Thoughts from the London Value Investor Conference

Posted on May 30, 2016 by VMcCarthy

On Thursday of last week I attended the annual “London Value Investor Conference”. This is the fifth year for the conference since it was established in 2012, of what can only be described as an investment marathon of a day with fourteen investment managers speaking. I found it to be extremely interesting, and so I have provided a summary of the key points from each of the presentations in the appendix of this blog.

If you are not familiar with value investing, it is considered a religion in the world of investments. While Benjamin Graham – author of the Intelligent Investor – is seen as the founding father of value investing, it is his protégé Warren Buffett who has taken it to the next level through his unrivalled success with Berkshire Hathaway (with much help from Charlie Munger). It became a running joke at the conference how many times Buffet was quoted or paraphrased. In the end it was somewhere in the 30’s.

You could be forgiven for thinking that surely all investing is about value? Why would you invest if you didn’t see value in the investment? However, the investment industry tends to delineate between “value” and “growth”, two categories of active investing, i.e. picking securities to outperform the market.

Value investors focus on buying companies with an “intrinsic value” less than the current market value, while growth investors are more willing to buy companies that might look expensive by traditional value metrics on the basis of expectations of faster growth in the future. In essence, growth investors are more willing to pay higher valuations for potential, what legendary investor Howard Marks called “buying dreams”.

Intrinsic value. Market value. Confused? Well the market value is the value the stock market – made up of all those “rational” investors – places on a company today. It is the price that the shares are bought and sold at a point of time on the stock exchange. However, intrinsic value represents the “true value” of the stock, typically derived through fundamental analysis, most often discounted cash flow analysis, the cornerstone of Ben Graham’s philosophy.

As the conference highlighted, even within the category of value investing there can be significant dispersion on style and most importantly what represents “value”. Still, what they have in common is their search for assets undervalued by the market.

In this context, there are three important considerations. The first is that for the market value and the intrinsic value to be different one must believe that markets are inefficient, that market participants have not priced all relevant information correctly. At a Value Investor Conference I was in a room full of the converted, in their eyes that is a given.

Effigies of Professor Eugene Fama holding his despised Efficient Market Hypothesis Paper (EMH) – which argued that markets are efficient with prices reflecting all relevant information and therefore one cannot beat the market – would have been put to only one use. The most glaring flaw in Fama’s model is the assumption that investors are rational. I cannot subscribe to that. People are not rational, and the market environment exacerbates that irrationality. (I touched briefly on the psychology of markets in this blog last year “The Psychology of Markets & the Beard Trend”)

The second consideration is that while one might be driven by the belief that the market can be wrong, to unearth opportunities where market value has become divorced from reality, an active investor must be right that their perceived reality is the correct one. In other words, their view of the world and the underlying company, reflected in the model they have used to derive intrinsic value, must be the right one. Otherwise what they see as a mispricing is merely an illusion.

The third consideration is that even if the active manager has correctly identified a mispricing, there is the question of the timing of when markets will realign in order for him/her to realise the true value of that security. While asset prices can move significantly beyond (or below) some reasonable long term fundamental value, it can also be some time before they return to that true value. As John Maynard Keynes said: “The market can stay irrational longer than you can stay solvent”. Or perhaps in the case of active fund managers, it might be more apt to say that the market can stay irrational longer than your clients can stay patient.

While patience is a key attribute of successful investment managers, since they do not have permanent capital how patient they can be is subject to the limits of the patience displayed by their clients. As GMO’s James Montier noted, time horizons are becoming shorter and shorter, ‘everyone starts out as long term investor right up to the first period of underperformance’.

This lack of patience on the part of clients gives rise to an interesting dynamic. Clients employ active managers to be active, to show conviction in their ideas to beat their respective benchmark. However, knowing that clients are impatient and that one or two quarters of poor performance, by materially deviating from the benchmark, could get them fired – known as “career risk” – a large percentage of active managers will abstain from making big calls and simply hug the benchmark. These managers offer little value over passive alternatives. The irony is that their existence is a function of client behaviour.

Therefore, if clients want true active managers they have to be prepared for periods of underperformance, which are guaranteed to happen. Of course, this does not mean giving investment managers a free pass. Calling oneself a value investor and decreeing the market inefficient is the easy part, finding value is the difficult part. Just as active managers are selective on the stocks they own, clients must differentiate between good and bad active managers. (See my blog: The Elusive Search for Alpha: Natural Enthusiasm)

Ultimately, if one decides to employ an active manager it is crucial to have a clear process in place for the consistent monitoring and evaluation of performance. Having a clear sell discipline in place can avoid hastily firing an active manager or holding on for too long in the hope that the good times will return. (See blogs: Active Investment Management: The Jose Mourinho Dilemma and Thoughts on Decision Making)

End

Vincent McCarthy, CFA

Appendix 1: Notes on Manager Presentations:

The notes below on each of the presentations are intended to give you a snapshot of each of the presentations. Had I known how long they would have taken to put together I would most likely have just included a summary with one key point from each. I could have worked on my tan this weekend. However, while they will also take longer to read in this format, they carry more value than a simple summary, value being the order of the day!

1.”The Jamie Vardy Porfolio” – Andrew Hollingworth, Holland advisors

Andrew kicked off the day with a discussion on owning deep value or franchise value, drawing on a football comparison of Leicester City versus Manchester City.

This is not a franchise in the sense of a franchise company who licenses its trademarks and methods.

Warren Buffet, who popularised the term, to describe difference between owning a great business and a good one. In his annual shareholder letter from 1991, he described it as:

“An economic franchise arises from a product or service that:

(1) is needed or desired,

(2) is thought by its customers to have no close substitute,

(3) is not subject to price regulation.

The existence of all three conditions will be demonstrated by a company’s ability to regularly price its product or service aggressively and thereby to earn high rates of return on capital. Moreover, franchises can tolerate mismanagement. Inept managers may diminish a franchise’s profitability, but they cannot inflict mortal damage.” Coca Cola is the often cited example of a franchise play.

Deep Value

Tobias Carlisle describes deep value as: “Deep value is investment triumph disguised as business disaster. It is a simple, but counterintuitive idea: Under the right conditions, losing stocks – those in crisis, with apparently failing businesses, and uncertain futures – offer unusually favorable investment prospects”

Hollingworth emphasised the point that deep value has never been more hated, while franchise investing is at its most loved. There is difference between a great company and great investment, the differentiator is price. Own a portfolio of mispriced quality or high priced superstars, a Leicester City or a Manchester City, he’s choose Leicester City.

He shared his Jamie Vardy Portfolio, his first eleven with Exor and GM up front. He focused on Exor, Exor is an Italian investment company, controlled by the Agnelli family. With a capitalization of US$12 billion, investments include Juventus F.C., The Economist, Fiat Chrysler Automobiles, CNH Industrial, Ferrari, and Banca Leonardo.

He talked up John Elkann, the 40-year old New York born Italian industrialist, the heir of his grandfather Gianni Agnelli, who is now Chairman and CEO of Exor.

The constituent parts look very cheap, but for Hollingworth, the game changer came last summer with the purchase of PartnerRe, the 8th largest global reinsurance business. Why? Because the purchase brings float, something he describes as “the magic dust that turns ordinary investors into stars”, citing the example of Fairfax, difference is float, other people’s money.

“It could be fantastic compounding machine”.

(“Float, or available reserve, is the amount of money on hand at any given moment that an insurer has collected in insurance premiums but has not paid out in claims. Insurers start investing insurance premiums as soon as they are collected and continue to earn interest or other income on them until claims are paid out”. Source: Wikipedia)

2. “The Family Company Effect” – Philip Best and Marc Saint John Webb, Quaero Capital

This presentation focused on what they call “The Family Company Effect”, essentially investing alongside families, whereby this long term ownership can bring an extra level of governance and long term stability.

They consider family owned companies where the family owns a stake above 20%, giving them a strong position on advisory board. While the board is controlled by the family the operational management is outsourced to top managers.

Their first slide of Paris Hilton posing beside a Pink Bentley looked to emphasise the misperception of the family company effect being the Paris Hilton effect, i.e. families using the business as their own personal ATM. Over the period 2002 to 2016 the constituents of the German DAX index with family ownership vastly outperformed the overall DAX index, +397% cumulative gain versus +149% for the overall German DAX index. They cited increasing academic research on the family effect.

While Philip and Marc advocate active management they noted that German based index provide Solactive has launched The Solactive Global Family Owned Companies Index. (See http://www.etfstrategy.co.uk/solactive-launches-global-family-owned-companies-index-76256/)

They discussed some of the negative preconceptions, like the one thing all families have in common, the ability to argue with themselves. However, while it can be bad for business, it can be good for the share price, citing the example of Hermes.

Companies with family ownership tend to

think in generations rather than quarters
tend to be against taking on debt
avoid the horrible dilutive rights issue at times of crisis
focus on net profits rather than, what they call “EBE – earnings before excuses”

The other consideration is that in the case of takeovers, families only sell out at a big premium. Family companies are not incentivised by small premium

They gave included their slide from the presentation they gave at the same conference two years ago on an air conditioning company called DeLclima, a company which was trading at €1.41 per share at time and which they purchased over the 2012/13 period at around €0.60 – €0.70 per share. In May 2014 LVIC made a bid of €1.44 per share which was rejected. On August 25^th 2015 a bid of €4.44 was accepted.

The lessons:

Spin-offs can provide excellent value opportunities
Families can be very demanding on exit price.

Within European small cap value, they believe family governance is a conservative filter. Given the success of their last recommendation, interest was piqued for their latest recommendations;

SONAE capital

A diversified holding company with assets in Portugal, the majority of which are in real estate, residential and office, but with other assets including hotels, power plants, fitness clubs and air conditioning engineering. C

Constituted and listed in 2007/2008, the Azevedo family owns 64% of the shares. Key attributes include:

Share price – €0.62
Market Capitalisation – €149 million
Book Value – €296 million
Sales – €173 million
Dividend Yield – 10%
NAV per share – €1.20

Link to website: http://www.sonaecapital.pt/PresentationLayer/homepage.aspx

The Portuguese economy is improving, asset sales started over the last year and prices received have surprised on the upside. Tourism revenues are booming. There is a dividend yield of 10% and further asset sales expected. The next valuation at end of year and expected a mark-up in the net asset value of the holdings. The last Cushman and Wakefield valuation points to a sum-of-the parts NAV of €320 million, more than double the current market value.

Flurida

Founded in Spain in 1969 by four Catalan families with substantial worldwide expansion since then. Its core business is swimming pool equipment supplies, now the world leader, ex USA, with a presence in 41 countries.

The company went public in 2007 at €5.70. Current attributes are:

Share price – €3.75
Market Capitalisation – €420 million
Book Value – €317 million
Sales – €667 million
P/E Ratio – 32 x 2015, 15.3 x 2016e

Now recovering from the contraction in Southern Europe, with organic sales growth of 10% in Q1 2016.

Bissse

Founded in Italy in 1969 in Pesaro by Giancarlo Selci. The Selci family owns 59% of the shares. The company makes machines and systems for the woodworking sector. After having been managed by the founder’s son Roberto, the CEO role has been trusted to a professional manager.

The company has a culture of ‘lean production’ and ‘continuous improvement throughout the company.

After years of underinvestment, the woodworking sector is now ramping up investment in new equipment, and Philip and Marc expect higher sales to lead to a recovery in margins to double digit levels.

Current attributes are:

Share price – €12.44 (Still 50% below the 2007 peak)
Market Capitalisation – €340 million
Book Value – €142 million
Sales – €522 million
P/E Ratio – 15 x 2015, 12.5 x 2016e
Net Debt – 0

In essence, Quaero look to harness 3 effects:

Value effect
Small call effect
Family company effect

3. “An Unconventional Approach to Value Investing” – David Iben, Chief Investment Officer of Kopernik Global Investors

Dave puts cheap first, believing in deep value and the unconventional. As he points out, ‘the crowd is often right but it is wrong when it most matters, at inflection points’.

Dave founded Kopernik Global Investors in July 2013, the choice of name alone emphasising his contrarian nature. Polish born Nicolaus Copernicus (Mikolaj Kopernik, in Polish) was the ultimate contrarian. At a time when almost everyone believed the earth was the centre of the universe, in the early 1500’s Copernicus identified the concept of a heliocentric solar system, in which the sun, rather than the earth, is the centre of the solar system. As this short bio of Copernicus notes: “He changed the way we think about everything”.

Like Copernicus, Dave Iben strikes me as someone who likes to question conventional thought, with a philosophical tilt to his presentation. Like any good philosopher, he probes beyond the defined. “What is value?” he asks. “What is value and are there other ways to appraise value? People need to think twice what value is?”

As he points out most value investors defined it as the present value of future cash flows, what they call ‘Intrinsic value’. While highlighting the ultimate flaw in this model – “It is not future cash flows, it is estimated”.

Franchise stocks, corporate profit margins are double normal levels so what do you put into model. There is a wide margin on discount rates, low because central banks or printing money cause high inflation. 2% or 20%? “You could drive a truck between that”, which garnered plenty of laughter.

Ultimately with any discounted cash flow model one must be careful, “garbage in garbage out”.

Further addressing his original question of “what is value?” Dave focuses on this notion that intrinsic value can only be derived if there a set of future cash flows. He contends that investors have it backwards. Rather than looking at just the present value of future cash flows, investors must consider the fact that “future cash flows can be derived from assets’/people’s intrinsic value”.

. There won’t be many value investors that will share his view on this, but I guess that’s what makes someone a contrarian.

Highlighting the fleeting nature of value, he talked about technological advances, how “the Abacus was hugely valuable, until it wasn’t” – ‘value can come and value can go’. “Can value really be as simple as: human expectations for the future boiled down to neat little formula? We think not”. His advice, ‘use DCF (discount cash flow analysis) but only as small part’.

His firm are looking hard for value given that there is not a lot around. Assets have value, get the assets before they give the cash flow. Key areas Dave highlighted, without giving the company names:

Agriculture in Brazil and Ukraine: number of options around book value (BV) & ranging from 5x to 13x 2016 earnings
Hydroelectric power: Russia and Brazil, 0.04 x BV in Russia and 0.26 x BV in Brazil, two largest in world
Gas: world’s largest gas company, Russia 0.35 * BV, price 70 cents per reserve barrel of oil
Electricity transmission: EM 0.23 * BV, 2.8 x 2016 earnings estimate
Tankers: four stocks, 3 in Greece and 1 in Norway; 0.22x to 0.46x BV.

While the countries and the companies he is investing in do carry significant risk, in his mind the price is right! In other words, the price has fallen to a level that more than compensates an investor for the risks.

Dave is also bullish on gold in the context of central bank policy. Over the period 1913 -2007 the US Federal Reserve printed less than a trillion US dollars. From 2007 to now the Fed has printed $4 trillion USD.

He referenced a quote from Austrian economist Frederick A. Hayek:

“With the exception only of the period of the gold standard, practically all governments of history have used their exclusive power to issue money to defraud and plunder the people”.

“Does value come from expected cash or is cash likely to be generated from things that are intrinsically valuable?” “The cash flow will come.”

In the Q&A session Dave noted that they pursue a diversified approach –50-100 holdings– as market will be right some time, but they can afford to be wrong on some. Couple of quotes from Dave:

‘Whatever the market doesn’t like, you will probably find us”

‘Patience and conviction are key. Coming into this business, you think intelligence will be your differentiator but you realise everyone is intelligent. People are inherently emotional. And trying not to be emotional is what we look to do better.’

4. “Successful Failure” – Nick Kirrage, Schroders. Co-manager of Schroder UK Income, Schroder UK Recovery and Schroder ISF Global Recovery Funds

If I was to sum up Nick’s presentation in one word, it would be humility. Nick chose to talk about the failures, something that is guaranteed to happen, and how it has defined himself and his team.

As he pointed out value is a broad church, from buying cheap like Ben Graham to the Warren Buffett and franchise value. For them, the most important part of equity investing is what you pay, not the growth you get, viewing price paid as the biggest driver of future returns.

He argues that over the last 5-10 years it is harder to be a Grahamite. The cheapest items are more uncomfortable. There has been a shortening of investor time horizons and volatility is considered risk.

In terms of the dogs of his portfolio he highlighted Lonmin -66.8%, -90% ignoring rights issue.

‘The reality – stocks that have the ability to make us immense returns have the ability to elevate our career risk and make us look immensely stupid.’

Schroder Recovery fund – 20% turnover

‘Rather shockingly Lonmin wasn’t the worst. We went off benchmark and out of 20.000 stocks picked Apollo education which fell -76%.’

He showed their 5 worst performers, and ‘it must be the exception?’ No. It is the same every year. Some shocking stats. Privileged to manage money but they are painful. In 2011 they lost -98% on their investment in Blacks Leisure,

As he points out ‘we don’t live in a deterministic world, it is about probability. Right 70/100.’

It is Impossible to find great returns without fishing in this market.

Then shows his best performers, some points included:

Value of averaging down. Avis Europe which they lost -90% on the previous year, 2009 +568%
Dixons – basket case to one that is much loved
St Ives – terrible business, buying at 4 times current earnings, doubled money

Over 10 years, the Schroder Recovery Fund has delivered annualised relative return +2.8% and is ranked 18/360.

Again Nick emphasised: ‘To earn this potential return we have to fish in markets that give us career risk and make us look extremely stupid.’ He concluded his presentation on why he believes Royal Bank of Scotland (RBS) offers an excellent opportunity.

RBS – Really Bad Shareprice

What people are missing, amount of change over the last 8 years.

Post ABN Amro takeover 2008-2015

Business has halved, no investment bank
Regulatory capital had gone up, higher quality regulatory capital now. Margin of safety has dramatically improved.
K. Retail and commercial bank, this is an oligopoly. 5 banks.
Porters 5 forces. Huge barriers to industry.
Customers are sticky.
Can’t think of another sector that has been de-risking so dramatically over the last decade

Conclusion: RBS: Real Bargain Stock. Trades at 0.6x tangible book value. A despised sector, an undervalued company, a potent combination.

5. “The Power of a Virtuous Cycle” – Dan Abrahams, Managing Partner, Alfreton Capital

Dan summarised his firm as European value investors, research intensive, concentrated and long biased. His presentation was on the investment case for Ocodo.

(About Ocodo: “Ocado was established in the UK over 15 years ago and listed on the London Stock Exchange in July 2010. We are the world’s largest dedicated online grocery retailer with over 500,000 active customers shopping with us today. Our objective is to provide our customers with the best shopping experience in terms of service, range and price, which builds a strong business and delivers long term value for our shareholders.

We have developed a unique end-to-end operating solution for online grocery retail based on proprietary technology and IP, suitable for operating our own business and those of our commercial partners.

The world is changing fast, driven by different shopping habits and ever more advanced technology for the consumer. Grocery is the largest of all retail segments and is moving online. Moreover, the rapid growth of shopping using mobile devices opens new opportunities. We are well positioned to take advantage of these long-term structural trends for the benefit of our customers, partners and shareholders.” Source: http://www.ocadogroup.com/who-we-are/ocado-at-a-glance.aspx)

With a P/E of 130 it is hard to see how it falls within the value category but Dan made the case for it based on the evolution of the supermarket and their positioning ahead of everyone else in online grocery. The UK grocery market is an oligopoly with four main retailers.

In terms of the evolution of structure, the cycle has been: a superior customer proposition, share gains, increased scale and lower average costs. This is an example of self-reinforcing virtuous circle, something that works in favour of long term equity holders. Supermarket growth – 22% of compound growth.

Ocodo is an unloved stock:

Ocodo – 25% on loan for shorting. Half of outstanding shares. One of the most crowed short trades.
FT: Even the spelling begins and ends with a zero

‘We believe history is repeating itself with Ocodo offering an industry leading customer proposition. They have already sunk significant capital into technology and the virtuous cycle gets stronger every day, average unit costs continue to fall.’

On the question of why can’t others simply replicate, he makes the case that online grocery is difficult. Ocodo uses technology but most retailers use staff to run around stores. ‘Supermarkets are on razor margins, locked into viscous circle of decline. They lose money on online but online is fastest growing revenue stream’. As example of this viscous cycle of decline Dan show the Tesco share price, with their online tagline “You shop, we drop”. Literally for shareholders.

Regarding the potential of Amazon Fresh entering the UK market: Big risk to bricks and mortar retail, but see it as a big opportunity for Ocodo. Morrisons have already partnered with Ocodo. Big retailers they have talked to are saying Ocodo has huge potential. In terms of competing with Amazon if they enter, he sees it as an opportunity more than a threat as big retailers will move to partner with Ocodo. Picking groceries is much different skillset; Amazon workers are still walking around fulfilment centres.

On trading at 130 earnings: they look at cash flows. Long term alignment with management, founder. 5% stake. His stake larger than combined Tesco, Sainsbury and Morrisons combined. His tenure also larger than each of 3 CEOs combined. Over 40% of shares tied up with those who have long term mind-set.

Conclusion: ‘The most effluent solution to the world’s large retail opportunity. There is massive greenfield of opportunity for Ocodo’.

6. “Finding a Golden Nugget in a Muddy River” – Jonathan Mills, co-founder of The SF Metropolis Valuefund, Metropolis Capital

Jonathan made the investment case for Ryanair, the golden nugget in the muddy river that is airline stocks, an industry notorious for bankruptcy and losing money for investors. This was another one of my favourites on the day, as Jonathan delivered his thesis with a considerable amount of humour, with the use of quotes from Michael O’Leary, some disgruntled customers and even a staff member.

As well, whether it is sport, business, music, acting etc., there is that sense of pride whenever you hear about Irish people competing at the highest echelons. While he might not be everyone’s cup of tea, Michael O’Leary is nothing short of a revolutionary in the airline industry and he is revered worldwide.

Jonathan began by talking about the negatives with Ryanair. ‘I flew Ryanair once, my bad experience was extra charges but got away compared to some’, as he showed pressed headlines with stories of irate customers.

‘Ryanair is the airline the press loves to hate.’

‘And then there is CEO?’ as he shows a slide with O’Leary dressed like a jester. ‘Is he a buffoon or egomaniac?” ‘I met him a few months ago and I was very impressed’.

Summary of key points Jonathan mentioned:

Fourth largest in the world; the Amazon of the airline industry
Highest margins in industry because far and away they have the lowest costs
15% growth per annum for the last 10 years
Only 13% of the market with plenty of high cost competitors to go after
CEO in place since 1988 with no sign of want to exit; relentlessly focused on maintaining his cost advantage
Excellent capital allocation with large share buy backs and dividends
Balance sheet with net cash
Trading on a forward multiple of profit of 11x
O’Leary’s Personal stake of €600 million

Start with cost of planes: Go back to 2001. Outrageous auction with the two. Shook hands with Airbus and then called Boeing up ‘one last chance’. He talked about how O’Leary is a value investor when it comes to buying planes.

Staff: On O’Leary’s attitude to labour relations Johnathon got a laugh with the quote: “My staff is my most important asset. Bullshit! Staff is usually your biggest cost. We all employ some lazy bastard who needs a kick up the backside, but no one can bring themselves to admit it.”

Ryanair don’t pay as well but still attract staff ahead of other airlines because they offer more opportunities for promotion than at other airlines because of the high growth rates. At Ryanair, you can become a captain within 3 years.

Staff are incentivised on what they sell.

On drink sales: “If drink sales are falling off, we get the pilots to engineer a bit of turbulence. That usually spikes sales.”

Costs: O’Leary has turned saving money into a religion. Nothing about ego. He will do anything for free marketing, just another way to save money.

O’Leary has even tried to change customer behaviour. On the cost for bags, it wasn’t about the money he just didn’t want the bags. On the €60 to print boarding pass O’Leary merely wanted to avoid the need for desks at airports:

To those who are not happy about charges for printing a boarding pass O’Leary noted: “99.98 per cent of Ryanair passengers print their boarding passes in advance, to those who don’t, we say quite politely: bugger off”

Opportunity in Germany: As O’Leary hilariously put it: “Germans will crawl bollock-naked over broken glass to get low fares.”

On competition: Johnathan gave the example of how Ryanair took on the airline “Go”, noting that O’Leary ‘is the most aggressive competitor ever’.

“You can’t take on someone with lower costs because they dig deeper than you to lower their prices and still make money while you’re bleeding” – Barbara Cassani, CEO of low cost airline GO who lost on route competition with Ryanair.

New nicer Ryanair:

Three years ago there was a revamp but it did not come at the expense of cost. Profits continued to soar:

In 2015, O’Leary remarked: “If I’d only known that being nice to customers was going to be so good for my business I would have done it years ago”

Risks:

Load factors decline (currently high)
Terrorism/plane crash – safety one area he doesn’t try to save costs
Oil rise – Ryanair is hedged 2-3 years out. Moving inversely to oil prices, but makes no sense.
O’Leary leaves: Jonathan is confident O’Leary will be at the helm for another five years.

As one staff member summed up the prospect of O’Leary leaving: “I’ll only believe it when he is carried out in box with a stake through his heart”.

Conclusion: Regarding the value godfather, Warren Buffett, hating airlines Johnathan reaffirmed that “Ryanair is exceptional, with a very powerful cost advantage”.

7. “Passive Aggressive: The Implications of ‘Industrialized Capital Allocation”, Michael Keller, Partner Brown Brothers Harriman, co-manager of BBH Core Select

Unlike others Michael began with the company pitch. This was quite an academic presentation, which didn’t appear to be as well received as other presentations by a crowd more interested in pure investment.

The roots of industrialised capital allocation. Movement away from individual stocks, move from DB to DC, open architecture in private wealth.

Loss of portfolio concentration by size of money pool, too many managers became index driven. Little incentive to be different. It wasn’t going to last forever – enter passive.

Diversification, low fees and buy and hold. It has evolved, then ETFs in 90’s. Massive universe now, 6 fold increase in 10 years over $10 trillion. Total passive now $20 trillion.

Passive – benefits and drawbacks. Market share gains for passive at expense of market removes information from the market. Decision making given to 3rd parties who design the index.

Marriage of manager selection and asset allocation. Proliferation of passive had been an enabler of this industrialised capital allocation. The irony in that people are against active managers but asset allocation is making an active decision.

The market is not a smooth linear system that can be resolved to a template for future performance. Passive lacks any real judgement. If capital allocation became 100% industrialised, it would lose ‘weighting system’ and ‘voting system’ Ben Graham spoke of. Long term winners and losers determined by fund flows and index creation.

‘Opportunity for active investor: most passive products not built to care whether something is expensive or cheap. Value investors approach in a polar opposite way.’ Michael believes that the index and factor based flows can add to the amplitude of market flows. Indiscriminate buying and selling.

Challenge for value managers – sustained periods of underperformance. The key is to stick to principles and full cycle compounding.

Basic takeaway – low cost some positive attributes but they are not a panacea. The press has set up religious battle between active and passive. Not like that, both benefits, key is design of particular product.

Key attributes for an active manager:

High Active share
Low Turnover

Long only managers – population of managers that beat benchmark over 10 years. High active share and low turnover. It doesn’t mean they will always lead to outperformance but pattern is compelling.

Other key: Favourable downside capture. Big benefits for long term compounding. Caution that it doesn’t imply causation,

Zoetis: – healthcare idea; potential takeout candidate but not baked into expectations.

Perrigo: more of a value play but recent challenges, one is loss of CEO. The CEO went to run Valeant – ‘it is a bit like breaking into prison’ which got a laugh.

8. Audience Q&A: If Value Investing Makes Sense and if it Works Over Time – Which it Does – Why so Few of Us?” Jean-Marie Eveillard – Senior Adviser to the First Eagle Management Global Value Team

Jean-Marie is another legendary investor. Now retired as a money manager he acts as an advisor to the First Eagle Investment Management Global Value Team. Like David Iben, Jean-Marie came across as an investment manager with a philosophical perspective.

He talked about a movie – league of their own, about a semi professional baseball player. Someone in it said, “I’m quitting” why? “Because baseball is hard”. ‘Of course it is hard, that’s what makes it great.’

Jean-Marie’s view on life and one he believes is the same when it comes to investing:

“Much of life that is worthwhile comes hard, it doesn’t come easy”

He talked about Stan Wawrinka’s tattoo, a quote from Samuel Beckett:

“Ever tried. Ever failed. No matter. Try Again. Fail again. Fail better.”

Jean-Marie sees it as a tribute to humility – the idea of failing and a tribute to effort.

“People forget that asset values are contingent, which is forever”

Few poor periods, near death experience – career risk

‘Risk is simply not just looking like an idiot, loss of bonus but at extreme is loss of job. Fear of one losing job. Even if the herd running over cliff hard to move away from the herd’

On underperformance by not buying into tech bubble: ‘Lagged in 97, 98, 99 after 1 year displeased, after 2nd year they were furious and after the 3rd year they were gone. 7/10 investors left.’ AUM went from 6bn in 1997 to 2bn in spring of 2000. Today they the AUM is 90bn.

‘Money stays for 2 reasons:

Some procrastinate – don’t look at statements, relative perf.
Happy few continue to believe’

Questioned on the challenges in EM, whether deep value principles throws up more barriers? He agreed with Dave Iben, ‘there is a price for everything’.

‘I am very positive on India from a long term perspective, much more so that China which is a command economy. If the regime was to stop delivering the goods, they would have a big problem’ since 2008 on back of big credit boom. Always leads to credit bust, as night follows day.’

‘Buffet was right, to be reasonably successful investor it doesn’t take a high IQ, it takes temperament.’

‘Value investing can be fashionably and unfashionably, when it is fashionable some enter value investing without the conviction. Accept in advance that every now and again you will lag.’

‘Mutual fund groups tend to be run by marketing types trying to be asset gatherers.’

9. “Investing on the Road Less Travelled” – James Montiier, GMO

James Montier discussed the behavioural side of markets, something he has written a number of books on. It was quite an entertaining presentation.

Hurdle 1: Human Nature

The Solomon Asch Experiment

“Each person in the room had to state aloud which comparison line (A, B or C) was most like the target line. The answer was always obvious. The real participant sat at the end of the row and gave his or her answer last.”

Results: Asch measured the number of times each participant conformed to the majority view. On average, about one third (32%) of the participants who were placed in this situation went along and conformed with the clearly incorrect majority on the critical trials.”

More information at: http://www.simplypsychology.org/asch-conformity.html; as this article points out there are limitations to the 1951 study.

Matt Lieberman – computer game social exclusion experiment

‘2 players stopped playing with 3rd player – scanning brain as it goes on, brain was lighting up same place as real physical pain. Value investing is like getting your arm broken.’

‘Physical pain and social pain have a degree of overlap.’

Hurdle 2: Institutional Imperative

Keynes’s Edict:

“Worldly wisdom teaches us that it is better for reputation to fail conventionally than to succeed unconventionally.”

James explained “career risk” – the fear that causes managers not to deviate from the benchmark – in the world of Keynes’s edict as a cycle with 6 key stages:

Heeding, momentum and extrapolation
Market inefficiency: prices move away from fair value
Replacement cost, valuation as an anchor – A North Star in tubule the seas
Arbitrage or mean reversion to push back to replacement cost, fair value
Timing uncertainty – when will prices move back, but you have to deploy capital ahead
Client’s patience: ‘Everyone starts out as long term investor right up to the first period of performance’

As James points out: ‘In the investment management world it is better to be wrong with crowd.’ This is essentially why we see fund managers herding around the index.

To make his point James showed a picture of the average fund manager, what he called “Homo Ovinus – A Portrait of the Average Fund Manager”, a sheep with a man’s face.

If you can’t de-bias then re-bias

He talked about turning a behaviour – anchoring – into your favour

He gave an example of anchoring.

1000 fund managers were asked to write down their last four digits of their telephone number. Then they were asked to estimate the number of doctors in London?

If the last four digit were 2300 or below they answered around 2000 doctors
If the last four digits were 7300 or higher they answered 7000 plus

‘It was their subconscious and they didn’t even know they were doing it.’

James argues that if we know anchoring exists, then we are ‘better off using valuation as your anchor, turn anchoring in your favour. A form of behavioural self-defence’.

An (almost) real time example – Emerging Markets

James discussed their use of anchoring when considering emerging markets.

First step:

Bofa survey – everyone hated it in 2015.
It was really cheap, peaked their interest
Private sector debt as % of GDP
EM sub value even cheaper to EM
Stripped out resources and financials

‘I worked in investment banks for 20 years. They don’t know what they are doing internally, never mind someone outside trying to understand what they do’.

“Anyone who understands investment banks is clearly smoking craic”

Second step:

‘Then we thought about how could we be wrong? Better to think that way than focus on right.’

Has EM being equity-like? Have the returns been commensurate with earnings yield? Yes

Implied real EPS growth rate % p.a over next 10 years?
Pricing in 1% real pa growth
Since 2000: EM value, only about 1.5% growth, tempered their excitement a bit
A biased sample? MSCI Emerging Markets real eps growth % p.a.?

DuPont Equation:

ROE = Profit Margin x Asset Turnover x Turnover x Leverage

Leverage has been broadly stable
Marked change in asset turnover – gave pause for thought

Left with one question – could it be the currencies? Yes they had fallen a lot but not as cheap as they have been. Again, looks kind of like their fair value.

On basis that we chose to own some EM. This is an example of the framing when we think about how we might be wrong along our baseline assumptions around mean reversion.’

‘Relative investing is very dangerous, you start altering their perceptions’

Relative risk: “Benchmarks are an incredible dangerous thing”

Quoting Steinhardt, Greenblatt and Graham, James concluded with the ‘Three elements to being a contrarian,

The courage to go against the dominate view
Being an independent thinker
Stick to it

Not care what anyone else thinks.’

I asked James a question:

‘You are saying that benchmarks are an incredibly dangerous thing but how you would you propose measuring the skill of an active manager? If they have no benchmark you just give them a free pass if you have no way to measure them. We are seeing the difficulty in measuring the skill of absolute return managers, deciphering market returns and skill’

The crux of his response was that it is a challenge. ‘There is a balance between using as an evaluation tool and manager tracking. We use CPI on our global macro fund to get around it.’

10. “Value Investing Beyond Mean Reversion – Alex Wright, Fidelity. Manager of Fidelity Special Situations Fund, Fidelity UK Smaller Companies Fund, Fidelity Special Values PLC

The focus on the supply side of capital. Capital leaves unloved sectors. Like financials today. Supply has exited. Similar for the oil and gas sector. Whereas for supermarkets there are new entrants.

Beyond industry change, they look at a company level, looking for as many shots on goal as possible, in terms of positive catalysts.

They ask ‘Is our view different to the market?’ They have noticed that when competitors talk highly of their competitors it is good thing as tendency for them to talk down their competitors.

He discussed two stocks, Royal Mail and CRH:

Royal Mail FTSE 100, est 1516

8% free cash flow.
Very little debt
Stock crashed after big run, mention of Amazon
Speaking to competitors you get a clearer picture of Royal Mail’s business
Conservative management: one of few rare meetings where business executives suggested stock was overpriced
Company change – privatisation with recent listing, room to improve margins.
Big property assets.

CRH, FTSE 100

6% cash flow
Industry change – industry still recovering in US, even earlier in Europe
Even at time industry is depressed, were able to buy up assets that came out of Holcim/LaFarge merger

Good time to invest in value stocks. Huge amount of bifurcation in markets, expensive and cheap. Like banks and life insurance.

He wouldn’t invest in bonds, what he calls “return less risk”.

11. The Power of Moats: Competitive Advantages Drive Super Performance – Alex Morozov, Director of Equity Research, EMEA, Morningstar Institutional Equity Research

Alex made the case for their best investment idea Elekta, a Swedish based company that radiotherapy machines. One of founders pioneered radio therapy. The company has had a lot of issues, pattern of missed guidance, slowdown in order growth but he believes the market being myopic, extrapolating the last year or two: Key points includes:

Best technology,
Operates in a duopoly
Strong secular growth, cancer incidence growing
Replaced management team
90% short interest
Wide moat
Great portfolio of products
Switching costs are high
Oligopoly – two competitors, high barriers to entry. A number of companies left because they could not compete.
Secular tailwinds on industry
Competing therapies – synergistic opportunity with immunotherapy
Underutilised:
- Lancet oncology – “call to arms”, The world needs a 25% increase in capacity by 2025
Herfindahl index – highest for all sub medical device industries
Expect 6-8% growth rate
Company margins have bottomed
Margin up lift
Expect improvement on cash flows as management improve accounting practices

12. “Growth at a Value Price” – Francois Badelon, Amiral Gestion

Francois was definitely the most eccentric presenters. The investment manager, with a very distinct French accent, made the case for EasyJet, what he calls growth at value price.

He talked about the information theory. In the 1940’s in Bell observation, can you can observe everything.

Sun is rising – no informational value
Sun is not rising – informational value, we are dead

They were able to remove noise and just listen to person on the moon. The moon has a specific noise.

Just a word on the Efficient Market Hypothesis (EMH), I found a way to destroy it, they made a very basic mistake. Efficiency is always, this does not exist, a defined set of available. Everything is information, impossible that all market participants have all the information.

The idea is to find the relevant information. For example of what you read – I read vanity fear, don’t read the Wall Street Journal or the FT, very interesting information

A few year ago there was a very sad story few years ago, Air France flight from Rio that crashed and explained exactly what happened, bit controversial but I believe it happened because of union, believe they are all powerful.

15 years ago I got an Air France ticket, turned up, told there were as a strike. Pulled that morning. The unions are all powerful, if you can’t be fired why would you work especially hard?

On the Air France flight from Rio, after two hours, the head pilot, tired because he was partying in Rio went out of the cabin to sleep even though he knew turbulence was coming, the co-pilot was scared and the 3rd pilot was from the union. Why was he there? It was just there because he needed to keep flight license.

Stall, stall alert happened but they didn’t understand.

As long as Air France alive companies like EasyJet and Ryanair have a long way to go.’

After hearing Johnathan’s presentation he said he might buy some Ryanair.

‘I didn’t buy Ryanair, because I don’t like Beauvais. I want Paris to Venice, not Beauvais to Trivaise’

Concluding on the impact of oil prices:

“Jet fuel rising it is a disaster, jet fuel falling it is a disaster. In the end it doesn’t matter.” Laughter as this quote kind of summed up his presentation style.

13. “Winning by Not Losing” – Anne-Mette de Place Filippini, Portfolio Manager Emerging Market Equities, Burgundy Asset Management

Anne-Mette described Burgundy as a “value manager with a pretence for owning quality”. She talked about being a tennis player before she was an investor, making the comparison between winning at investing and winning in tennis.

In tennis making your opponent hit another shot or errors is what matters. She talked about Wimbledon 2008, Federer v Nadal, known to one of the best finals ever, and in her eyes “the greatest match in my lifetime”.

Showed the statistics from the match and on most metrics Federer did better or at least as well. However there was one metric where Nadal did better, “unforced errors”. Nadal had significantly less unforced errors, only 27 against 52 for Federer.

Anne-Mette sums up Nadal’s reason for victory: ‘Even though he was outplayed on winners he won by playing within his game’. She believes in a similar philosophy in investing, sticking to your game to avoid the big losers that can hurt your portfolio. Key principles Anne-Mette highlighted as integral:

Business approach to ownership
Independent thinking and research
Focus on quality
Choose partners carefully
Margin of safety

She mentioned the risk of chasing winners, showing the front page of Economist from two periods, “Brazil takes off” when Brazil was booming and “Brazil’s fall”. In 2015 the main Brazilian equity index hit the lows reached in 2008.

Peak to trough, Petrobras fell -90%, ‘effectively a state entity and a reminder of pearls of investing alongside government’. Sound principles were infringed upon.

‘If hitting winners is hard, you might revert to covering a lot of ground, Andy Murray, diversifying – equivalent to buying the whole market.’ However, Anne-Mette would not be in favours of this:

Ownership structures – risks are not trivial,
You end up overpaying for companies. For example ‘there are massive multiples on Indonesian stocks – would need compound ground rates of 14-20% over next 5 years to close the gap with peers.’

Stock Idea: Cielo S.A. (Ticker: CIEL3)

“Cielo is the largest Brazilian credit and debit card operator. Cielo is the biggest payment system company in Latin America by revenue and market value.” Source: Wikipedia

The Brazil Payments Industry is an oligopoly, 3 companies have market share, Cielo own 50%+ market share. In EM where inflation is an issue, fee on spending gives inflation protection. The company meets their criteria on growth, profitability and financial strength.

Anne-Mette referenced Winston Churchill’s quote: “Never let a good crisis go to waste”, believing that ‘good CEOs can turn crisis into opportunity’.

Conclusion: ‘Investing a game of patience: In a time of full valuations, which we think where we are, these are the times of winning by not losing.”

14. Conversation with Howard Marks, Oaktree Capital

Howard Marks was the credenda of the Value Investor Conference. Unfortunately he was unable to attend but instead it was a conversation with the moderator. Howard is well known as a legendary debt investor, the Founder and Chairman of Oaktree Capital Management.

However, he also well known for his memos, writing with an engaging and interesting style as shares new insights with clients in an easily understandable manners. Warren Buffet has been quoted as saying: “When I see memos from Howard Marks in my mail, they’re the first thing I open and read. I always learn something.”

(You can subscribe free to his memos at https://www.oaktreecapital.com/insights/howard-marks-memos)

I have tried to provide a snapshot of some of the nuggets of wisdom shared by Howard.

Are you bored or terrified?

‘I think it has been pretty boring since mid-2010. No fundamental developments.

Like the airline pilot we have to keep our focus in times of boredom. We have been living through a time of complacency, fuelled by central bank stimulus.

We call it TINA – there is no alternative.’

Any more areas you feel a bit more concerned about? Areas of acute overvaluation?

‘Principle problem is a pervasive one. Lower base rates have made all assets look more attractive and raised prices of assets.’

The way you go about investing, would you describe yourself as a value investor?

‘As for value, within the value pantheon there are lots of things. The value spectrum from cigar butts to good franchises at reasonable prices. Buffett when he started in the 40s and 50s was buying cigar butts.

‘Sounds a bit like the Republican Party, what’s left out, really just dreams, companies with dreams of an optimistic future – growth.

Oaktree is somewhere in the middle of the value spectrum. We are primarily credit investors – to get value you somehow have to find company that looks like it is not doing great.

What is your attitude to losses?

Founded in April 1995 – guys worked together for 10 years. We wrote out an investment philosophy, business principles and a motto. The motto was “Avoid the losers, and the winners will take care of themselves”.

Like most mottos it is over simplistic. To achieve an IRR (Internal Rate of Return) of near 17% – to get those returns or even high single digit returns you have to do more than just succeed by avoiding losses.

Focus on mind-set of controlling losses. Notice I said risk control and loss avoidance, I didn’t say risk avoidance. We skilfully take risk to avoid losses.

Howard on risk:

We look for when all optimism has been driven out of the price quote. Everything that is important in investing is counterintuitive. What determines the risk is the relationship between the price and fundamentals.

In 1978 I got a call from someone at Citi (where Howard worked at the time). He says ‘can you talk to some guy called Milken about high yield, figure out what it is?’ (Howard talked about nobody know what it was and pension funds explicitly banned it in their investment mandate)

The conclusion from Moody’s at the time on high yields was: “Fails to display he characteristics of a desirable investment”. There was no mention of price. All views were so negative that the negatives were overdone, and no positives.

Fast forward to October 2008. On senior loans yields were c. 20%.

Howard discussed a conversation at the time with a possible investor (at a pension scheme if I recall correctly). He asked:

What is default rate?

At Oaktree over the history since 1995, our default rate is 1.5%.

What if it is worst than that?

Okay well the default rate of the wider industry is 3.5%.

What if it is worse than that?

Well. The worst year in history is 13%.

What if it is worse than that?

Okay well at 1 1/2 times 20%, even if that happens each year you break even.

What is it worse than that?

Do you own equities? Well in the world you are describing you better sell all your equities because if that happens nothing be left for equities.

In my 2008 Memo I talk about the limits of negativism.’

On Intrinsic Value

In contrast to David Iben, Howard was adamant that “non cash producing assets can’t produce intrinsic value”.

Howard believes the main problems are little changed:

Lack of growth
China
Geopolitical difficulties
Lack of leadership around the globe

Howard on how the game has gotten harder:

Did you go to a value conference in 1968, I dare say you didn’t. Now search for value drives our value. I discussed this in my Jan 14 memo “getting lucky”.

The margin of outperformance should be expected to be smaller, the challenge has come stiffer.

What is your view on real estate?

Real estate is extremely heterogeneous. Prime properties sell at too rich. Often bought as bond substitutes, just as bonds too expensive and yields too low. Different from real estate in non-prime, unlevered yields in high single digits and then add some leverage.

Zombie properties. Building worth 80 and debt is 90. Nobody rational will put money in so there is no investment in the properties. If we can get banks to sell the loan at 75 we can put money in.

Howard on the importance of staying in the game:

‘Experience is extremely important. Good attitude toward risk, risk control has put us in good stead. ‘There are a lot of old investors, there are a lot of bold investors, but there not a lot of old bold investors’.

How do you first decide to pursue a career in investments? Any advice for 20 something?

In my Jan 2014 memo I discussed my haphazard career decision, how went back to Citi, for the simple reason that I had spent summers there. I went to Chicago Business School and learned about the Efficient Market Hypothesis (EMH). I concluded that trying to beat market with high quality big name stocks was not possible and would do anything other than buy Merck or Lily, which led me to high yield.

Single best thing to read is Berkshire annual letters, teach you about value and contrarianism
The intelligent investor – learn about how the market can be a ‘weighing machine’ and a ‘voting machine’.
His own book chapter – key is “second level thinking”. (The Most Important Thing Illuminated: Uncommon Sense for the Thoughtful Investor”.

Pre the credit crisis could you have ever imagined where rates are?

First of all, nobody ever imagined we would have 0% rates. First few years tended to assume they would go back up. Over time our expectations get eroded away, nobody thinks they will go away. Now everyone expects: Low growth rates, low birth rates, low demand for capital and consequently low rates for some time.

My guess is that people could be too negative. My intellectual side says outlook is lacklustre but my alter ego says maybe I am being too conservative. I don’t tend to listen to my alter ego.

Category: Active Management, Decision Making, Education, Thoughts, Valuation