Waiting for the fat pitch
The economic environment we find ourselves investing in is extremely abnormal. Financial repression has caused all asset prices to rise with little regard for fundamentals (for equities these would include cash flows, earnings and dividends). This cannot continue indefinitely but while it does, we continue to practice caution in our investment: We will only invest where we see attractive medium term absolute returns and will not compromise our valuation discipline simply to stay fully invested. Our aim is to deliver attractive medium term absolute returns. If there are insufficient opportunities that will deliver this then we are happy to be patient and wait for ‘the fat pitch’. It is our experience that markets oscillate over time and provide opportunities to invest at compelling valuations at times. Today is not one of those occasions and while we continue to look for ‘special situations’ that we believe will deliver attractive returns there tend to be fewer of these opportunities at any one time.
However, this does not mean that there are no opportunities for investment – rifle-shot investing in specific companies with a compelling investment case and valuation over the long term is still achievable especially if the company in question is facing a short term ‘issue’. In the past few months we have had the opportunity to invest in the following companies (among others):
- Airbus: The opportunity to invest in Airbus arose as consequence of their investor day which was poorly received by analysts leading to the share price declining over 15% in the subsequent three days. These analysts were concerned following a comment from the CEO, Tom Enders that all options with regards to the unprofitable A380 programme were on the table including stopping the programme, leaving it as is or undertaking an expensive re-engine of the plane. Our analysis indicated that the share price decline was not warranted as the company continues to transition to a higher margin, higher return and highly cash flow generative company with an order book that extends to almost 10 years. We believe that over time the A380 will be re-engined and as a consequence of increased crowding at airports will be a successful and profitable programme (although this is not factored into our financial modelling). Furthermore the company is a big beneficiary of a weak euro over time as they have a large euro cost base but sell primarily in US dollars and the benefit of the weak euro was not reflected in the company’s valuation at our entry point.
- American Express: We also took the opportunity to establish a position in American Express. We first analysed Amex a couple of years ago and since then, its strong balance sheet and capital position has become more apparent, as evidenced by its strong performances in the annual Federal Reserve stress tests. Earlier this year, however, its share price weakened sharply following the news that it was losing its co-branded card partnership with Costco in the US, lowering earnings in the near term. In part, the share price weakness also reflected concerns over claims by the US authorities that Amex is anti-competitive, although we believe that Amex has a strong case and the subsequent proposed remedies are not overbearing. After adjusting our forecasts, we believe that Amex soon returns to growth and that the market’s focus on the short term offered an opportunity for us to exploit.
Amex has a strongly spend-centric model with high attractive returns; and is a key beneficiary of both economic recovery and the network effects stemming from the structural shift from cash to electronic payments. Amex dominates the affluent customer segments, where its cardholders are high spenders and highly attractive to merchants. No doubt competition for these shall increase, but we attempt to control for that in our forecasts. Amex management have demonstrated the ability to adapt to a changing environment with new initiatives, e.g. to boost acceptance for its existing operations or even in entering new areas e.g. prepaid cards, while keeping control over costs to generate operating leverage. This is a high quality company where we believe the risk-reward is skewed to the upside.
- Halliburton: As the oil price collapsed in the second half of 2014, Halliburton’s share price almost halved as the outlook for oilfield service activity levels in 2015 deteriorated. While 2015 will undoubtedly be a challenging year for every company in the energy supply chain, we do not consider the future of correctly positioned oilfield services companies to be permanently impaired. Due to its financial strength and strong market position in a relatively concentrated part of the industry, the group has the ability to cope with the downturn better than most of its smaller competitors and can therefore emerge from this downturn a stronger company.
In addition to aggressive cost cutting and rationalisation to reposition the business for a tougher trading environment, HAL announced that it will merge with the number three player in the market, Baker Hughes. The combination of these two businesses will afford the group the opportunity to substantially narrow the competitive gap with its main competitor, Schlumberger. Despite being similar sized (both in terms of geographic exposure and product / service lines) to Schlumberger post the merger, the combined HAL / BHI has margins well below the industry leader (around 1,000bp lower in the ex-US business). This margin differential is largely a function of scale benefits at Schlumberger and over time the merged Halliburton / Baker Hughes should largely close this margin gap. This ‘self-help’ potential is not currently being recognised by ‘the market’ which remains fixated on the near-term challenges of 2015.
We have also sold a number of positions in the past few months largely as a result of share price appreciation and the company in question reaching our intrinsic value. Such sales include Fiserv, Citigroup and Allergan. The consequence of equity prices rising ahead of fundamentals is that holdings are more likely to reach our intrinsic value and therefore be sold. We retain our valuation discipline on selling as well as on buying and therefore sell when a company attains our target price.
Dependent on opportunities for purchase, such selling may lead to higher cash weighting in the Nedgroup Investments Global Equity Fund and over the quarter, this is exactly what has occurred with the cash level in the fund ending the quarter at just over 10%.