Robert Swift explains his strategy and how the TAMIM Global Equity High Conviction IMA (or the underlying fund) has managed to achieve such impressive results over the years.
The VMQ Ranking System
Robert Swift – Head of Global Strategies
Aside from being small and nimble, today’s report seeks to highlight the main reason for this out-performance: A well-executed quantitative scoring system that ranks each company in our universe on its Value, Momentum and Quality rankings. One of the many tools that a skilled stock-picker can use to justify their existence as an active portfolio manager, and break down the common misconception that active portfolio management doesn’t work.
The three factors that make up our VMQ process are:
Value – We seek to identify securities that look cheap (intrinsic value is less than the prevailing market price). Our measure of value is calculated through a multi factor model based on forward looking estimates such as EVA adjusted B/P, earnings yield, dividend yield and cashflow yield.
Momentum – We like to see that price is moving in the right direction, indicating that the market sees what we see. This is highly critical as the market ultimately holds the power to stock-price movements. Catching a falling knife usually ends up with cut fingers, and there are many stubborn fund managers around the world who refuse to accept their mistakes, resulting in poorly performing investments where a stock price will languish for far too long.
Quality – This is profoundly important, especially in market conditions like these where lending standards have been increased by regulators globally, resulting in funding pressure for a lot of poor businesses. We prefer lower leverage, more stable earnings and higher return on equity because only the truly strong businesses prosper in the long term. The other effect of holding high quality names is the reduced amount of risk within the portfolio. Risk is measured by the probability of capital losses. If we hold high quality companies who have a strong financial position, our investors’ capital is not exposed to as much risk as a traditional index fund is exposed to. At TAMIM Asset Management, capital preservation and strong risk-adjusted returns are what we aim to deliver, and focusing on quality businesses is one way in which we aim to achieve these goals.
Once this detailed process is complete, we then look at the equally important qualitative business factors and make a decision on the companies place in our investment portfolio. Keep an eye out for the full education course including access to our VMQ modelling spreadsheet, video tutorials on stock picking, and portfolio construction techniques on the new InvestorU education service.
At TAMIM Asset Management we invest in stocks – not markets. The recent volatility in markets has highlighted to investors the need to own high quality stocks in their portfolios. Robert Swift utilises his VMQ (Value, momentum and quality) screen to access whether we would hold Rolls Royce in our client portfolio’s.
The TAMIM Global Equity High Conviction IMA works on a quantitative scoring system which ranks each company in our universe on its Value, Momentum and Quality rankings.(see the
VMQ Ranking article)The current and persistent low economic growth environment globally has recently seen a reassessment of credit risk all around the world. Many of you reading this would be feeling the pain of the reassessment through your holdings in any of the big 4 Australian banks, or the harsher losses seen in the sharp price declines in European bank stocks. We’ve seen this many times before and therefore believe that the best business to hold in the current market climate are those that are financially sound, that is, those who screen strongly on our quality metric amongst the other factors we look for. Financially weak companies are being punished by the market, including the business we investigate in this weeks’ article.
Recently we ran the VMQ screen over Rolls Royce Holding PLC, a UK based aerospace company making jet engines, not to be confused with the car company that is owned by BMW. Rolls Royce was popular with analysts for a number of years because of its order book growth and steady progression in declared EPS. Our VMQ scores in recent years gave us doubts. Quite simply, the EPS growth wasn’t reflected in free cash flow and upon further investigation we decided that the VMQ rank was correct. This assessment and strict adherence to our processes meant that we haven’t been worried about not owning this market darling.
The above workings will show that our quantitative VMQ process has resulted in a very unfavourable rating for Rolls Royce. The lower the VMQ score the worse the ranking. This alone does not tell us to avoid the stock completely, so we dug a bit further and produced the following important qualitative findings:
Rolls Royce (RR) announced on 12 November 2015 an earnings revision based on a negative outlook for 2016. This was the fifth downgrade in 2015. The share price fell by 20% overnight and was down 48% for the calendar year 2015.
RR order book is very reliant on demand for aircraft from fleets operating in emerging market countries which are economically challenged as commodity prices fall.
Many of the planes powered by RR engines are being retired by airlines that are seeking more fuel-efficient models
RR is also challenged by the accounting treatment of revenue and earnings.
The accounting treatment for “risk and revenue sharing partnerships” has long dogged the company. This was first flagged in 2002 and has always been at the back of our minds. Effectively component suppliers contributed to the cost of new engine development in exchange for a share of the profits. Rolls Royce considered these as revenues as opposed to loans or R&D to be amortised.
In 2013 the Financial Reporting Council, the UK accounting regulator, forced the company to restate this practice.
Additionally the maintenance contract revenue is booked on a smoothed basis in advance of the actual work being done over the life of the engine.
It’s transparently done for all analysts to see but it is aggressive recognition of revenue – something we don’t like.
There is still a fair size pension fund deficit with defined benefit obligations exceeding value by about GBP1.1bn (A$2.3bn)
The company had never changed its aggressive accounting treatment of revenue and the use of off balance sheet R&D (partners) to reduce engine development costs. The company was making a lot of money from service contracts on older generation aeroplanes and was alienating customers with the terms of those contracts. All this came to a head and the CEO was replaced late last year and the share price fell back to where it was 5 years ago. The company’s new CEO, Warren East, has decided to reset the guidance of the business and reduce costs. This is a standard procedure for a new CEO and we expect a few more nasty ‘surprises’. Interestingly an activist investor has now appeared on the share register. We continue to watch this through the lens of the VMQ scores. We currently hold Northrop Grumman from the USA instead which has performed better than Rolls Royce and has far fewer issues with respect to its balance sheet and strategic position. We will take some time to explain our investment in this great business in a later edition of our weekly investment newsletter.
Summary Our quantitative analysis indicates very poor earnings yield and earnings quality (both bottom decile), arising from accounting restatements. The bottom decile momentum score arises from the short term market reaction to the earnings downgrades. Earnings guidance restatement tends to be serially correlated (both good and bad news), which the momentum factor picks up.
The outcome demonstrates the importance of evaluating multiple factors and avoiding reliance solely on one dimension. Value factors are liable to have exposure to value traps (superficial analysis suggests stock is cheap, but to get better stock selection results you need to understand why and if it will change). Analysis still indicates a poor outlook, even after the share price declined significantly in 2015.
The point of this story is not that we will always avoid these kinds of stocks; we won’t.
Nor that other investors are stupid; they aren’t.
It is more about the conviction we have in our investment process and the fact that applying a well constructed quantitative stock selection model with some knowledge of a company’s “fundamentals”, is a powerful and rewarding combination. This can be seen in the stellar performance of the underlying fund which has grown by 144.5% since inception compared to the All Ordinaries which is only up by 10% in that time-frame.
The Pain Report will provide you with a weekly independent and objective commentary on the global economy, in an attempt to help you identify the key forces which will shape the world in the years ahead. For example, I believe that the most significant and defining economic phenomenon of our time is the rise of the Asian middle classes. I urge you to beware the prism through which you view the world, and to be aware that much of the western media’s negative and sensationalist coverage is biased against the so-called emerging nations. In my view, the decades ahead will see an era of prosperity, enlightenment and opportunity that very few today are predicting. If any of the above resonates with you then please read “The Pain Report”.
Let’s sit back, relax and enjoy the pictures. Global equity markets had a good week. In fact mid-week the S&P 500 strung together its best 3-day winning streak since October 2011. And talking of 2011 quite a few investors think that the current decline in equity markets is analogous to that period, which we remember as the depths of the eurozone sovereign debt crisis. (see chart below)
S&P500 Index
I wish I could feel that way too. Do you think the current environment is like 2011? I’m sorry I don’t. In fact everything, and I mean everything, is different. China was doing just fine. Emerging market companies were happily borrowing lots of money and hadn’t yet borrowed too much. The ECB hadn’t yet launched QE and Kuroda hadn’t yet arrived at the BOJ to launch the biggest shock and awe monetary campaign of all time. The FED was aggressively easing policy. Since 2011 we have had a Chinese stock market crash, an oil market and commodities crash and Donald Trump…to mention just a few! I think the “its 2011 all over again” cheerleader squad have lost the plot and are clutching at straws, and that there are simply too many differences to mention. You see the simple and stark reality is that it really is DIFFERENT THIS TIME. And yes I know those are loaded and emotive words for all of us in the investment industry, but, really, you have to agree we have never been here before. We have no roadmap, well, no monetary roadmap. This time investors appear to be losing faith in the central bank’s ability to influence markets. Just look at the reaction of the market to the BOJ move to a negative rate and the subsequent strengthening in the YEN, post Jan 28.
Japanese Yen Spot
And, as I have mentioned in previous weeklies and The Pain Report, look at the performance of bank stocks in Japan (first chart below) and Europe.
Topix Banks Index
Stoxx Europe 600 Banks Index
These charts, as I have mentioned before, are telling me that the ‘hissing’ sound you can hear is the deflation of a global credit bubble.
Now let me be very clear, as there is much discussion of late about the prospect of a US recession. I do not see a recession in America this year. I also believe that the US banking system is fundamentally sound, in fact I think it is very robust, unlike in 2007/2008. I also do not believe that the crash in oil prices, and the indebtedness of oil and oil related companies, pose any kind of systemic risk to the US banking system. Most of the risk is held outside the banking system in various credit funds, ETFs and the like. I do recognise the weakness in the industrial and manufacturing sector in America, BUT the US consumer is in pretty good shape…ditto the housing market looks fine. Having said all of that the US economy will not set the world on fire with sparkling economic performance. Quite the contrary, growth will be about 1.5% to 2% this year. The problem THIS time is not in America. THIS time the winds of deflation come from the east, and not the west. Stuck in the middle we have Europe. We have a migration crisis, we have a bad debt problem in Italy, we have issues in Portugal and yes we also have issues in Greece…but really, who cares about Greece anymore? The recovery in Europe is young and fragile and the bank stocks are suggesting some trouble ahead, nothing systemic as yet, but the problems in the east could not have come at a worst time. Keep an eye on European truck sales…as you know my favourite economic indicator. And talking of economic indicators, and to make things even more complicated…oh boy…and they are complicated…I feel that we have a data integrity problem across much of the world. We all know the China story and the integrity of the GDP figure, but here in Australia, we have the nonsense that the ABS issues each month in the employment report. Then there is the mother of all economic statistics, the US employment report. In times such as these I rely on the charts. Listen to what the market is telling you. They are looking forward, not backward. Right here and now equity markets look like they want to move higher. Not surprising given how far we have fallen. The two charts below (Dow Jones Transportation Index and the Russell 2000) tell me that markets want to go higher.
Don’t forget it was these two markets which led the broader indices lower.
Russell 2000 Index
Dow Jones Transportation Index
But both these markets could move a lot higher and still be in a downward channel. So, to try and sum up, the short term trend is higher, but the long term trend is lower. Also, worth mentioning that the Chinese appear super-determined to defend the YUAN and most importantly we at long last heard from PBOC Governor Zhou. Many say that part of the problem in markets is the lack of communication by Chinese policymakers. In the west, particularly in America, a day does not go by without a FED official saying this or that. In China we can go months without any comment from the PBOC. Well, Governor Zhou has spoken with a long and detailed interview in the Caixin Weekly and his message was LOUD AND CLEAR, don’t mess with my currency!! Just let me devalue it quietly…he didn’t say that bit! All in all financial markets appear to be stabilising and the ‘chatter’ of an imminent Chinese devaluation is fading.
And on that note I am fading too…have a good weekend.All the best,
Markets are always made up of at least 2 opposing views. This is what makes markets what they are. Trying to come to a price through the discovery of existing and new information and factoring all of this into future cash flow projections is what makes financial markets. That is why the team at TAMIM is passionate about what we do, we love the intellectual pursuit of finding out information that perhaps the market has not yet figured out. We use this knowledge in putting portfolios together. Because we know that different investment methodologies will work in different market environments, we work with a number of managers across a number of investment styles and asset classes, this allows us to always have a solution for the current investment environment.
European banks are in free-fall. The Stoxx 600 Bank index is down 42.5% from its high on the 20th of July 2015 to the low on 11 February 2016. This is largely driven by concerns over the ability of Central Banks to support markets globally. Mario Draghi’s policy of more and more quantitative easing is not working. Europe’s banking system is fundamentally weak. There is not enough capital supporting the mountain of debt on the banks’ balance sheets. In addition to this the ongoing weakness in oil prices causing worry about banks exposure to oil and gas corporates and the weakness in emerging market debt emanating from China continues to make the situation worse.
source: www.stoxx.com
On the surface, Australia’s banks are much stronger. But our love affair with residential property has resulted in housing dominating the asset side of banks’ balance sheets (as we all know, house prices never fall!). On the liability side of the balance sheet, it is believed that banks have a large reliance on offshore borrowing which to be fair is partially offset by a large and stable domestic funding base. The liquidity pressures on the global banking system mean that the cost of financing these liabilities will rise. The ASX Financials ex A-REITs index has fallen 24.9% since its peak on the 20th of March 2015 to the low on 12 February 2016. Is there more weakness to come. It is interesting to note that there is divergence in this index with CBA down 27.1% at is low (it has since recovered) while for example ANZ is down 41.3% from its high.
source: au.yahoo.com
Given the above global and local movements there has been a lot of commentary on the banks recently so TAMIM has done its research and has the following Bull and Bear summary of the issues for you to consider.
The Bear View
Dependence on offshore wholesale funding is what’s having most impact on local bank share prices in the short-term. Despite a strong local deposit base funding pool there is still a reliance on offshore wholesale funding. With concerns around European banks and financial markets at present there are concerns on the Australian banks ability to continue to raise funding offshore in the short term.
The risk of a recession in Australia has increased over the past year especially with the global resource led slow down. A recession and a resultant increase in unemployment would have a negative impact on the banks. Australian banks are highly exposed to lending to the household sector (over 50% of their loan books). Australia has the highest levels of household debt to income globally at 185% and any significant increase in unemployment would see the Australian banks profitability levels impacted.
Concerns that bad debt provisioning especially that focused on residential house lending is low and bad debts in these areas are likely to increase in the face of a possible recession.
Banks are increasingly being required to hold higher levels of capital to strengthen their balance sheets. The increased capital requirements are hurting returns on equity and earnings per share. As their share prices fall, the cost of raising this equity increases. This will suppress future returns from the sector.
Negative fallout from the financial planning review which could result in class actions for the banks’ wealth management and financial planning arms.
There is concern that the banks will not be able to sustain dividend levels especially NAB and ANZ.
The Bull View
Domestic funding capability continues to be strong with deposit funding in the 4 majors between 50% to 64% of total funding. Interestingly it seems that the banks have been able to extend the funding tenor for wholesale debt to longer terms. For example, the average wholesale funding tenor for CBA has been maintained at 3.9 years while liquidity coverage further improved to 123% of total net cash outflows. We wait with interest to see the results from the other 3 majors.
Valuations on ANZ and NAB are at the best levels since the GFC when taking price to book values into account. Book value is the value of the tangible and intangible assets on a bank’s balance sheet. If you are willing to pay more than book, you are signalling that you expect ROE’s that are greater than the cost of equity required to fund those assets. In the first half of 2009, ANZ and NAB’s price-to-book multiples were 1.1x. While CBA was 1.3x and Westpac was 1.4x. Six years later CBA had bounced back to 3x, Westpac was 2.5x and NAB and ANZ touched 2 times. The last 12 month of regulatory-enforced de-leveraging and a string of global shocks have reduced ANZ and NAB’s price-to-book multiples to 1.2x and 1.4x, respectively. This would seem to suggest that on this measure ANZ and NAB are of interest.
The sale by NAB of the Clydesdale business and ANZ retreating from its riskier Asian businesses are both credit positives.
The current generation of bank bosses seem to be superior risk managers than their predecessors which will be required in this ongoing global debt deleveraging cycle.
Dividend yields for the banks are now high (between 5.7 and 8.2% on a 12m forward yield) given the recent share rice falls which will bring buying from the retiree sector. This will provide a level of support to bank share prices.
Credit exposure to energy is 1.1% for the CBA while the other Australian banks have exposures up to 2%. The exposure of Australian banks to this sector is about half of their global counterparts.
Mortgage repricing on investment loan books took place in November and has not fully flowed through to the Net Interest Margins of the banks. This will be a positive for the bank’s profitability on a forward looking basis.
Source: CBA company filings
Should you own, buy or even sell the banks. The case can be made for all 3 situations and we believe the answer will largely be impacted by your circumstances and especially your time frame of investment. The recent correction in banks has vividly illustrated the risks of running portfolio’s that have a high level of concentration to 1 sector. In this case, the banks. It is even more important to be aware of this concentration risk when holding the banks because as Australians we are also highly leveraged in most cases to the property market. As always, consider both side of the argument, safe investing from the team at TAMIM.
The Wellcom story starts with industry doyen and patriarch Wayne Sidwell. One of the Wellcom non-executive directors remarked Wayne Sidwell is Wayne Sidwell, nothing more need be said”. When James first met with Wayne, he immediately recognised the business had a very astute, experienced and engaged leader. Subsequent due diligence, including feedback from competitors, confirmed Wayne’s reputation as a fierce competitor but at the same time an honest and honourable man.
While WLL may only have a 10 year track record as a listed entity on the ASX and 15 years as an incorporated company, the history with the Sidwell family in the industry runs for over 8 decades. Wayne’s father Bill entered the industry in 1932 as an apprentice and eventually built up a family business. In 1968 Wayne joined the family business Show Ads / Omega as an apprentice. Fast forward to 1993, Show Ads/ Omega is floated on the ASX and becomes Shomega Limited. Shomega Limited was subsequently acquired by PMP Limited in 1996 where Wayne took over the role as CEO of the pre-press division. In 1999, Wayne resigned from PMP and started Wellcom a year later with 14 hand-selected employees. Incidentally out of the original staff, seven are still with the company in senior roles within the business. In 2005 it was obvious to Wayne that the industry was changing and the business required substantial investment in technology and for future international growth. Hence, the business was floated to raise capital in the same year.
2016 overview from Wellcom group from 2015 AGM presentation
Before articulating the unique Wellcom business model, it is worthwhile adding a little background on the industry to provide context. Years ago, advertising agencies were a one stop shop for clients; they would come up with the ideas, produce and then place them (known as media buying). When media buying was taken out of agencies, they lost control over where and how their idea would be viewed by the consumer. The next big change is taking place right now and relates to the separation of production of the idea from the advertising agency, referred to as decoupling. Enter the few global businesses like WLL who at their core are more akin to technology companies with their sophisticated software programmes, which enable them to offer the full spectrum of services relating to creating, managing and distributing content at a lower cost with faster turnaround times than the traditional incumbents. WLL is at the forefront of disrupting the industry status quo.
Wellcom 3 year share price chart source: Commsec
Today WLL is a truly global company with around 500 staff and 750 clients, with offices and 50 odd Hub’s (internal graphic studios) operating in Australia, New Zealand, USA, UK, Singapore, Kuala Lumpur and Hong Kong. The Hub model is unique to WLL and contributes around 70% of the Group’s revenue. This service involves installation of WLL technology and the placement of staff in the client’s offices, providing a range of sticky services “on-site”. Importantly, they are also an essential marketing resource; new products and services can easily be marketed and deployed to the client managed facility.
As an investor, you feel like you have hit the jack pot when you find a small listed company that is largely misunderstood by the investor community with world leading products and services on the cusp of rapid international profit growth. In 2015, Australia and New Zealand contributed around 75% of Group earnings, with clients including the largest local banks and retailers. To give you an idea of the rapid international expansion, recent global business wins include BASF, UK Trade & Investment, Canon, Patek Philippe, Simon Malls and Tesco. WLL now has global expertise to manage any corporation’s brand management, brand consistency and communications delivery across the globe, including adapting content for local markets.
WLL’s partnership with BBH is worth individual attention. Bartle Bogle Hearty is a leading international advertising agency and have shared a partnership with WLL for many years. It began as a hub/studio in London and then extended into Singapore and New York. 2015 was a year of consolidation for the WLL London office (which was noticeable in the financial accounts) as considerable time, investment and resourcing was deployed in preparation for the on boarding of Tesco business. Tesco is the size of Woolworths and Coles combined. We believe the London office will be a significant contributor to the Group in future years and we expect continued rapid growth from the US and further expansion in Asia.
Wellcom campaign images
To conclude, we own a meaningful position in WLL, a small listed business that is a world leading global production company capable of offering around the clock services connecting industry leaders with customers. The Executive Chairman, Wayne Sidwell, has almost five decades of experience and remains as passionate about the industry as ever. We have a penchant for well-managed, risk adverse (especially when it comes to debt) listed companies generating good cash flow with a strong family business alignment and pedigree. Wayne controls ~ 50% of the company and, as recently as September 2015, increased his holding by acquiring more shares on market. In 2015 the international profit contribution to the Group was still small (especially in absolute terms); there is enormous potential for this company to grow in a large global profit pool from a low base.
