Oldfield Partners’ global equities investor day conference transcript.
Oldfield Partners (OP): Richard Oldfield = RO, Andrew Goodwin = AG, Richard Garstang = RG, Robert White = RW, Juliet Marber = JM, Harry Fraser = HF,
Oldfield Partners – Transcript
Richard Oldfield: Good afternoon everyone.
As usual we will spend 40-45 minutes on the presentation and then 15-20 minutes on questions. We will stop at 5pm for a 10 minute tea break and then continue in the German AGM model image, where we’re not allowed to leave until you have decided you have finished asking your questions.
This is an afternoon devoted to the Global Funds we manage. We’ll begin with performance (pg. 2).
When we last met we were pretty optimistic and we remain optimistic, about the potential in the portfolio for returns over the next five or ten years. The upside in the portfolio was higher than at any time since March 09. The upside remains at a very high level, having in fact been even higher at the depths of the market on 11th February which I think we’re going to look back on as the turning point. We will see. We’re below for the year to date in sterling terms, just below breakeven and that is a little bit behind the World Index. That follows a few years in which we’ve had a pretty rough time. I will explain first of all in overview terms why we remain optimistic and then we’ll get into the specifics of the portfolio.
We’ve shown you this chart before, which shows the performance of the MSCI World Value Index relative to the MSCI World Growth Index (pg. 3). It’s the bottom half of the MSCI World Index in value terms (price to book value, earnings and cash flow) against the top half of the Index. We’ve had this extraordinary period in which growth has out-performed value for longer than any time in my experience. It’s also been about as severe as at the end of the 90s which was obviously a quite exceptional period in terms of the polarisation of markets. The elastic gets ever more stretched. At some point it has to snap back. Of course the credibility of those who are pointing to the stretched nature of the elastic diminishes the further it stretches but it doesn’t make it any less true that the snap back when it comes will be very powerful. We’ve had eight or nine years of relative famine, we’re due for an eight year feast in relative terms.
This next chart (pg. 4) presents basically the same thing in a slightly different way. It shows the ten year rolling performance of value versus growth is now almost as bad as it was in 2000. Value has under-performed growth by roughly 2% per annum over the last ten years and that has not been matched since 2000. Of course this time it came from an even higher peak and so this has been a more severe period than that one.
Why might it change? We came across a chart from Franklin Templeton (pg. 5) which shows that the average return in the three years following a Fed Funds increase. There have been six occasions since 1974 in which the Fed Funds has begun to rise. So in those six three year periods this is the pattern of the average return. It shows in green the MSCI World Growth Index, which has done pretty well on average after a Fed Funds rise, up 30% over the ensuing three years which is equivalent to about 8% a year, a little bit below long term nominal equity returns The Value Index is plus 50%. Why might that be so? I think one reason is that if interest rates go up then you have to apply a higher discount rate to earnings and cash flow that are long into the future in order to justify the valuation of a growth stock. So a higher discount rate is bad prima facie for growth stocks.
The second reason is that you tend to see higher interest rates associated with more normal economies and that favors cyclical stocks and it’s very often the more cyclical stocks which are in value territory. That is certainly so for us now. I would say that for us the major risk is one of recession. We do not believe and have not believed that we’re going to see a recession in the US in the short term. We don’t see the ingredients for it. We’ve got low interest rates, a very low energy price, the consumer is pretty strong, car sales are strong, housing is strong. Those are not the usual precursors to a recession. If there is a recession, if we’re wrong, then we’ve got a problem, but if there isn’t, it seems to us that recession is embedded in the valuations of many companies, certainly many of those we hold. Therefore if there is no recession the upside is huge.
The second major dislocation in markets has been the outperformance of the US market over the last several years (pg. 6). We’ve seen the US outperform to an unparalleled extent, going through these previous peaks of outperformance. Now there is no sacred law to say that this line can’t go up and up. The US has been a wonderful place with a very resilient economy, a very low price of energy and a quicker policy reaction after the financial crisis, but it does seem to us that strength has been reflected in the valuations of the stock market. So again this is a piece of elastic which has got too stretched and it needs to reverse.
This next chart (pg. 7) shows that when the Fed Funds rate begins to rise then non US markets tend to outperform the US. This is again the average pattern of performance in the nine major periods of Fed Funds increases since 1970.
The chart on page 8 shows returns on equity in different markets. The point about this is that the US return on equity which is in the top, the grey line, has been much higher in recent years than in Europe or Japan but this is not a permanent state of affairs, Europe has quite often had a higher return on equity than the US, there is no reason why it shouldn’t have it again in spite of the headwinds which Europe faces compared with the US. There is no permanent guarantee that the US will always have a higher return on equity.
Japan is the dark blue line and its return on equity has been on an increasing trend. You will hear more from my colleagues as to why we think we’re quite likely to see that trend continuing.
Turning to the portfolio at the aggregate level these are valuation figures for the portfolio (pg. 9). We tend to have lower valuation measures on average than the market, that may not be so for every measure at every point but generally across the board the valuations of stocks in the portfolio will be lower than the average for the market. That is so now with a price to earnings ratio of 12 versus 19 for the market, the price to book is very much lower, not far off half. In return for that there is some sacrifice of return on equity but not very much in exchange for the lower valuation. Then finally the net debt to equity in the portfolio is a good deal lower than that of the market. We don’t like to combine very high operating leverage with very high financial leverage in the same company, we do make exceptions to that from time to time, Fiat for example was a notable exception, but generally we avoid that combination of financial and operating leverage and at the portfolio level the financial leverage will always be a good deal lower from that of the market.
Those measures over time have been lower for the portfolio than the market. Price earnings ratio is much lower than the market now, price to book much lower than the market now, price to cash flow much lower than the market and dividend yield much higher. The point I want to make in looking at the history of these things is that the gap is wider now than it’s been at almost all times in the past (pg. 10).
So that is the introduction. My colleagues will talk about some specifics. First of all, Andrew.
Andrew Goodwin: Firstly let me talk about the contributors and detractors. You can see here for 2015 one of the key things to note is that all the contributors are Japanese. That hasn’t continued into 2016 and you can see the worst performer year to date is Mitsubishi UFJ and I’ll touch on that in a moment. It’s also pleasing to see in 2016 two of our worst performers of recent years, Barrick Gold and Tesco, both up strongly in the year to date with Tesco up 30% and Barrick Gold up a whopping 80%. Richard will touch on Barrick Gold and commodities later.
First let me deal with Japan. We continue to be excited by the valuations we find there and the growing sense of corporate change that we can see. As you can see in this chart (pg. 12) here Japan still trades on a very low price to book, it’s low relative to its historic range and it’s also a significant discount to the US today. Now in Japan you can get very low returns from the corporates – in Japan today there are still around a third of corporates that have a return on equity lower than 5%. One of the key reasons for this is (on the bottom graph) the amount of net cash and large equity portfolios that are held on the balance sheets of Japanese corporates. Some 55% of Japanese corporates sit with net cash on the balance sheet and as a proportion of their market value it’s the highest globally. Then we have the large portfolios of equity holdings. They serve to depress the actual return on equity, but we are seeing signs of change in Japan.
In June last year a new corporate governance code meant that corporates must justify why they hold each holding to their shareholders and we’ve had the introduction of the new index, the Nikkei 400, which we’ve talked about previously. Inclusion in this index is importantly based on a return on equity criteria of 5%. Also the Bank of Japan is basing its purchases on the Nikkei 400. All of this is changing corporate behavior. It means that these corporates focus on the efficiency of their balance sheet and the returns and this can significantly drive shareholder value.
We are seeing these sleeping giants in Japan waking up across all sectors.
One such sleeping giant is Kyocera, which we hold in the portfolio. There are three key things I want you to take away about Kyocera. First of all this is a good quality business. It’s the market leader in packaged ceramics, it has about 80% market share globally. It is also developing battery storage solutions for its solar panel business, fuel cell technology. It has exciting long term growth prospects for this business, yet its return on equity is less than 5%. Why is this? This is the second key point, it’s the sum of the parts valuation (pg. 13).
Kyocera sits with about a third of its market value in net cash on its balance sheet. There’s another half of its market value in equity holdings, the largest of which is KDDI. All this serves to depress its ROE at the group level. If we strip the net cash and equity holdings out, not only does the core business itself trade on a p/e of less than 2 times and comparables in the market are on 13 to 14 times, but the return on equity is actually mid-teens levels.
The third point is there are signs of change here. KDDI is the largest proportion of the equity holdings and there’s a good reason why it holds KDDI, it founded that business and still supplies mobile phones and base stations to KDDI, which make up around 10% of its sales, so it’s a key customer. It hasn’t sold a share of this business since it IPO’d it in 1993, that is until this year.
It’s a small sale – they held 12.7% of KDDI and it has fallen to 12.4%. What we are seeing is an evolution, not a revolution…but speaking to the management at a recent company visit they say that this is the start of a process. They themselves cited the changing corporate governance environment in Japan and actually, the first time they mentioned this as a way to drive their own return on equity. This is the start of a process, we’re seeing this in Kyocera and across a raft of corporates in Japan. Importantly, this can drive shareholder returns irrespective of the underlying economic environment because these are assets that they hold on their balance sheet.
Now we turn to the banks. MUFJ, Mitsubishi UFJ, was one of the best performing shares last year in the portfolio, but it’s actually our worst this year to date. To some extent we have Mr Kuroda at the Bank of Japan to thank for that with his move into negative interest rates. This shocked the market in that only a week before he denied that such a move would take place. It is a negative for the banks, as it squeezes their interest income and, not surprisingly, the banks’ share prices reacted significantly. MUFJ was down around 40% on the back of this move.
We can understand why Kuroda has made such a move in Japan. He’s trying to shake Japan out of this 20 year deflationary mind-set that’s built up among the corporates and among households. If cash is going to be worth more in a year from now, or three years from now, it’s no surprise that corporates and the households hoard it. It’s perfectly rational behaviour, but as the flow of capital calcifies in Japan, the economic growth slows to a trickle. Kuroda with this move is attempting to open the floodgates.
Today, we can buy MUFJ on a price to book ratio of 0.4 times (pg. 14), that’s a significant 40% discount to its global peers, even in Europe where we also have negative interest rates. Importantly, MUFJ has a very strong balance sheet. One of the key attributes we like is the strength of this balance sheet. In terms of liquidity it has a 70% loan to deposit ratio, so has ample liquidity. It also has a large portfolio of equity holdings which it is now reducing and committed to reduce over time. Again, having met the CFO for the bank he stated that this move by Kuroda will cause them to be more aggressive in the sale of these equity holdings and that will realise significant profits from capital gains. We think that the bank will continue to do very well and the banks will be great beneficiaries of Kuroda’s policy.
Now I’d like to hand over to Richard Garstang to talk about another bank that we own.
Richard Garstang: Thank you Andrew. I’m going to talk about Citigroup which has also had a tough start to the year. However we do remain excited about this investment and see upside of more than 50%. I’d like to start with a bit of background.
We’re approaching 8 years since the great financial crisis and banks around the world are still working through the consequences of the crisis. Citigroup was badly hit and required significant support from the US Government. New regulations impacted both its capital positon and its underlying business. New management and a recovery plan were put in place. They worked on paying back the Government’s support, they reduced their leverage, they improved their capital ratios, they closed down certain businesses and they created a bad bank called Citi Holdings. However the share price was not reflected in this improved outlook and we were able to buy Citigroup in May 2012 at just half its book value.
So what does the bank look like now? As part of the restructuring Citigroup split itself into a good bank called Citicorp and a bad bank called Citi Holdings. The good part Citicorp is comprised of two divisions, Global Consumer Banking and Institutional Client Group. Global Consumer Banking focuses on personal loans and credit cards. It’s a global franchise and current operating trends are very favourable. It’s got loan growth, good net interest margins, excellent cost control, stable credit and returns in this business are generally excellent.
The Institutional Client Group comprises banking services for large corporates and involves activities like treasury solutions, corporate lending, M&A advisory services and fixed income and equity trading. It’s been widely publicised that all these businesses have been struggling recently.
Finally there is Citi Holdings, the bad bank. In recent years this has been loss making and a drag on the overall group’s profitability. However as this chart (pg. 15) shows on the right, when Citi Holdings was first established in early 2008 total assets in this bad bank were 900 billion dollars, there were a lot of bad assets to work through. However over the last 7 years you can see assets have just fallen to 70 billion dollars which comprises 4% of total assets and this “bad” bank is now performing and generating a profit for Citigroup.
So what is the current outlook? We’re now starting to see underlying loan growth, which includes the recent purchase of the Costco credit card loan portfolio. The net interest margin is stable and, whilst a dangerous prediction, the US does appear less likely to adopt a negative interest rate policy. There are some non-interest income pressures from the trading activities I just talked about. Cost control remains excellent, while still investing in new parts of the business. C credit also remains excellent, although we do allow for some increases in provisioning given where we are in the credit cycle and with exposures to the energy sector.
Finally, I’d like to talk about capital and valuation. Citigroup remains one of the most well capitalised banks in the world with a core equity tier 1 ratio of 12% and capital continues to grow at a good pace. While reassuring in one sense, this high level of capital actually has a negative impact on return on equity. Citi can’t leverage its return on assets to the same extent as other banks around the world. So a key next step in the investment thesis is being able to return capital to shareholders and it does this via a stress test each year with the Fed. Last year it passed the stress test and subsequently returned almost 7 billion dollars to shareholders through share buy-backs.
We expect Citigroup to continue to pass the stress test. It’s now a much better bank with a strong capital position and as a result we think capital will continue to be returned and buy-backs will increase. This will drive growth in earnings per share growth and book value per share.
In terms of valuation we believe Citigroup can achieve earnings per share of over $5, which means the implied price to earnings multiple is less than 8 times. Tangible book value is currently $65 per share and that compares to a share price today of $42. So you can buy this company at just 0.6 times its book value. As you can see in the chart on the left (pg. 15) this is towards its historic lows.
We believe that the fair value of Citigroup is 1 times book value, so $65, and that gives an implied upside of more than 50% from today’s level.
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