the month of November and up over 12% year to date. Thankfully we have got more right than we have got wrong.
Two we got right: maximising gains
The below table outlines our top five holdings at the start of the year (first published back in our 2017 Outlook).
When we look through the year to date returns, we have some significant success.
Gentrack has returned 57% including dividends;
IMF Bentham has returned 36% including dividends;
Altium has returned 58% including dividends;
Greys Ecommerce Group was taken over, we sold our position for a profit prior to the takeover;
Integrated Research has returned 44%.
Due to the nature of these, our current top five looks quite different as we have taken profits and locked in gains. In order to give you an understanding of how we have managed these positions we thought we would work through two quite different examples.
Altium (ALU.ASX)
Altium was our third largest position at the start of the year with a weight of 5.3%. We first acquired Altium back in 2015 at c. $4.35; we were attracted to the quality of the business and believed the market was under valuing the potential growth. As the stock rallied we took advantage and locked in some profits, most notably on its FY16 result when it almost hit $10. When the stock fell in the broader market selloff late last year we again took advantage and topped up our position to 5%. Altium is a very high quality company with global revenue and a sticky client base; as a result we are happy to take significantly more exposure to the company than the likes of Inabox.
The company recently reported a very strong set of FY17 numbers and the stock price has gone from $8.50 to above $12.50. Once again we have used this significant share price strength to rebalance our position, whilst we still hold Altium we do see increased valuation risk and as a result we have reduced our position to c. 2.5%. The company in our opinion remains the highest quality IT company listed in Australia. If the company does achieve its 2020 goals of becoming the market leader in PCB software and achieves its $200m target then over the medium term it will offer a good return, however short term risks have been amplified.
Gentrack (GTK.ASX)
Gentrack was our largest position at the start of the year (7.5%) and it remains that way now (7.5%). We have been shareholders since early 2015 shortly after the company’s IPO. The company made the cardinal sin of downgrading barely 6 weeks after listing. For a newly listed company this can severely impact credibility with the institutional market. As a result the share price fell and was trading on 16x earnings, significantly below peers trading in the mid-20s. When the share price fell further we bought more.
We have been less active with Gentrack than Altium. The company still trades at a discount to peers (with more conservative accounting) and as a result we have only traded to keep our weight below our 10% maximum. Whilst the share price has run significantly, this has been backed by earnings growth, most notably through the acquisition of Junifer Systems in the UK.
Whilst Gentrack is not the largest company on the ASX, we feel comfortable with a large position due to the nature of its industry. Gentrack is a software company servicing both the utility and airport sectors. Once their software is embedded in a company’s operations it becomes difficult to switch and hence you get a business model that sees:
A high degree of recurring revenue (Gentrack estimate that 50-60% of their revenue is “highly likely” to reoccur);
Low additional costs of bringing on customers, leading to high margins;
And very low capital costs leading to high returns on capital.
Due to these characteristics, we are happy to carry our current 7.5% weight.
Conclusions:
No stock picker in the world gets every call right and we have to acknowledge that when we construct a portfolio. There are two areas of risk we focus on, inherent weakness or lack of quality in the business model and valuation risk. Unfortunately finding positions where the risk is minimal on both counts is rare, when we do find them as was the case with Gentrack we take a high conviction position. When we find potential investments that we like but do have risks then we take a smaller position. If the story doesn’t play out as we expect it therefore doesn’t hurt us as much. On the other hand if the story does plays out and the risks dissipate, we can always increase our exposure if and when the story derisks
In the wake of the US Election result yesterday, we at TAMIM have asked a couple of the managers we partner with to give us a few quick reactions and thoughts on where they see opportunity now that President Donald J Trump is a reality.
In the wake of the US Election result yesterday, we have asked a few of the TAMIM investment managers to give us a few quick reactions and thoughts on where they see opportunity now that President Donald J Trump and “The Apprentice: Global” is a reality.
SPECIAL: Presidential Reactions
TAMIM Australian Equity Small Cap IMAThe stocks in our portfolio are largely domestic focussed, many with strong defensive qualities. We expect these types of companies to continue to perform well operationally, and produce good financial results, irrespective of the political or economic situation in the US.
Overall market weakness presents potential buying opportunities in these domestic facing stocks, such as:
Paragon Care Limited (PGC) – a supplier of consumables and equipment to Australian hospitals and aged care facilities, with strong defensive qualities.
Joyce Corporation Limited (JYC) – the owner of three high performing national businesses, with a very strong balance sheet and no international exposure. Click here to read our more in depth analysis.
TAMIM Global Equity High Conviction IMA
There will be a lot written about the US election so we will be brief and confine ourselves, mostly, to how it affects the stock markets.
As Donald Trump promised the result was Brexit +++! Yet again all the polls were wrong – in some states by quite large margins, with Pennsylvania being the biggest shock. In a sense it shows how the media and pollsters create a false world that seduces outsiders in to believing their rubbish and biased reporting.
Just like Brexit those who clearly don’t like this result have made hyperbole apocalyptic statements following this shock win. But perhaps after Brexit we shouldn’t be too surprised. All of the same issues have brought about this result – changing demographics and social engineering of multiculturalism, the falling real incomes of vast swathes of America hurt by globalisation and another poke in the eye for the liberal elites.
People are now poring over every sentence that Trump has uttered in a long bitter campaign to show what a nightmare he will be. But as we all know, when in power reality takes hold and some of the wild statements will just be a fading echo.
Trying to distill through likely implications for the US and World economy and its effects on markets, a few points stand out. Whether all of these aims can be realistically achieved – these things were never costed! – is highly doubtful but at least we have some sense of direction of travel:
Trump has pledged lower corporate taxes and this will aide in the repatriation of a lot of cash on some US corporate balance sheets (Apple, Google, etc) back to the US.
Higher infrastructure spend – a topic we have discussed on a number of occasions where there has been a notable deterioration in the infrastructure in the USA as money has been diverted to overseas wars, etc.
Less government and less regulation – no bad thing in a country which is already overburdened with too much legislation.
NATO – Donald Trump is quite right that Europe has been getting away with too little a contribution to the burden of the defence of the West. This should be good news for defence companies particularly in Europe (BAE Group, Thales, GKN). USA companies such as Lockheed Martin and Northrop Grumman, if allowed, will be big beneficiaries of exporting USA defence technology and hardware.
Pharmaceuticals – Hilary Clinton has form in being particularly harsh on the Pharmaceuticals industry. Going in to this election the Pharmaceutical sector has been significantly de-rated and this result is likely to help lift the sector.
Banks – Overall it would seem that Trump’s policies are likely to be more reflationary which means interest rates may be somewhat higher than the market is currently expecting. This would be helpful for direct beneficiaries like construction companies but will also help banks where a steeper yield curve is likely to help margins. Again this is something we saw as inevitable and we have invested heavily in North American financial stocks.
This week we present a piece by Hamish Carlisle, analyst with the TAMIM Australian Equity Income IMA powered by Merlon Capital Partners, as they follow up a previous piece on the merits of value investing.
While the long term returns from “value investing” are strong and well documented, the approach has struggled over the past decade prompting many investors to question its merits.
This paper represents the second of what will now be a three part series discussing value investing from an Australian perspective. In the first paper we concluded that value investing on the basis of free-cash-flow has performed well through a number of market cycles and has displayed low levels of volatility when compared to traditional classifications of value such as earnings, book value and dividends.
In this second paper, we begin to explore the question of why value strategies based on free-cash-flow outperform the broader market. Consistent with our philosophy, we present findings that show a linkage between value investing on the basis of free-cash-flow and earnings quality. We then go on to dismiss the notion that value investing is “riskier” than passive alternatives.
Why do stocks with high free-cash-flow yields tend to outperform?
The performance of value investing on the basis of free-cash-flow in an Australian context has been compelling and, in our view, represents a strong foundation for active stock selection. This key finding underpins TAMIM Australian Equity Income portfolio’s investment philosophy which is built around the notion that companies undervalued on the basis of free cash flow and franking will outperform over time.
A second key tenant of the TAMIM Australian Equity Income portfolio’s investment philosophy is that markets are mostly efficient. We don’t believe that value stocks outperform simply because they are “cheap” but rather because there are misperceptions in the market about their risk profiles and their growth outlooks.
We are focused on identifying and understanding potential misperceptions in the market. To be a good investment, market concerns need to be priced in or deemed invalid. We incorporate these aspects with a “conviction score” that feeds into our portfolio construction framework.
Value investing & earnings quality
The outperformance of stocks with high ratios of free-cash-flow to enterprise value could capture two sources of mispricing:
The well documented value premium; and/or
The accruals anomaly (See: “Do Stock Prices Fully Reflect Information in Accruals and Cash Flows about Future Earnings?”, R Sloan – The Accounting Review 1996), representing the degree to which accounting earnings are backed by cash flows
To further explore this question, we compared the returns from a strategy of investing in companies with good “earnings quality” – which we define as the ratio of enterprise-free-cash-flow to enterprise-accounting-profits – with the returns from the enterprise-free-cash-flow classification of value.
We find that the returns from investing on the basis of earnings quality are remarkably similar and remarkably correlated to the returns from investing on the basis of value as measured by enterprise-free-cash-flow. This could be interpreted in a number of ways:
“Value” has been arbitraged away while the accruals anomaly has persisted; or
The value and accruals anomalies are one in the same (See, for example: “Value-glamour and accruals mispricing: One anomaly or two?”, H Desai, S Rajgopal, M Venkatachalam – The Accounting Review, 2004).
It is difficult to definitively answer this question but in our experience both explanations are valid in particular circumstances. With regard to earnings quality, management teams and boards are becoming ever increasingly creative about how they define profitability. Our favourite notorious measure is “pro-forma adjusted Earnings Before Interest, Taxes, Depreciation and Amortisation (EBITDA)”. This measure usually and conveniently ignores capital expenditure, working capital requirements, restructuring costs, discontinued operations and asset impairments to name a few. It is often used to justify expensive acquisitions and even more cynically, used as a basis for management remuneration.
The bottom line is management teams can define profitability however they choose but can’t as easily hide from the realities of the cash flow statement. Eventually these realities come home to roost and when this happens stocks with low earnings quality tend to underperform. So long as investors place weight on measures such as “pro-forma adjusted EBITDA”, we think the accruals anomaly is likely to persist.
At the same time, we think it would be irresponsible to “pay-any-price” for companies with high earnings quality (or indeed high quality businesses in general) and this style of investing is prone to many of the behavioural biases that support excess returns from value investing in the first place.
Are value strategies riskier than glamour strategies?
There are two schools of thought as to why value strategies have historically outperformed glamour or growth strategies. The first is value strategies are riskier than passive strategies. This is intuitively appealing when we consider the nature of value stocks. These companies are typically plagued with investor concerns, surrounded by popular pessimism and often have high levels of financial and operating leverage.
A brief look at the top 10 industrial stocks in the ASX200 ranked by free-cash-flow-yield highlights this point.
Different investors will perceive risk differently but for us the most crucial measure of risk is how particular portfolios perform in down markets. Figure 4 illustrates the performance of value strategies based on enterprise-free-cash-flow through a variety of market conditions. The point to note is that there is little difference in performance in up markets and down markets. If anything, the value portfolios perform better in more adverse market conditions.
Figures 3 and 4 highlight one of the challenges faced by many investors and their sponsors. The challenge is distinguishing between diversifiable risk (or company specific risk) and non-diversifiable risk (or systematic risk). By definition, company specific risk can be diversified away whereas systemic risk cannot. Myer – a department store – might appear to be a risky investment. However, investors should be only be concerned with how the stock performs within the context of a portfolio and how such a portfolio is likely to perform in a meaningfully down market.
Indeed, when we invest in businesses we place significant weight on understanding and quantifying downside valuation scenarios and their dependencies on uncontrollable external influences such as macroeconomic conditions. These are “systematic risks” that cannot be diversified away. This “margin-of-safety” concept is explicitly considered when we develop our “conviction scores” that combine with valuation to determine portfolio weights.
Concluding comments
The performance of value investing on the basis of free-cash-flow in an Australian context has been compelling and, in our view, represents a strong foundation for active stock selection. This key finding underpins Merlon’s investment philosophy which is built around the notion that companies undervalued on the basis of free-cash-flow and franking will outperform over time.
Any investment philosophy needs to be supported by an understanding of why a particular approach is likely to generate excess returns. In this paper we begin to explore this question. Consistent with our philosophy, we present findings that show a linkage between value investing on the basis of free-cash-flow and earnings quality. We then go on to dismiss the notion that value investing is “riskier” than passive alternatives.
In our third paper in this series to be released next quarter we will highlight a number of well documented behavioural biases that are empirically and anecdotally evident in the Australian market. We will also point to various elements of the TAMIM Australian Equity Income portfolio investment process, structure and culture that are aimed at minimising our exposure to these biases.
