In the words of American investor Howard Marks: “What matters most in determining the success or failure of an investment isn’t whether it’s in a fast-growing company, a desirable asset or a highly-rated security, but rather the relationship between the price you pay and what the asset is worth.”
In 2018, the South African economy entered a technical recession for the first time since 2009. What followed were articles in the press containing lists of recession-proof businesses that investors should hold as bulwarks against declining GDP numbers. This theme will no doubt grow in fervour as South Africa gets closer to national elections in May. The political uncertainty that comes with a hotly contested election raises perceptions of investment risk. Such articles typically put forward the argument that businesses with steadier profit margins and more stable growth profiles are less risky investments.
At RECM, however, we believe investment risk is the possibility of a permanent capital loss caused by paying too much for an asset.
Businesses surrounded by negative sentiment receive lower market valuations as they are usually seen as risky investment propositions. But it is this negative sentiment that translates into low investment risk: negative sentiment causes market participants to forecast lower future cash flows with depressed cash flows extrapolated into the future, or to discount cash flows at higher discount rates due to perceived higher risk.
If the adverse future outcome does transpire, since it is already reflected in the low price it is less likely to result in a permanent loss of capital. And the investment outcome will be positive if the future turns out to be even marginally better than expected.
The opposite also applies. Businesses surrounded by positive sentiment and high expectations typically trade at high market valuations. But the market may well be pricing in an overly optimistic future for these businesses while ignoring any possibility of tough times ahead. If the business simply does not live up to these lofty expectations, the investment outcome will be disappointing.
Investment opportunities seldom present themselves by way of low prices unless there is negative sentiment surrounding the business. As such, negative sentiment around a business, sector or industry should in fact pique an investor’s interest rather than be avoided entirely.
A portfolio of businesses that all have low expectations attached to them could be described as a collection of businesses at recession-proof prices.
Fortunately, the South African mid and small cap landscape contains many businesses trading at recession-proof prices. An example that has found its way into the RECM Equity Fund top 10 holdings is Stefanutti Stocks, a local construction and earth-moving business.
The construction sector is littered with business failures, problem contracts, capital leaving the industry and the still-recent memory of Competition Commission fines. Basil Read, Esor and Group Five have all recently gone into business rescue, and sector darling WBHO has disclosed that it is encountering difficulties on a contract in Australia. Murray & Roberts has exited the local construction sector for all intents and purposes, while Aveng has decided to focus on its Australian construction business and contract mining operations as it too turns its back on the local construction industry.
It is no surprise that Stefanutti Stocks is perceived to be a risky investment proposition given all of this negativity in the sector. But with its current share price trading at only three times its current earnings, we believe the investment risk at current prices is low. (By way of comparison, the average South African business trades at around 13 times current earnings.)
All else being equal, good returns are likely when assets that are priced for disaster recover, and poor returns are likely when assets that are priced for prosperity disappoint.
Cheap opportunities are not limited to the South African mid to small cap space.
A recent addition to the RECM Global Fund is French-listed car manufacturer Renault – another business that has been in the news for all the wrong reasons of late.
There are many popular reasons for an investor to steer clear of the automotive sector. The current narrative is that the industry is ripe for disruption from technological advancements that vary from autonomous driving vehicles to electrified vehicles and the rise of the mobility sharing economy. Talking heads and many analysts are forecasting that this disruption will lead to significantly reduced levels of demand that will reduce the growth profile for car makers.
It hasn’t helped sentiment surrounding the industry that Chinese vehicle sales have contracted for the first time in two decades.
These low expectations have translated into a market valuation that can, at best, be described as paltry.
Renault is currently valued by the market at three times its last reported earnings. This means the market expects Renault to produce another three years’ worth of earnings at the same level as in the last financial year, and no more beyond this!
Renault produces approximately 3.7 million cars annually. Automobile manufacturing rightfully has a reputation for poor economics, with thin operating margins that fluctuate from profit to loss and back again on a fairly regular basis. But some manufacturers combine these manufacturing operations with profitable sales financing operations – Renault being an example of this.
Additionally, Renault owns 43% of Japanese car maker Nissan Motors – a larger and more profitable car maker than Renault. The market appears to be completely ignoring the value of this significant stake in Nissan Motors in its assessment of Renault.
The valuation assumptions for Nissan do not have to be too optimistic before we arrive at the scenario where the value of Renault’s investment in Nissan is greater than Renault’s entire market capitalisation. This implies that an investor can pay for Renault’s stake in Nissan Motors and get Renault’s car manufacturing and sales financing operations for free.
Points raised by car industry naysayers are valid but market participants are placing a lot of emphasis on the extent of the disruption and the corresponding impact on car makers’ earnings, while ignoring their ability to leverage their manufacturing expertise and distribution footprint to adjust and thrive within a digital and carbon-free future.
Investment ideas surrounded by negativity do not make for the most enviable shares to mention during cocktail party conversations. But the best way of stacking the odds in favour of limiting permanent capital losses is to pay low prices for the businesses you invest in – when the business is out of favour, and expectations are low.
If the business continues to report disappointing news, the effect on the share price is often minimal. The market has already anticipated bad news and has no need to knock the price down much further. Conversely, when things turn out to be rosier than expected, the price can rise quickly and dramatically. This asymmetrical payoff profile stacks the odds in the investors’ favour, mitigating the risk of permanent capital loss and giving capital the best chance to compound off a low base.
‘The secret to happiness is low expectations.’
– Barry Schwartz, American psychologist
Psychologists argue that happiness depends not on how well things are going, but on whether things are going better or worse than expected. Successful investing works in precisely the same way.
Richard Court is a portfolio manager at RECM.