Fundamental Thinking in an Uncertain World
by Jimmy Desai
What do Rolls-Royce and John Deere have in common? The answer would be – not much! The former, a storied British engineering firm, evokes images of quality engineering and luxury1. The latter evokes the image of a humble farmer riding atop his green machine. For our purpose though, what the two do share in common is the level of uncertainty facing their core businesses and how their share prices react under such situations. In this article, we would like to share with you our view on how we use fundamental thinking to look for opportunity in the midst of uncertainty and how we harness these opportunities to deliver returns for our clients.
A well-known adage is that financial markets hate uncertainty, and there is plenty of anecdotal evidence to back that up. If an uncertainty-inducing event occurs, most people would agree that individual stock prices will move substantially more than broad market indices. Empirical evidence also backs this up. Figure 1 shows the number of days where the price movement in the respective security exceeds 5%. Since 1970, the S&P 500 index moved more than 5% on only 38 days2; whereas just since 1990 Rolls-Royce and Deere share price moves have exceeded 5% on 223 and 201 days, respectively! In other words, stocks are typically more volatile than the major indices. When put this way, perhaps it doesn’t seem like such an epiphany now, does it? This volatility leads to situations where stock prices diverge from their intrinsic valuation. When armed with the knowledge about a business and its valuation, one can assess whether a stock is under or overvalued, and hence this volatility can be harnessed to our benefit. Let’s look at how through our two examples.
Figure 1: The volatility in Rolls-Royce and John Deere far exceed that of the S&P 500.
1 Rolls-Royce cars – usually what one thinks of when the name is mentioned – are actually produced by BMW. For a history of how a German company now has the license and rights to manufacture cars of a British marque, see a brief history here.
2 21 days down more than 5% and 17 days up more than 5% = 38 days exceeding 5% absolute
Warning: Building Empires May be Fatal for Your Career
Rolls-Royce (RR) is primarily an engine manufacturer with products ranging from gas turbines (used in planes and ships) to internal combustion engines (for use on ships, trains, heavy off-road vehicles, and as generators). Other aspects of the business include designing and building nuclear reactors for the submarines of the Royal Navy, providing various instrumentation and control systems for civilian nuclear power stations, as well as designing entire ships (remember the Boaty McBoatface?), and providing an assortment of components for use on these ships.
On the back of no less than five cuts to management guidance for revenue and profitability, RR’s share price steadily declined from a high of more than £12 in 2013 to a low of £5 in late 2016. For reasons only they know – though likely related to empire building – management redefined Rolls-Royce from being primarily an aero-engine company to being a company that manufactures engines for all applications. In the process of expanding into these other domains, the company started taking cash from a very profitable line of business (aerospace) and started using it to expand in not-so-profitable lines of business (marine and land), mostly through acquisitions. To make matters worse, collapsing commodity prices in 2014/15 decimated demand in the non-aero side of the business. The CEO and CFO were effectively fired after they cut their guidance three times. Once a new CFO was appointed, he cut guidance once; and shortly thereafter, the newly-appointed CEO duly cut the guidance yet again. “Kitchen sinking” of expectations by a new management team is nothing new. The process allows them to cleanse the junk without getting their hands dirty3; and more importantly, it lowers the baselines so that subsequent years have a low starting point and even marginal results look amazing in comparison.
In this case however, the cuts were well deserved. The new team also rightfully suspended the wasteful share buyback and also cut the dividend in half. Naturally, fatigue set in with the investors and sell-side analysts. The press jumped all over the matter and even the UK government expressed its concern4. It became fashionable to dump the shares and many investors went to great lengths to express their frustration with the company5. Most of the sell-side analysts now hated the stock and cut their target prices to well below £5.
Naturally, your always-curious investment team decided to take a look. If everyone hated the stock, and the fact that the shares fell more than 30% (at the time), it meant there just might be some value there. Yes, the company was bloated and slow in decision making, the disclosure was lacking, and while they had a great set of products and services, they weren’t being deployed optimally. Yes, the opaque accounting did not help. Yes, there were worries around the actual profitability of core business model - selling engines at a loss initially and recovering profits through long-term aftermarket servicing6. But at what price did this all cease to matter? The key was to establish whether this was a value trap or a value investment.
The new CEO, Warren East, presented a reasonable turnaround plan and this reinforced our interest. We took a detailed look at the company’s operations, the prevailing end-market conditions, and East’s turnaround plan and determined that a lot of negativity was already reflected in the stock price. The flip-side of the accounting issue was that for those who did bother to spend the time understanding what was truly going on, it was actually a source of value since most people just reflexively discounted it7. Upon valuing the company (Figure 2), we found that only in an extremely negative case would the shares be worth less than £6. In a scenario where only the aerospace division was profitable8 and the rest just puttered along, the shares were worth around £9. If East’s cost cuts and realignment bore fruit, the valuation would easily exceed £10.
3 “Hey, we just started. It’s not our fault!”
4 The Health of Rolls-Royce Matters to the Nation, BBC. Link.
5 Star fund manager Neil Woodford dumps entire Rolls-Royce stake. The Telegraph. Link. Original post here.
6 This model is fairly common in the industry, and also in other industries, such as Gillette razor blades, HP printers, etc.
7 Rolls-Royce and Netflix shouldn’t have a valuation in common, Bloomberg. Link.
8 Rolls-Royce has an almost 60% market share on the Airbus A330, 50% on the A380, and about 45% on the Boeing 787 and 777. They are also the sole supplier for the new A350 and the A330neo. RR delivered approximately 300 civil engines up to this past year, but will ramp up to 600 engine deliveries by 2019. The model showed that the downside was very limited if they continued to deliver and service only 300 eng
Figure 2: The chart reflects the valuation range when we analyzed Rolls-Royce and the corresponding share price movement since our purchase in October 2015.
Source: Bloomberg, M&P Research
A useful reminder here is that “value” is different from “price”. “Value” refers to the fair price of a business under a given set of circumstances, whereas “price” is what the business is currently trading for in the market. It is this divergence between value and price that allows one the opportunity to buy undervalued businesses (when price < value) or to sell overvalued ones (when price > value). Of course there are many assumptions one must make to derive these valuations, but it was fairly clear in Rolls-Royce’s case that even with conservative estimates there was a very high margin of safety.
We are always cognizant about the risk-reward ratio for our stocks, and use it as a guide for when to buy, how much to hold, and when to sell. In RR’s case, we felt that getting in below the £7 mark would significantly skew this ratio in our favor. With our current average price of £6.6, the ratio is 10% downside to ~50% upside; truly making it a case of Mohnish Pabrai’s “heads I win, tails I lose only a little.” This sets us up in a position to take advantage of the volatility to the upside. Sentiment could undoubtedly drive the shares below £69, but they shouldn’t stay there for a long time. We started with a position weight of 0.75% (in late 2015) in both our International Equity Pool and Global Dividend Growth Pool. Over time as management delivered on their promises, the downside risk gradually diminished and we felt comfortable increasing our position weight to 2.0% today. The share price as of writing is around £8.3. We will continue to add as the thesis evolves, and if the shares are overvalued at some point in the future, we will consider selling entirely or reducing our position.
9 And it did. The shares bottomed around £5, but they promptly rebounded within 3 months to above £7.
Jet-Powered Tractor Anyone?
Unlike Rolls-Royce, John Deere didn’t go through any internal turmoil. The company is run in an extremely disciplined fashion and it would be tough to find major faults with their operations. Even Warren Buffett, through Berkshire Hathaway, held more than 5% of the company. There can’t be any greater seal of approval! Deere’s problem was related to the evaporation of demand in the agricultural segment, which accounts for nearly 80% of the company’s operating profit. High crop prices from 2010 to 2014 combined with low interest rates had incentivized farmers to upgrade their equipment at such a rapid pace that the average fleet age fell to a record low10. When crop prices started tumbling in 2014, it didn’t take long to figure out that demand for agricultural equipment would fall precipitously.
The unforeseen collapse in oil and other commodity prices hurt further as demand for heavy construction equipment in the shale oil and mining sectors also dried up. Deere’s management thus guided to a 25% drop in sales in 2015. Initially the shares did not react much11, but nevertheless we decided to work on the stock just in case it did fall. We used the same approach that we used to analyze Rolls-Royce. At what point does the lack of sales become irrelevant? If demand evaporates to a level even worse than what management expects and from there recovered just gradually12, what is the company worth?
With a reasonable level of negativity built in to our valuation13 (Figure 4), we felt that in the worst case, the stock would be worth around $70. Using slightly less pessimistic assumptions, we obtained $80. However, if we modeled the demand returning to previous levels over the next five years, the stock would be worth well over $100. With that in mind, we waited. Despite the negative guidance, Deere’s shares did not fall until late 2015. In August 2015 the market finally lost faith and the shares collapsed to the mid-$70s. We did not buy immediately but added later around $78. The risk-reward at this point was similar to Rolls, with roughly 10% downside to 30% upside, a return skew that favours us.
10 Fleet age is the average age of all the vehicles currently operating in the economy. At the time, the average fleet age was around 5 years for combines and 7 years for tractors. The average life of these machines is typically 15+ years.
11 The market was also aware of the issue, hence Deere’s share price had been range bound between $75 and $95 from 2013 to mid-2015.
12 That is, no “V”-shaped recovery. We modeled revenue collapsing by 30% and thereafter recovering at a gentle 2.5% rate annually, with profit margins never recovering to their former glory days.
13 Achieving this “reasonable” level of negativity requires an understanding of the company, the industry, some judgment, and experience. If we used overly pessimistic assumptions, we would never be able to buy anything because the implied downside would always be far too low!
Figure 4: The chart reflects the valuation range when we analyzed John Deere and the corresponding share price movement since our purchase in April 2016.
Source: Bloomberg, M&P Research
Notice, we did not call for the turnaround of the agriculture cycle; we did not forecast crop (or oil) prices returning to previous highs; nor did we predict when the equipment sales would turnaround. We just knew that despite the low crop prices, crop production remained high and that farmers were using their equipment, which meant that they would have to spend money to maintain and eventually buy new equipment. There would always be some level of underlying demand and if we valued the shares using that level of demand, the chances of us losing money over the long run would be limited.
The election of President Donald Trump and the accompanying expectations of reflation, infrastructure spending, building “The Wall”, and corporate tax cuts drove up Deere’s shares by 25%, easily outpacing the 11% gain in the S&P 500. On merely expectations, not any actual improvement in demand, Deere’s shares flew past the $100 mark and reached $110. Since the election, Deere’s management has guided that while they expect an improvement in their sales, they expect profits in 2017 to remain flat relative to 2016, i.e. 55% below the peak in 2013. Yes the tax cuts could improve profitability14, yes a huge spike in infrastructure spending would be beneficial, but the rally already priced in much of this. With shares priced over $100 and no immediate improvement in profits, we believed that the upside was limited and that the downside risk was now much greater. Bad news or a change in sentiment could collapse the share price rapidly. We thus started selling our shares and fully exited our position at $110. While usually we take pride in being different from the crowd, it was quite heartening to find out later that Berkshire Hathaway also exited its entire $2+ billion position around the same time!
Got it: Buy Low, Sell High!
It’s of course not a brilliant new insight: buy low and sell high. Everyone knows this. But the reality is that it is difficult to execute in practice. It is very difficult to buy a meaningful amount of shares when they are falling with seemingly no bottom, everyone hates the stock, and the macro scene looks bleak. Yet it is what must be done. Once an opportunity has been deemed to be an investment rather than a trap, and the skew of returns is to the upside, one should buy. Emotionally it is a difficult thing to do, but it is important to remove emotion from the equation. We use our investment process and philosophy as a guide to help us identify the correct opportunities and separate the wheat from the chaff15.
While we presented two individual examples here, we have applied this concept many times across the portfolios. Over the course of the last couple of years, by analyzing and buying companies on a bottom-up basis, we eventually ended up being overweight in financial and technology stocks when nobody liked them. As investors later started snapping up these shares, we have been selling them down profitably and have been gradually reducing our overweight position in those sectors. Concurrently, we are finding many opportunities in the healthcare sector as investors have been turned off by the discussion on cutting drug prices and the replacement of Obamacare. Some of these stocks have reached valuations where we feel that a lot of negativity is already implied in their prices, and hence we have been building up our positions in these companies. While we cannot say if and when the cycle will turn, which in turn means some risk of underperforming in the short run, we believe that the chances of us losing money over the long run is limited16. If we continue to execute diligently in line with our process and philosophy at the stock and portfolio levels, our clients’ portfolios should grow steadily over the long run. Because ultimately, fundamental thinking should deliver results in an uncertain world.
14 Or would they? One view point is that competition would erode away the benefits of tax cuts. The ultimate beneficiaries would be the consumers, not the corporations.
15 Pun intended.
16 We are not saying that we will never lose money. Anything is possible! What we are saying is that the chances of us losing money over the long run are limited.