Roger Federer, Howard Marks and how to stay “Active”.
Why StockViews focuses on small and mid cap research and how we find mispricings.
Those accustomed to watching top level sport will be familiar with the over-arching strategy employed by some of the best players and teams, namely that of targeting your opponents’ weakest points. Whether you’re Roger Federer consistently hitting it to an opponent’s backhand, Jimmy Anderson swinging the ball into left-handers or Cristiano Ronaldo switching wings to put yourself up against an average right back, the very best know that there is a much higher probability of success if you isolate and target your opponents’ flaws.
This strategy is usually mimicked in business too. For instance Aldi and Lidl knew that price perception was a struggle for incumbent supermarkets and because they had a very small range of products and structurally lower operating costs they could continue to reinvest their gains from growth in price, thus crippling the conventional UK supermarket groups and gaining 14% market share in no time at all.
For a large majority of equity market investors however they seem to be playing a different game. The vast bulk of active investment in equity markets predominates in the largest stocks by market capitalisation. Without being too much of a cynic there is plenty of rationale to this. If you are charging an annual AUM fee, as is the industry norm, then the larger the pool of assets you manage the greater those fees, and large pools of assets are easier to invest in large companies due to liquidity and apparent risk metrics. Q.E.D. the industry flourished under the pretext that bigger is better.
Equally the sell-side/broking industry has also gravitated this way, arguably to an even greater extent. Historically commissions were what paid the bills and it doesn't take a genius to realise that operating in the large caps, where trading was greater was a strategy for generating the most commission. Advisory fees, which increasingly pay for the bills, reinforced this large cap obsession. Winning the business of a large corporate placing €10bln of 10 year bonds usually came about due to having a very strong research franchise in that corporate’s sector. To give this some real world context in the recent ABI/SAB mega deal the broking/financing fees totalled not far from $1bln…compare that to the total European cash equities trading and research payments of $2.9bln per year (as of Q2'17)…not winning the advisory fees clearly matters. The irony is that given the recent pressure on research payments brought about by MiFID2 this status quo only looks set to amplify as that advisory subsidy becomes even more pronounced.
The result of all this large cap focus (see Exhibit 1) means that this part of the market is the most efficient. The brightest and best analysts spend hours trying to unpick the likely trajectories of the biggest stocks meaning that any new information is very quickly factored into the share price; gaining some alpha in the truest sense of the term is very challenging. Bringing back my sporting analogy it effectively means that Cristiano Ronaldo is constantly putting himself up against Ashley Cole (who he claimed was the toughest opponent he ever faced). A 0–0 draw is more than likely as the two cancel each other out.
Given the factors above it is no surprise that there has been a well documented dearth of alpha from fund managers as a whole, and a concurrent rise of passive investing. This is especially well documented in the US but this end of 2016 report from S&P and Exibit 2 above shows it isn't just a US problem.
As a consequence more and more focus is shifting to active share contribution. This recent report from Morningstar made some interesting observations about European fund managers active share. Not only did it show better performance from those with high active shares but also an ability to command higher fees, unsurprisingly, and perhaps most critically it showed the high proportion of mid and small caps within those funds with the highest active share (see Exhibit 3).
Equally Exhibit 4 from a Dodge & Cox report titled “The Case for Active Management” demonstrates a similar result but in this case ties active share with low turnover, a pre-requisite for smaller cap investing given more limited liquidity.
How does this is all relate back to StockViews? Well we believe that this large cap focus is creating an opportunity and are endeavouring to the put the smartest minds at work where few are hunting and mispricings are more likely to occur; thinly covered European mid-caps. Naturally we aren’t the only ones adopting this strategy but our model does allow for unique focus as analysts spend up to two months solely researching their chosen mispricing. This means that the chances of understanding and picking mispricings is increased and, as I have outlined in a prior post, our linking of analyst remuneration with ‘alpha’ should ensure their motivations are aligned with those subscribing to our research.
But what is a mispricing and how do we go about finding them?
Our process for thinking about mispricings is heavily influenced by Howard Marks thoughts around the subject and his anchoring to an intrinsic value. Here is an excerpt from his excellent “The Most Important Thing”:
“the pursuit of profit has to be based on something more tangible. In my view; the best candidate for that something tangible is fundamentally derived intrinsic value. An accurate estimate of intrinsic value is the essential foundation for steady, unemotional and potentially profitable investing.”
Over the last year, of the 475 European stocks with market capitalisations between €500m and €10bln, 150 rose by more than 40% while only 16 fell by more than 20%. This doesn’t mean that those 166 were clearly mispriced as of 12 months ago. Indeed of the 150 risers the average gain was 65% vs forward earnings upgrades of 32% on average, which implicitly means a rerating drove half the gain, all the more tricky to predict.
Indeed we are increasingly finding it tricky to spot obvious mispricings on the upside. Our preferred starting point for valuation is to use McKinsey’s equations from “Valuation: Measuring and Managing the Value of Companies” which factors in the reinvestment rate to continue growing. This is simplified as:
Using a WACC = 7%, g =2.5% and running that across our universe of 750 stocks (namely the €500m to €10bln market cap range) yields only 90 with upside of more than 15% and 406 with downside of greater than 10%. Being more generous and allowing the last 3 years’ average growth for the next 5 years, then returning to 2.5% terminal growth still only yields 114 stocks with upside >15%.
This might explain why our recent work has focused more heavily on risks that seem unappreciated by the market or hidden within accounting metrics (cf Balfour Beatty & ASM International). A wider more mainstream view on “risk”, conventionally measured by volatility, itself a major bone of contention, shows just how benign the current period is vs history (exhibit 6).
Perhaps the greatest area of risk lies once again in leverage. Having been through a decade of zero central bank rates corporate, consumer and mortgage lending rates are now all plumbing record lows. Interest costs have been an easy source of upgrades while M&A, funded by “free money”, has added another boost. Yet the rate cycle seems to be turning and even if 3% is still low vs history its a damn side higher than 1%. The most recent Red Flag report from Begbies Traynor, the leading UK insolvency practitioner pointed to a 27% rise in the number of firms experiencing a “significant” level of distress to 450,000 with 107,000 of those in London, a 6% increase on the previous quarter.
Turning back to Howard Marks, who devotes multiple chapters in his aforementioned book to risk appreciation, this little quote seems to sum up the current situation quite neatly:
“Most people view risk taking primarily as a way to make money. Bearing higher risk generally produces higher returns. The market has to set things up to like that’ll be the case; it if didn’t, people wouldn’t make risky investments. But it can’t always work that way, or else risky investments wouldn’t be risky. And when risk bearing doesn’t work, it really doesn’t work, and people are reminded what risk’s all about.”
The danger now is that more money is looking to small & mid caps as a way of providing alpha at a time when the P/E premium of these stocks, compared to their larger peers, is looking rather elevated.
What is more the research in this space, which has always had a positive bent anyway, is ever more tipped towards corporate broking relationships and is under existential threat…so unlikely to help you navigate any incumbent risks (exhibit 8).
This is the weak point that StockViews is targeting. While we want to help you find those hidden gems to buy we also want to help you avoid the calamities where the consensus has developed a certain myopia. A point that became very real for us as the only cautionary voice on IWG’s hidden price declines and while researching into Provident Financial’s weaknesses earlier this summer (sadly not concluded before the spectacular warning on 22nd August).
I’m sure we are all aware of Warren Buffett’s playful quote about tides going out and swimming naked but back in the world of sport I rather like the bluntness of notorious boxing legend Mike Tyson, who puts it rather more succinctly:
“Everyone has a plan until they get punched in the mouth…”