The Fed shifts on inflation – What does it mean?
The Fed unveiled a revision to its monetary policy, allowing for higher inflation to help support the labor market. We believe this action could keep interest rates low for years.
What trends are you seeing in the market and have they helped Fund performance during the current rally and year to date? Was there any Fund repositioning that took place during the downturn that we are now seeing the benefits of?
Most of the Fund’s performance has been driven by some of the changes we made in the downturn. We thought we had a firm handle on how some of these businesses would perform relative to the rest of the market in the downturn. A lot of the stocks we either swapped into, increased weightings, or decreased weightings in were what aided relative performance. Clearly the backdrop of the market has benefitted quality growth as opposed to core or the more attractively valued part of the market. We did increase the quality of the portfolio by buying more core names but not dramatically.
What would you say to investors who are asking why they should stay invested in this strategy if it may be awhile until we see another market environment that supports relative value investing?
In this environment of low growth and low interest rates, we believe the market has gone over its skis in buying momentum growth and quality, while avoiding other parts of the market at any costs. We don't think it is a guarantee that the market will act like this over time, but it's certainly how it's acting today. In fact, this is how the market has behaved for the last twelve years. So, many investors are conditioned to believe this is how the market performs because it’s all they have ever known. There are a lot of outcomes we could see taking place in the next year that could change this environment somewhat.
Last week, Adidas issued bonds and were paid eight basis points for a five-year maturity in Europe. The only way they will go up is if an investor is willing to pay 2% a year to lend money to Adidas. Yet, this was oversubscribed by eight times. This just shows that there are a lot of investors willing to pay to have Adidas bonds and how poorly the bond market is priced. We believe this is an environment where there is no reward and only potential risk. Inflation presents some meaningful downside risk of these bonds. It's not that we're necessarily calling for inflation, but for this to be eight times oversubscribed shows high confidence from investors that there won't be any inflation.
One of the few things that is left that is inexpensive are high, cash flow yielding stocks that have some challenge to their business. High free cash flow yield is free cash flow per share divided by a company’s share price and is a strong indicator of how well a company can cover its obligations. And we have many stocks in the portfolio with a 10% free cash flow yield and dividend yield of 5%, which is the amount paid to shareholders for owning a share of a company’s stock as a percent of its current stock price. When will the market care about these stocks? We're not exactly sure when that turns, but we feel they are an attractively priced portion of the market, and eventually the world will recognize this. In an environment where people are willing to pay an infinite price-to-earnings ratio, the valuations you can see in the market will keep rising until something shocks you into realizing the cash flows aren't worth that. In this environment, relative value investing has been tough, but we are hopefully close to some reconciliation to where it starts to do better. We don't think we'll be having this conversation in two years.
Also, a low interest-rate environment across the globe, in a lot of ways, helps support a risk profile and cash flow generation for some of those good companies that have a challenge.
How has the Fund’s thesis on energy evolved from a few years ago, and where does it stand today?
Clearly, we were early on our energy exposure and underappreciated the capacity for U.S. shale to grow. We do think this has been permanently impaired by a combination of what Russia and Saudi Arabia did. In the downturn, we exited Inpex Corp. and BP plc; reduced our allocation to Total SA; and added India- based Reliance Industries, which is considered an energy holding because of its refining and petrochemicals operations, but its main growth will come from telecom and retail. We also slightly added to the Fund’s Canadian energy exposure. As a result, the Fund has an approximate double weight to energy relative to the benchmark. We do believe that once we get back to a more normal level in oil prices, we should have a much better supply and demand balance. The highest cost energy is shale, and these shale companies shouldn't have been producing like they were in that environment. We could see our energy exposure decrease over the next year to make room for some other attractive opportunities we're seeing after the recent volatility.
What other parts of the market besides energy, either sector or industry, do you feel are still significantly undervalued or may have been unfairly punished?
In general, financials appear attractively valued because rates are low across the world, making it difficult for financials to produce a strong topline. They may get a little bit of growth in business volume activity, but from an interest rate spread perspective, they are under pressure. Almost every central bank has said they plan on keeping interest rates low for the foreseeable future with the exception of the U.K. European banks are trading between 0.3 to 0.6 times book value. If we go back to any kind of reasonably sloped curve with rates near 1%, those same companies should be at least 1.0 times book value. European Union banks probably have the most pressure currently. In terms of our exposure there, we only own one European bank which is BNP Paribas.
Outside of financials, there are three names we added this year that are good examples of where we've found relative value:
None of these companies are perfect, but when the market is trading at around 20 times earnings and most of these are each around half of that, we think these have potential to work well. There are gems like these throughout the world that are mispriced because of this very narrow market, and we're trying to take advantage of it.
What will we have to see happen to make the value trade turn around to have a more sustainable run?
The trajectory of the economy is hard to know. Central banks have had very good control of the market. When you look at the performance of growth versus value, there's usually five- to 20-year cycles where one outperforms the other. This is about the longest cycle we've had of growth outperforming value. When the cycle gets to the top, and there's people who haven't seen another type of market, they have enormous conviction it's the right way to go. These things can turn, and when they do turn, they turn powerfully. Just like in 2000, there were all the same arguments we're hearing now. If you put your money in 1999 and missed the 100%+ rally, you would've done better in a value strategy by 2003. The disparity of price is enough for us to keep us from sifting through what's on the growth side. To be clear, we're still a core Fund. We do have growth names in the Fund like Alibaba and Prosus. Within the health care sector, we're more skewed towards growth names than value names. Where we see the greatest opportunity as a relative value investor are in the kinds of names that we mentioned earlier, but it doesn't mean that we aren't participating in parts of the market that we think has a reasonable tangible value. We may lag it if it continues to be a very narrow market environment. There are a ton of things going on in the world that could upset the desires of central banks.
Also, if we were to have a large market selloff, investors typically take profits to de-lever or return cash to their shareholders, and they tend to sell what's worked. That could be a catalyst if the markets weren't to recover quickly. Regulation could also be a catalyst, especially for technology stocks. Both in Europe and the U.S., there's already a big focus if these giant technology companies should be broken up, which would be an additional catalyst.
Any thoughts of there being a shift in the way you look at valuations given the amount of intangible value that is present with a lot of the new technologies driving market value?
For many of these disruptive technology companies, in order for them to generate free cash flow they just have to be better and a first mover. We own Alibaba which is growing sales around 30% and generates loads of free cash flow. This is almost unheard of in a highly capital-intensive sector like energy where in order to grow 20%, you would have to be putting in one field after the other, which is very costly. We're familiar with this, and we try to normalize for it, but when you look at these companies on a yield basis, most of those businesses don't have a great yield, and if they slow down their growth, their cash flow isn't going to grow significantly either. It is true that a lot of these technology companies do have better business models where they don't have to put up a factory to create additional growth and can just pay a few smart people in a backroom. These are great business models that didn't exist before, and we don't doubt that, but there comes a point where investors are overpaying for them, too. The idea that they generate cash flow is understood, and we take that into consideration when evaluating companies. We don't buy companies based on their price-to-book ratios, which is where intangibles often don't end up in the book.
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Top 10 equity holdings as a percent of net assets as of 06/30/2020: Nestle S.A., Registered Shares 2.6%, Roche Holdings AG, Genusscheine 2.5%, SAP AG 2.5%, Newcrest Mining Ltd. 2.0%, DNB ASA 2.0%, Airbus SE 1.9%, Legal & General Group plc 1.9%, Merck KGaA 1.8%, SPDR Gold Trust 1.8% and Anglo American plc 1.7%.
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