Notes From London Value Investor Conference 2015: Woodford, Ruffer, Brandes & More ~ market folly

Tuesday, May 26, 2015

Notes From London Value Investor Conference 2015: Woodford, Ruffer, Brandes & More

The 2015 London Value Investor Conference recently concluded and below are notes from each speaker's presentation.

Notes From London Value Investor Conference 2015

Neil Woodford – Woodford Investment Management
Q&A Session.  Neil Woodford is one of the UK’s most respected and successful fund managers. After 26 years at Invesco Perpetual where he managed £30bn in 2013, he left to set up his own fund management business. Woodford has a background in economics and finds it natural to combine bottom up stock picking with top down analysis. He focuses on the medium and long term. Trying to value a business without taking into account the macro and competitive environment is like music without instruments; it doesn’t work. He places emphasis on portfolio construction – not just the cheapest stocks. Trying to be scientific about the future is an inherently odd thing to do. Portfolio construction is not a science, more an art and involves lots of judgement. Valuation should always involve a range of intrinsic values and not an absolute number. He uses revenues, earnings and cash flows to value a business and spends a lot of time getting close to businesses including meetings with management.  Considering history and the past is important when making a valuation but they are only part of the judgement because companies, management and technology can change. He does not spend time worrying about what other managers are doing.
On how to value early stage companies – he uses the same tools and valuation methods and flexes them. It is possible to value pre-revenue businesses. They project cash flows just as they would for established companies.
On fund management - smaller scale boutique style fund managers have advantages as smaller teams are often more effective than large. Fund management lends itself to being a cottage industry. The industry generally charges too much in fees. The thing that offends him most is charging high fees for closet indexing. The industry needs to become more open and transparent.
On the £18m fine that Invesco received after Woodford had left - he said the FCA report is pretty comprehensive and makes good reading. The fine related to disclosure rather than the use of excess leverage. He has learnt from the incident to keep his new fund’s model very simple. They will only use derivatives for currency hedging and nothing else.
On how to deal with underperformance - all investors go through difficult periods.  He underperformed in the tech bubble of the late 90s. It was a draining and emotional experience. Woodford said you must trust your discipline in good times and bad. You need investment anchors to stay consistent.
On what he saw that made him sell out of Tesco at the same time that Warren Buffett was buying - he did not like the way Tesco were deploying capital and he became less convinced about future returns. “They were planting flags.” He thought that competition would increase in the sector but he did not foresee the rise of the discounters, Aldi and Lidl. After a 30-minute conference call with the new CEO, Philip Clarke, he thought the problems facing Tesco were structural and not cyclical and sold all of the stock within a few weeks.

Jonathan Ruffer – Ruffer LLP
“Value investor,” like “democrat,” is one of those words that it is hard to say you are not. Ruffer thinks of himself as value investor but in the negative sense that he is not a momentum investor.  Unlike some value investors, Ruffer believes we must grapple with and try to predict the future. The Romans distinguished between futurum and adventus. Futurum refers to events that roll away from us. For example, a turnip farmer was reasonably sure that he was going to eat boiled turnip for dinner but the further ahead one looks the harder it becomes to predict the future. Adventus refers to those events or shocks that come at us and hit us, things that we could not possibly have seen coming. The momentum investor concentrates on the futurum.  Unlike the Roman view of adventus (which sees the challenges that come at us as acts of god) it is the task of the value investor to spot the next crisis coming. This can be done by studying history, starting from the beginning of limited liability in 1840. Stock market crashes do not come out of a blue sky. The big question for investors now is how the huge amount of debt in the world will be resolved? Collateral is a crucial part of the lending process but today central banks have made too many gifts through QE and taken collateral out of circulation. Since 2009, the money supply in the US, Europe and Japan has been expanded. By keeping interest rates below the rate of inflation a new asset bubble has been created. There is a crisis on the way in which all asset classes will fall in value but it is hard to say exactly when. When the crisis does arrive “safe” investments will be the most dangerous. As in Britain in the 1970s, inflation of 10-20% is likely.

Tim Hartch – Brown Brothers Harriman
Looks for companies with: a loyal customer base, a sustainable competitive advantage, essential products and services, leaders in attractive markets, strong balance sheets, high returns on capital, disciplined capital allocation. Looks to own 25-35 stocks and invests with a 3-5 year horizon. He sells investments when they approach intrinsic value. How is intrinsic value calculated? Hartch takes into account revenue growth, margins, business mix, capital intensity, ROIC, acquisitions, discount rate and terminal value. He is looking for a 15% return per annum over five years.
Hartch warned that valuations generally are high due to QE. Another bubble is forming in bonds, biotech, pureplay cloud applications, peer to peer lending and M&A activity. It will be important to have cash on hand to redeploy. There are still some good investments to be found.

Investment idea - Oracle (NYSE: ORCL)
Hartch’s funds made two new investments in 2014 and none so far in 2015. They purchased Oracle stock in late in 2014 in the high $30s and low $40s.
- High customer retention rate
- No.1 in application server, database, data warehouse, engineered systems, identity and access management, middleware, UNIX server shipments
- Recurring revenues, $20bn annual recurring license fees.
- Margins around 40%
- $14bn free cash flow in 2014
- Intrinsic value $50-60 per share

Investment idea – Campari (BIT: CPR)
- Brands include: Campari, Cinzano, Aperol, Skyy Vodka, Wild Turkey. Hartch likes premium spirits as customers tend to be loyal allowing the company to compete on advertising, not price.
- Margins around 50%
- The company has made several acquisitions and is at a turning point where the benefits of the new products are about to kick in.
- The stock has been trading sideways for five years
- Intrinsic value Euro 7.7-8. It is a modest discount but it is hard to find bargains in this market.

Hassan Elmasry – Independent Franchise Partners
Hassan Elmasry uses the term franchise to describe companies that have ‘vibrant intangible assets’ like patents, trademarks, licences, network effects and very high switching costs. These qualities give a company an enduring competitive advantage but on top of that Franchise Partners look for companies that combine intangible assets with very low physical capital demands.  According to Elmasry, such a business model gives a company a license to print money.
Franchise Partners’ approach is somewhat concentrated with 20 or 30 stocks. It is also concentrated by sector as they do not invest in financials, energy, commodities or most technology companies. Elmasry refers to it as an ‘ultra-high quality strategy’ but one that also needs to be combined with a search for value. Their universe is surprisingly small:  only 180 companies in the world meeting their criteria. That universe stays quite static regardless of changes in the price of assets. Franchise Partners’ best investments have had three characteristics:
- Organic revenue growth
- Healthy margins that show improvement
- Attractive valuations at purchase

Investment idea – Kirin Holdings (TYO: 2503)
- Kirin Holdings owns Kirin brewery in Japan
- Kirin is large player in the beer market in Japan, it has a distant No. 2 position in Brazil and is No. 2 in Australia. They also own 49% of San Miguel.
- At the moment there is not much in the way of volume growth.
- Franchise Partners bought their holding in Kirin in Sept 2014 between Yen 1300-1400.
- Kirin trades on an enterprise multiple EV/ EBITDA of 7, which is much cheaper than competitors such as AB Inbev, Sab Miller, Heineken and Carlsberg.
- Management has several options that could push the share price higher. Franchise Partners think of Kirin as a cash cow. Kirin could divest non-core beverage assets in Australia. Sell off the pharma assets. They could use the money from divestments to buy back shares. The payout ratio is only 30% - the dividend could be increased.
- There is a new CEO who might bring change. Margins need to be improved. Kirin is inefficient. A programme of simple operating improvements would help to improve margins.
-ISS, the shareholder advisory group, has recommended that several directors should be replaced.

Kevin Gibson – Eastspring Investments
Kevin Gibson has been covering Japanese equities for 20 years. He believes that predicting the future of markets and equity prices is very difficult and that those who think they can gain an edge through superior information gathering are usually wrong. There is no stable relationship to be found between fundamentals and price. Price is much more volatile than value. Market forecasters tend to echo backward looking observations, extrapolate observations into a trend and then miss the market turning points.
Gibson’s answer is to deemphasise the role of forecasting and replace it with a behavioural perspective on price formation. Representativeness bias leads to the extrapolation of trends, overconfidence, a focus on irrelevant information, herding and short investor time horizons.  Prices get driven to extremes and then market participants are surprised when they mean revert.
As biases are hardwired they are difficult to overcome. They use guidelines to anchor their decision making process. Valuation is used to search for the largest mispricings with quant screens as a starting point in an attempt to take the human out of the process but 80-90% of their time is spent digging deeper, trying to find the best ideas from the screens.

Investment idea – Mitsubishi UFJ Financial Group (TYO: 8306)
- In terms of price to book Mitsubishi UFJ trades at a 40% discount relative to other Japanese banks
- Strong and diversified balance sheet
- Diversified from domestic interest rate and credit cycle – offshore loans approx. 40%
- Foreign loans may re-price as US rate cycle normalises
- Total revenue diversified from domestic rate cycle: non-interest income 46%, fee and commission income 33%
- Marginal cost of future revenue growth likely contained
- Surplus capital meets Basel III
- Ample scope for increase in dividends or buybacks

Gibson believes that at current levels Japanese equities are still a buy. Real corporate change is taking place in Japan.

Charles Brandes – Brandes Investment Partners
Q&A Session.  Charles Brandes started work as a stockbroker in 1967 during the Go-Go Era – a time when many investors thought the Nifty 50 large cap stocks were a one-way bet. The market crash of 1969-70 left the S&P 500 down 45% and the number of customers coming to Brandes’ brokerage dried up. One day out of the blue Ben Graham walked into his office in La Jolla, California, to open an account and buy a stock he believed to be undervalued. The first meeting and subsequent chats with Ben Graham changed Brandes’ life. Value made complete sense to Brandes and in 1974 he started his investment firm. Sir John Templeton was also a mentor to Brandes. Templeton convinced Brandes to invest in Japan and influenced the culture and management of his business. Sir John also offered to buy Brandes’ investment business but Brandes told him it was not for sale.
Brandes has been a Graham and Dodd value investor throughout his career. Like Buffett, Brandes said you either get value investing straight away or you don’t. One area where Brandes was different from many of the other value investing firms was that he was prepared to look beyond the US and invest internationally. He felt that value is value no matter what country the business is in. Being a pioneer in international investing paid off in the 1990s when US investment funds and brokerages discovered a huge appetite to diversify. By 1998 Brandes had $100bn under management and closed to new business. He said that in retrospect that was too much money to manage and they should have returned some to investors. Today Brandes manages about $31bn.
Brandes’ firm takes quite a statistical approach to valuation and running into the 2008 crisis their screens showed that banks looked attractive. Brandes had had success investing in banks throughout his career by buying when they traded at less than book value and selling at 2x book but “this time was different.” One reason he gave for the difference was the vicious circle created by mark-to-market accounting. Once the banks marked-to-market their capital went down, they then had to raise money, which made their stocks go lower, causing the capital to go down, requiring them to raise more money.  Asked how he avoided value traps, Brandes said that it is a new concept that did not exist before 2000 and besides nobody asks about growth traps….
Asked about the current market, Brandes said that today is not like the go-go era. Things are not excessive or alarming. He is worried about interest rates being low but thinks there are still investment opportunities in good companies. He does worry about the growth of index investing. He argued that if big investors go passive they are abdicating the capital allocation role in capitalism, which will lead to inefficient allocations of resources.

Nathaniel Dalton – Affiliated Managers Group (AMG)
Nat Dalton is the President and COO of AMG. AMG has been listed on the New York stock exchange since 1997 and is the 9th largest asset manager in the world by market cap. AMG has an interesting business model. It enters into permanent partnerships with other investment companies, which he refers to them as boutiques.  These boutiques include some of best known names in value investing including ValueAct, Yacktman, Tweedy Brown, and Third Avenue. AMG takes an ownership share in the boutique and provide services including succession planning and marketing. They look to acquire stakes in outstanding investment managers with excellent track records. Historically they have paid 8-10x EBITDA for investments in new boutiques. The affiliates are autonomous and Dalton says AMG does not ‘screw up’ their businesses.

Dato' Cheah Cheng Hye – Value Partners Group
Value Partners are a Hong Kong listed asset manager with $14.7bn AUM focused on value investing in Asia. The flagship fund has returned 16.4% annualised since 1993 against the Hang Seng Index’s 8.6%. Cheng Hye started out as a Graham and Dodd investor but evolved to place more weight on the influence of politics on business in Asia. The ‘3 Rs’ are important in Asia: the right business, the right people, at the right price. Asia has policy driven markets. If government is against something avoid investing in it. However, in areas like renewable energy, healthcare, and the environment, good investments can be found by working out which companies are favoured by policy. He encourages his employees to assume that they are stupid as then they might then do clever things (that’s better than the other way around). Value Partners runs diversified portfolios. In order to manage more money effectively he has divided his team into clusters of 4 to 8 people.
An equity culture has not developed properly in China yet with the total number of stockbroker accounts only on par with Brazil. Chinese people are under-invested with only 6% of their wealth in the market. There is a general feeling of mistrust of stock markets because people have had their ‘fingers burnt.’ The recent dramatic rally in China stocks has further to go. The Hang Seng China trades on a forward PE of 9.8, 1.3x PB. There is an opportunity to invest in the ‘H’ shares as they trade at a 30% discount to the ‘A’ shares. It might be better to invest in larger companies as small-caps have already had a good run. He warned that ethical standards were low on the mainland. Investors have to do lots of due diligence but the market is inefficient so there are opportunities. Looking to the future, in the context of policy driven markets investors should watch out for 8 big government reforms. 1. Deregulation – the use of ‘negative lists’ listing out what cannot be done, meaning everything else can be done. 2. Opening up. 3. Financial liberalisation. 4. Land and Hukou (household registration system) reforms. 5. Resource pricing reforms. 6. State owned enterprise reform. 7. Social security reform. 8. Relaxing the one child policy.

Simon Denison-Smith - Metropolis Capital
Investment idea – Regus (LON: RGU)
Regus is a global market leader in the provision of serviced office space. It is trading on a PE of 36x and at a 14 year high - not an obvious value investment – but growth can be a component of value. When Regus opens new offices it take two years for them to breakeven and 4 years to reach full potential. The development of new offices hides future performance.
- At £2.50 Regus trades at 10x normalised (through cycle) post tax cash flow.
- It has negligible debt, 0.5x EBITDA.
- Regus is 13x larger than its nearest competitor. 
- Growing at 20% per annum and has been able to redeploy capital with a 20-25% return on investment.
- Intrinsic value without growth £3.70; with 10% growth £4.70; 15% growth £5.20.
- Regus is “owner occupied’: founder CEO, Mark Dixon owns 30% of the stock. See our notes from last year’s London VIC where Jonathan Mills of Metropolis explained the advantages of ‘owner occupation’.

Regus has a moat that comprises the sum of lots of small advantages:
-Dominates in internet search
-Global clients like TATA, Google and Toshiba like Regus because they are the only global player
- Add-on services produce 40% of revenue
- Network effect delivers better landlord deals
- Scale advantage in management and procurement
- Knowledge advantage in new office selection
Denison-Smith noted that there were aspects of Regus’s business model that they found harder to like. It is an operationally geared business in a highly cyclical industry that has been a roller coaster ride for investors.  The US part of the business had to be put into Chapter 11 in 2004. During the credit crunch, operating profits dropped by 70% from 2008 to 2010 with the UK business falling into a loss. Denison-Smith believes that Regus will perform better in the next downturn because they have signed leases within a SPV for 90% of its offices. This approach had been implemented in the US part of the business before the credit crunch and despite a fall off in office rents in some cities of as much as 50%, the US business remained profitable throughout.

Kevin Murphy – Schroders
After the popping of two equity bubbles in the last 15 years, everyone seems to want to invest in Warren Buffett style, high quality, stable free cash flow businesses that have a moat. These companies appear to offer low volatility and are comforting for clients but they do not offer safety at current valuations.  Murphy prefers Ben Graham’s approach of buying the cheapest items in the shop although he also noted that whichever value approach you adopt the most important thing is to stick to it and do it consistently.

Investment idea – Lonmin (LON: LMI)
Murphy noted that following Ben Graham and buying the cheapest items was often uncomfortable and as if to illustrate that he pitched aluminium miner, Lonmin.  Aluminium is mainly mined in South Africa, Zimbabwe, and Russia – not the most economically or politically stable countries. Commodity businesses are highly cyclical. Platinum is rarer than gold but unlike gold it does have some industrial uses including as a catalyst in catalytic converters. In 2007, platinum was the most valuable commodity and Lonmin had profit margins of 44% and price to tangible book was 4.9x. Times change, excess supply, weak end-demand, poor labour relations and a difficult political backdrop have all contributed to Lonmin screening as one of the cheapest stocks in the UK market. It now trades at 0.5x tangible book. There have been three rights issues since 2007 and now Lonmin only has a small amount of debt.
The majority of platinum, about 80%, is mined in South Africa. That is a good thing as all the aluminium miners face the same supply situation and the same labour relations challenges. They cannot rely on a third party in a different country to fix the supply and demand problem for them. The largest producer has been reducing production.
Murphy said that the job of the investor is not to look at today’s problems but to ask a simple question: “What if?” What if platinum jewellery becomes fashionable again?  What if European car makers make a comeback? What if Lonmin’s share price reverts to its 10 year average?  The answer to the last question, said Murphy, was that the stock will double.  Kevin Murphy and Nick Kirrage run a value investing blog called The Value Perspective

Bernd Ondruch – Astellon Capital Partners
Investment idea – Volkswagen (ETR: VOW3)
VW is one of the cheapest large companies in the world based on PE. It trades at a 42% discount to the average holding company. Ondruch believes that there is 60% potential upside and a substantial margin of safety.
Ondruch argued that there are a number of good reasons why VW has only traded at book value for 70% of the time since the 1990s. VW has been plagued by governance issues. Management have been rightly criticised for empire building, pursuing vanity projects and for poor capital allocation decisions.  They paid too much for the truck manufacturer, Scania. Over the last 20 years, the company has spent about Euro 30bn on M&A. Post dividends, the company has generated negative cash flow. The voting rights are dominated by an alliance of families who have an asymmetrical advantage.  The free float accounts for 40% of the capital but only 12% of the voting rights. Conversely, the Porsche family control 32% of the shares but 51% of the voting rights.  
Ondruch says the company is at a major inflection point. With the recent exit of the Chairman, Dr Piech, VW can become a more normal company. Ondruch argues that there are 4 levers of value creation that will now be important if his investment thesis is to play out. Firstly, the Euro 5bn modularisation efficiency programme announced in October which allows different models to share common parts and be built on the same production line should increase margins. Secondly, a programme has already been started to reduce the deep discounting of car prices in Europe. Thirdly, the Ferrari IPO highlights the value of Porsche. Ondruch thinks that Porsche has a brighter future than Ferrari because it will benefit from economies of scale by staying with VW. Finally, expect a demerger of the truck business via an IPO in the next two years.

Jeff Everett – EverKey Global Equity
Jeff Everett was part of Sir John Templeton’s research team and went on to serve as president of Templeton Global Advisers. He spoke about the insights that can be gleaned from studying Sir John’s approach. Sir John was the first behavioural investor, independent in thought, adaptive and visionary. In-depth research was his hallmark. Sir John built up micro and macro data sets and was data driven at a time when few others were. Using data that he compiled he was able to predict the rise of Japan’s productivity and export industries as early as the late 1950s – well before others thought it was possible. Sir John was a long-term investor and did not turn his investments over quickly like many of today’s fund managers. He advocated a concentrated approach dominated by equities. He encouraged his investment managers to hold a total of around 10 stocks each.

Ivan Martin Aranguez – Magallanes Value Investors
Before co-founding Magallanes, Aranguez worked at Santander AM, Aviva, and Sabadell Gestion where he delivered superior returns in Spanish and European equities until mid-2014 of +300% and 45% respectively for the last 12 and 5 years, considerably outperforming the benchmarks. After top Spanish fund manager, Francisco Garcia Parames, left Bestinver last year he recommended Aranguez as the best person to invest with in Spain.
Investment idea – Hornbach
Hornbach is a family owned company. The family hold 100% of the voting shares with 50% of the capital. There are two separately quoted companies in the Hornbach group: Hornbach Holding (ETR: HBH3) and Hornbach Baumarkt (ETR: HBM). Hornbach Holding has a 76.4% holding in Baumarkt.  Aranguez recommended both companies but said that Hornbach Holdings is more complex and maybe cheaper.
Hornbach Baumarkt is a DIY store operator and the most important part of the Hornbach business. It operates the 3rd largest chain of DIY stores in Germany with 99 stores. They have 146 stores in 9 countries and are the 5th largest DIY stores operator in Europe with revenues of about Euro 3.3bn. The DIY stores business is very tough and competitive with low margins. Praktiker (one of their largest competitors) filed for bankruptcy in 2013 reducing the competition a bit and creating a more profitable environment for the survivors. Despite the competition in the sector, Hornbach Baumarkt has been a consistently successful business over the years. It has a number of competitive advantages:
- It is a service-orientated company that has generated loyalty from customers
- They are the low cost operator in the DIY sector
- Baumarkt’s megastore concept offers the widest range of products to customers with low risk of running out of stock.
Hornbach Holding has hidden assets – large real estate assets carried at book value with no accounting for rent. Baumarkt trades on an enterprise multiple of EV/ EBITDA 9.5x with upside potential of 52%. Hornbach Holding has an EV/EBITDA multiple of 8.5x with an upside potential of 61%. At the next owners meeting, a proposal to simplify the organisational structure of the company will be considered. The capital structure could be simplified to merge common and preferred shares. Hornbach is a good play on the recovery of the German consumer.  Three quarters of German housing apartments are more than 30 years old, ensuring ongoing demand.

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