Finders keepers

Prominent investors adopt a contrarian approach and make their fortune by buying strong brands at low prices - and holding on. Simon Keane examines the methods used by recovery investors for detecting good value stocks in difficult conditions.

Warren Buffett wrote these words in his letter to shareholders accompanying the annual report of his Berkshire Hathaway investment company: “Beware the investment activity that produces great applause; the great moves are usually greeted by yawns.” These words, written in February 2009, capture the first element of recovery investing, which is to buy securities in good-quality companies and be prepared to hold for long periods.

Paradoxically, these same words were penned a few months following Berkshire making what was perhaps one of the most memorable investment moves of 2008 – a $3 billion purchase of General Electric preference stock the previous October. General Electric is a classic example of the kind of dependable business Buffett likes – it is not exciting but has strong brands that have created formidable barriers to entry and pricing power. However, fronting $3 billion at the height of a credit crunch was never going to draw stifled yawns.

”It is a very competitive market, there are very few opportunities, it is like walking down Oxford Street and finding £50”

But the timing of the General Electric purchase, and indeed Buffett’s earlier investments that year in Goldman Sachs and Wrigley, the later made via his debt financing of Mars’ acquisition of the iconic American brand, are ­studies of the second key concept of recovery investing as espoused in his 2009 letter: “Pessimism is your friend, euphoria the enemy”. Acquiring quality companies at cheap prices, like buying General Electric preference stock yielding 10%, has been the key to the success of Buffett and others like him.

Combining the discipline of an income investor – who realises that the high-quality, cash-generative, dividend-paying equities will beat any other, and indeed most, if not all other asset classes over the long term – with the rigour of a contrarian mindset, a recovery fund manager can produce truly exceptional returns. Buffett’s record proves this – a compound annual return of 20.3% during his 45 full years in control of Berkshire versus a 9.3% equivalent total return from the S&P 500 – as does that of Britain’s Anthony Bolton who generated a 19.7% compound annual return during his 28 years in charge of Fidelity’s Special Situations fund. (article continues below)

Alastair Mundy, the manager of Investec UK Special Situations, is one of the rising stars on the recovery British fund management scene and his search for ideas begins from a simple valuation screen, which filters out companies that have fallen 50% or more relative to the FTSE All-Share from their five-year peaks. His approach is not about chopping and changing the portfolio: “I’ll typically buy eight to 10 stocks a year, one new stock every six weeks. We are very inactive fund managers, it is hard to justify turning over your portfolio every six months.” And with a focus on FTSE 350 stocks, he recognises that an information advantage is extremely difficult to achieve given the amount of coverage these stocks attract: “It is a competitive market, there are very few opportunities, it is like walking down Oxford Street and finding £50 [on the pavement].”

Following the price screen, Mundy makes a judgement on the quality of any stock ideas thrown up. Explaining why he picked Signet Jewelers he notes that the business has pricing power “best for the customer not to be seen haggling” and elevated barriers to entry, the latter because a lot of working capital is required to buy stock and because “jewellery is one of the few things that does not work online”. Then, like any rigorous value manager, a judgement will be made on whether the stock has intrinsic worth. Mundy uses enterprise value (EV) multiples, specifically looking for companies on EV to earnings before interest and tax (EBIT) of less than 10.

Glen Pratt, the manager of Melchior UK Opportunities, sees intrinsic value in Smith & Nephew, one of the worst performing FTSE 100 stocks of 2010 year to date, and says that if the market does not address the valuation anomaly soon a corporate buyer will: “There are lots of synergies with Johnson & Johnson and the fair price is £8-9 intrinsic value rather than 550p [being ascribed to it by the market].” Indeed, he says Kraft’s bid for Cadbury, resulting in the latter being taken out for a near 50% premium, (see table, above) demonstrates how equity is being mispriced. Pratt uses EV multiples to arrive at this intrinsic value (see box, below).

Enterprise valuation multiples

The enterprise value (EV) is the sum of market value and debt and captures the overall valuation of a company. An EV valuation multiple is useful, versus, say, a price/earnings (P/E) ratio, when trying to establish how cheap, or otherwise, a business is against its own history when debt levels have varied over time.

Smith & Nephew is one of the worst performing FTSE 100 companies of 2010. It is trading below the bottom end of its historical EV to earnings before interest, tax, depreciation and amortisation (EBITDA) multiple, says Glen Pratt, the manager of the Melchior UK Opportunities fund. He estimates the long-term multiple range of the orthopaedics specialist to be 8-15 versus a forecast EV/EBITDA multiple of six. Using the EV measure creates a like-for-like comparison with the past as Smith went from £107m of net cash in 2006 to $1.3 billion net borrowings in 2007 on assuming $889m of debts with the purchase of Plus Orthopedics, a Swiss peer.

EV multiples are often used as the valuation reference in merger and acquisition negotiations. The EV is the true cost an acquirer pays to take 100% control, being the price paid to shareholders for the equity (market value) and the implicit cost of assuming a target’s borrowings (net debt). EV multiples of EBITDA are widely used in private equity deals.

Being a proxy for cash, multiples of EBITDA are relevant to acquirers like private equity who use debt. This is because it indicates how well the acquired assets will service future interest payments on the debt used to buy them.

With AAA-rated corporations able to raise money on debt markets at 1%, that being the yield on IBM’s three-year corporate bonds issued back in August, merger and acquisition activity is set to remain at elevated levels. If companies are not issuing cheap debt to buy back their own equity they will be employing it to make deals and that is why there are more discussions taking place around sum-of-the-parts (SOTP) valuations. Such a valuation technique is useful when there is an expectation that a business will be broken up, with parts either spun off into a separately quoted business or sold to a trade buyer.

“Prudential, because of the failed bid, is a turnaround situation,” says Derek Stuart, the manager of Artemis UK Special Situations. Sure enough SOTP valuations are circulating, ­predicated on Prudential’s fund management arm, M&G, being spun out, quoted as a separate company, and achieving a similar rating to that of Jupiter Fund Management, which has proven to be an extremely successful initial public offering (IPO). Stuart also holds Smiths, an industrial conglomerate, a long-mooted break-up candidate, which UBS, a broker, estimates could be worth over £20, versus today’s £11.45 share price, in the event that Philip Bowman, the chief executive officer, sells off its five divisions as separate entities (see box, below) at top-dollar prices.

Sum-of-the-parts valuation

A sum-of-the-parts (SOTP) valuation is used to put a price on a company in the event of it being broken up and its businesses sold off. Smiths, an engineering conglomerate, has been seen as a potential break-up candidate ever since Philip Bowman, the chief executive, was appointed three years ago.

Bowman joined in December 2007, a few months after overseeing the sale of Scottish Power to Iberdrola, a Spanish utility. Derek Stuart, the Artemis UK Special Situations fund manager, says: “At some point, to realise the value of Smiths, he will sell the business.”

In September 2008 Bowman announced a three-year plan to improve Smiths’ profitability, with the perceived objective of maximising the eventual proceeds of any disposals.

A new divisional structure, made up of Detection, John Crane, Medical, Interconnect and Flex-Tek, was unveiled and management of these five arms given margin targets to aim for. These targets, to be monitored with improved enterprise reporting systems, would be underwritten by ambitious cost reductions, including a downsized corporate headquarters.

Two years on and profitability has improved. The latest results showed the group’s operating margin had increased to 17.8% in 2010 compared with 16.4% in 2008. This was driven by large margin gains at the two biggest profit centres, the oil services arm John Crane and Medical, whose businesses manufacture medical devices. This improvement has stoked speculation a break-up is imminent. UBS, a broker, published a SOTP valuation for Smiths in September, giving it a value of between £12.44 and £20.46 per share, with a median of £17.21.

UBS applied enterprise value (EV) multiples of sales and earnings before interest and tax (EBIT) that have been achieved in the disposal of comparable industry peers. Using median multiples, UBS suggests Smiths could achieve an EV of £7.9 billion. Once borrowings are stripped out, and adjustments made for other balance sheet liabilities including a £260m forecast pension deficit, it arrives at an implied median market value of £6.7 billion equivalent to £17.21 per share, representing sizeable upside given a current £11.45 share price.

A relatively new management team can often be found at the helm of the more high-profile recovery stories, as with Bowman at Smiths. Other examples include Xavier Rolet, who took over as the London Stock Exchange’s chief executive in February 2009, and Javed Ahmed who was appointed the chief executive officer of Tate & Lyle in October 2009. Tate & Lyle and the London Stock Exchange (LSE) are both holdings of Stuart’s. Despite the competition from the Multilateral Trading Platforms (MTFs), chiefly Chi-X and BATS Europe, the fund manager’s contention is that the LSE’s brand is sufficiently strong to allow it to start winning back market share from the MTFs. This appears to be paying off. The latest interims (November 18) from the LSE noted that its share of British equities trading through its electronic trading service (Sets) order book had “stabilised” and this flattening out may be a precursor to a recovery next year when Rolet plans to refresh the technology driving Sets with the intention to compete on dealing speed with the MTFs.

A company whose share price is at or below its net asset value is a strong buy signal for many recovery fund managers and is a big reason why Deryck Noble-Nesbitt, the manager of the Close Special Situations fund, holds Velosi (see box, below). It is Velosi’s strong cash backing – with 75% of its net assets made up of either cash in the bank or liquid working capital – that has attracted the manager’s attention to the oil services testing group.

Price-to-book ratio

This is the ratio of the company’s share price to its net asset value (NAV) per share. The lower the number, the cheaper is the stock, since a greater proportion of its share price is backed by assets on the balance sheet. A figure of less than one indicates the company is a bargain.

The net asset figure value, which is also known as shareholders’ funds, gives an indication of what would be left over for equity investors in the event of a business ceasing operations, outstanding monies from debtors collected, assets disposed of, bank loans settled and creditors paid off. It is a low price-to-book value that has attracted the attention of Deryck Noble-Nesbitt, the manager of the Close Special Situations fund, to Velosi, an oil services testing business. “At £1 a share the market cap is under £50m, net cash and working capital is more than 50% of the market cap,” says Noble-Nesbitt. He is saying that this company is cheap relative to its asset backing (see ’Velosi – low price-to-book ratio’, below).

The table shows how the company’s net assets at its June 30 half point were $84.3m, which, versus an equity base of 48.4m shares, is equivalent to a 174.2 cents NAV per share. At current exchange rates, that translates into a NAV per share of 108.9p, which means today’s 101.8p share price is 93% covered by the firm’s assets, expressed by a price-to-book ratio of 0.93.

Noble-Nesbitt’s more refined point is that most of Velosi’s balance sheet is constituted of either cash in the bank or working capital. In other words, liquid assets the value of which is hard to dispute. Cash is instantly realisable and working capital, in principle, should be too – were the company to stop operations today it should not have a problem collecting outstanding monies from its debtors.

Velosi has $20.8m of cash on the balance sheet, which, once debt of $5.5m is subtracted leaves it with $15.3m of net cash. It is owed $71.6m by debtors (trade receivables), which, when offset by the $23.8m it owes its suppliers (trade payables), leaves net working capital of $47.8m. Net working capital plus net cash therefore equals $63m or 75% of the net asset value, or as Noble-Nesbitt puts it “more than 50%”.

Recovery managers will focus on cash as their best guide to intrinsic value and often use discounted cashflow (DCF) models to unearth ideas. DCFs are frequently used in the analysis of utilities, which have dependable future cashflows that can be discounted, using an implied equity-risk premium (ERP) (see box, below) to arrive at a net present value (NPV). They are equally applicable to an incumbent telecom network such as Vodafone.

Discounted cashflows – how they work

Fund managers use discounted cashflow models (DCFs) to determine a company’s intrinsic value. They will forecast a company’s future cashflows and work out their net present value by discounting them at the cost of equity as derived from the capital asset pricing model (CAPM). CAPM formalises the idea that investors require extra return for allocating capital to riskier assets. It does this by referencing the required additional return to the risk-free rate (RFR). The additional risk of investing in equities is known as the equity risk-premium (ERP), British investors tend to take their RFR reference point as being the yield on the benchmark 10-year government bond, currently 3.39%.

Cost of equity = RFR + B*(ERP)

From the company’s perspective the ERP is the cost of equity, in other words, how much it needs to pay potential investors over and above the rate on gilts to attract capital. CAPM reconciles the fact that certain securities within any broad asset class may be riskier than others with the concept of beta (B*). In terms of equities, a company with a beta of one tracks the market, in other words is carries the same level of risk as the market. A beta of more than one indicates higher risk and less than one, lower risk. Built on many assumptions, DCFs are only used to give a feel of intrinsic value.

Noble-Nesbitt has done his own DCF analysis on Vodafone and uses the result to make a wider point about British equities, saying they are undervalued versus the risk-free rate (RFR) of return as implied by the yield on the benchmark 10-year gilt (3.39%). Employing an ERP of 5% he calculates the NPV of Vodafone’s cashflows to be worth 280p, versus today’s 167p, when assuming a 3% RFR (8% cost of equity). In reference to the share price’s 40% discount to Vodafone’s intrinsic value given by the DCF analysis he says: “There is something really wrong here, it can be corrected in three different ways, government bonds falling and yields going to 5%, earnings collapsing or a really powerful [equity] market rally.”

But even if 10-year gilts returned to 5%, a reasonable assumption in light of returning inflationary pressures, that the Bank of England will not be in a position to employ further quantitative easing to keep bond yields depressed, Vodafone would still be worth 200p (based on 10% cost of equity), according to Noble-Nesbitt’s DCF, a 20% markdown to today’s share price. This implies that the anomaly is not simply a case of equity valuations becoming unanchored from the risk-free rate but also that there remains excessive fear in markets and that the equity-risk premium is unduly elevated.

Back in August, strategists at Barclays Capital used several economic models to arrive at an estimate for the ERP on European equities and these consistently revealed an elevated ERP versus historical norms. One, using a model developed by Jeremy Siegel (Stocks for the Long Run, McGraw-Hill, 2002), revealed the ERP to be at 7.9% versus a 4.5% 21-year average and for a contrarian fund manager this suggests that there remain plenty of opportunities. During bubbles contrarians tend to underperform – best illustrated by Buffett’s “poor” performance in 1999, as the technology, media and telecoms ­balloon was reaching bursting point. That year saw a flat net asset value per share from Berkshire Hathaway against a 21% total return from the S&P 500, Buffett’s most marked underperformance out of his 45-year track record.

Over his 28 years in charge of Fidelity’s Special Situations fund Anthony Bolton achieved exceptional returns but as the chart (see chart, above) illustrates it was not straightforward. Showing the discrete annual total return from Special Situations between 1986 and 2007 versus the equivalent total return from the FTSE All-Share, it illustrates how 1990 and 1991 were poor years. The lesson is simple, investors who want really exciting returns need to be prepared to hold for long periods and keep faith with contrarians during the rough patches as they will be the first to remind you being early is not necessarily the same as being wrong.