Stability at a reasonable price

April, 2012 Print

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NIGEL MASDING OF LONGVIEW PARTNERS EXPLAINS WHERE HE SEES ATTRACTIVE GLOBAL EQUITY OPPORTUNITIES IN AN ENVIRONMENT OF MACROECONOMIC UNCERTAINTY AND A SCARCITY OF GROWTH

Macroeconomic uncertainty and scarcity of growth are two of the major challenges that equity investors face today. The apparent response has been for investors to concentrate on the more obvious sources of stability and growth. For example, the traditional defensive companies and global growth companies, which are now trading at a significant premium to the market. To us, neither are attractive.

Here at Longview, we believe that the market is not paying appropriate attention to a set of companies that do not fit into either of these two categories, yet still offer stability and predictable growth. Many of these companies trade at below market multiples and offer attractive upside potential. We call these opportunities “Stability at a Reasonable Price”.

Equity strategies in vogue Investors, and subsequently markets, have been driven by macroeconomic events, to an unusual extent, over the last four years. The extent of these risk-on/risk-off swings, combined with generally disappointing economic growth, has pushed investors towards two equity investment strategies: 1) Traditional defensive companies that provide some protection against this macroeconomic uncertainty. 2) Global growth companies that offer superior growth prospects in a world that is growth-constrained due to their favourable geographic exposures, particularly in the emerging markets.

Most traditional defensives sectors, bar those in healthcare, are now trading at valuations well above their recent historical averages. As illustrated in Figure 1, the forward consensus P/E ratios for tobacco and utility companies in the US are now at almost the highest levels seen for 10 years and those in the food, household product and telecoms sectors are well above their 10 year average. Amongst the consumer staple companies, only beverage companies are valued in-line with their 10 year history, but these have seen a sharp deterioration in their revenue prospects as beer and carbonated drink volumes decline in the developed world.

One of the primary reasons for this flight to traditional defensives is that investors have been chasing dividend yield, which is not surprising in the current interest rate environment. However, as a note of caution, our analysis shows that high dividendpaying companies are now trading at premiums not seen since the late 1970s.

Global growth plays have high expectations

Now turning to the global growth plays, which offer good growth prospects in a macro-environment where growth is scarce. In our mind, expectations for many of these companies are too high. Most notable are the emerging market consumer plays, which are a very popular way to exploit emerging market growth. The basis of this investment thesis is to exploit the growth of the middle classes in the emerging markets, who undoubtedly will consume in a similar manner to the western world as their incomes grow. One of the most significant opportunities is in China, where the current 5-year economic plan, as issued by the government, emphasises the development of domestic consumption, after years of focusing on exports and infrastructure spending.

However, valuations for emerging market consumer plays are now at new 20 year relative highs versus the market, as shown in Figures 2 and 3. Whether investing directly in emerging market consumer companies such as Want Want, a Chinese snack and beverages company, or indirectly in developed consumer companies that have high exposure to emerging market consumer companies such as Unicharm (a Japanese diaper company with exposure in developing Asia), these companies look expensive.

Indeed, to own these companies one must assume both high levels of growth, as well as sustained high margins, for many years merely to justify current valuations. Currently, we are not comfortable making such aggressive forecasts and fear these companies will disappoint at some stage.

The luxury goods companies are particularly good examples of these global growth favourites. Their growth prospects are very enticing. Around 20-30% of their revenue now comes directly from sales in China or from travelling Chinese nationals, and these revenues are growing at more than 25% per annum.

However, this growth driver is well known and valuations imply very high expectations for these companies. Luxury goods companies are trading at high price to earnings (P/E) valuations versus their own history, which was only previously surpassed during the dotcom boom (Figure 4). Similarly, these companies have never been anywhere near as expensive on a price-to-book basis (Figure 5). Although these may be good quality companies, in our view there is a high risk of them disappointing at some stage.

Stability at a Reasonable Price

At Longview, we believe that the market is not correctly recognising the stability of a number of company’s business models which, as a result, are trading at very attractive valuations. Examples of this include companies such as Oracle and Brenntag.

Oracle is a good example of Stability at a Reasonable Price. Oracle dominates the corporate database software market and is also a significant participant in the applications software business. When it sells a new software licence, it also provides on-going maintenance, upgrades and support, which accounts for the majority of its profitability and value creation. Customers need to take this service to protect their significant IT investment and Oracle is able to charge 22% of the original licence fee per annum for this service. This is a very sticky and stable revenue stream and Oracle achieves in excess of a 95% renewal rate per annum on these contracts. Like its peers, Oracle is witnessing continued growth in its licence sales and associated maintenance revenue streams, as corporates continue to invest in data and information capabilities in order to improve their competitiveness. Despite the attractiveness of its growing, stable and long-term maintenance revenues, the market only values Oracle at 11.0x 2013 earnings, which is approximately a 20% discount to the S&P 500.

Another example of Stability at a Reasonable Price is chemical distribution company, Brenntag. Brenntag is often wrongly grouped by the market with chemical producers, which are anything but stable. However Brenntag is not a chemical producer and is in fact a relatively stable company. Firstly, it is not subject to the cyclical swings in profit margins experienced by the chemical manufacturers, as it passes through the chemical prices to its customers. Secondly, Brenntag sells very little into the cyclical construction and technology industries and instead has far greater exposure to stable endmarkets such as household and food products. As such, it experiences stable volumes and gross profit through the economic cycle. As the largest chemicals distributor globally, Brenntag benefits from economies of scale, through pushing more volume through each distribution centre and as a consequence of having more distribution centres has less distance from each centre to its customers, and hence lower transport costs. In addition, it has demonstrated good capital allocation decisions through successfully acquiring small competitors and consolidating their business into Brenntag’s network, at similar valuations to its own market price before the benefits of synergies. However, most importantly, for this stable business with low single-digit growth, you pay less than market multiples. We have owned Brenntag since it IPO’d in 2010 and we still see upside to be in excess of 20%.

At Longview, our rigorous, bottom-up investment research process has identified many such companies, which currently make up the majority of the holdings in our portfolio. These companies typically have the following attractive characteristics:

•Recurring or predictable revenue streams •A low, but acceptable level of cyclicality •Low asset intensity and high returns •Modest, but sustainable long-term growth drivers, which are either company or industry specific •Good allocation of capital

We believe valuations are modest for these companies, with the average 2013 P/E for companies in our portfolio coming in at just 10.6x, based on our forecasts. This equates to approximately a 15-20% discount to the S&P 500. More importantly, in terms of cash flow, which is the metric we prefer to look at, on average these companies trade on an 7.8% free cash flow (FCF) yield, with reasonable expectation of FCF growth going forward. have seen a sharp deterioration in their revenue prospects as beer and carbonated drink volumes decline in the developed world.

 

 Nigel Masding
Research Analyst
Longview Partners

FOCUS Global Equities

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