Fund Insights: Value Investing Amidst Volatility
Senior Vice President, Investment Management, Portfolio Manager
Senior Vice President, Investment Management, Portfolio Manager
Vice President, Senior Investment Director - Equities
We sat down with the Mackenzie Cundill Team leads to understand how they are managing the volatility in global stock markets and how they are positioning their funds.
It has been a tough environment for value stocks. Why should investors stick with value?
Value and growth styles are cyclical and there is plenty of research that shows these styles go in and out of favour for years at a time. For example, the dot-com era in the late 1990s was followed by a value resurgence in the early to mid 2000s. We have included a chart below showing the longerterm outperformance of the value style over growth. The past 10 years have been very challenging for value investors trying to keep pace with growth, with the MSCI World Value index underperforming its growth counterpart. More recently, Bernstein published research, "Global Quantitative Strategy: Supportive sentiment + tentative macro turn + wide dispersion = Buy Value", March 6, 2019, which demonstrated that valuations between growth and value stocks are at their widest since 1951. They found that when this happens, there is typically a reversion of performance, that is, value stocks begin to outperform growth.
What is your view on 2018 and where are you finding opportunities around the world?
2018 was a tumultuous year of performance in global markets, with volatility dominating the first and fourth quarters. The year started with concerns over Trump's tariffs on aluminum and steel imports, U.S. - North Korea tensions and rising worries over China-U.S. trade as well as the fear of a Federal Reserve policy mistake. That culminated in panic out of risk-on assets (e.g. banks, energy, industrials, technology) and into perceived safety such as cash and utilities stocks, in the fourth quarter.
The disappearance of risk appetite and tax-loss selling in markets during Q4, particularly of holdings in Cundill funds, is akin to holding a beachball under water. We believe that once the selling pressure eases and shares begin to reflect fundamentals again, the beachball will pop right back above the water.
The fourth quarter was characterized by investor worry, panic, and capitulation. The panic engulfed many cyclical sectors including energy and financials which are overweight in our portfolios. The selling pressure was further exacerbated in our opinion by technical, algorithmic, and short-selling traders especially in the energy space. This happened against a backdrop of trade war concerns, relatively weak economic data, and an inversion in the 2-5-year segment of the U.S. government bond yield curve (short rates higher than long rates). As a result, there was a sudden and dramatic disappearance of risk appetite in the marketplace. Deep value stocks, which trade at substantial discounts to intrinsic value because they tend to be in various stages of operational improvement, financial deleveraging, business turnaround or restructuring, were indiscriminately discarded by the market as market risk appetite vanished.
Given the market volatility during the year around some names, the Cundill Value Fund has gradually built a position in General Electric (GE). While GE faces several challenges going forward, we believe that a significant amount of negative news is now discounted into the share price. For instance, excess capacity in the large (>100 MW) gas turbine market is well-understood; actuarial assumptions in the company's long-term care insurance closed book (not actively marketed) have been updated, in conjunction with GE's January announcement of $15B in statutory reserve contributions over the next 7 years; and GE's dividend was cut to $0.04 per annum from $0.48 previously. This last move will conserve $3.9B in cash each year, an important step as GE seeks to both de-lever its balance sheet and address its residual liabilities. While the dividend cut was disappointing to some and may result in yield-oriented investors and related passive funds liquidating shares, it does not impact our assessment of the intrinsic value of the business.
Over the past year, former CEO John Flannery enacted what we believe were crucial steps in advancing GE's turnaround. We believe that current CEO and Chairman Larry Culp is the right person to address GE's lingering issues (continued challenges in GE Power and separately, liabilities related to legacy subprime mortgages), given his vaunted track record as CEO of Danaher. GE's board has been high-graded; the cost structure at GE Power and Corporate is being right-sized; and asset sales have generally occurred at attractive multiples. Given that GE shares are trading with an attractive margin of safety, we believe that any further weakness would present an attractive buying opportunity.
In Japan, there are signs that the corporate sector has improved its focus on shareholder returns in the last couple of years due to reforms initiated by the current Japanese government. As we look for value opportunities in Japan, we have focused our attention not only on cheap valuation, but also on the companies' likelihood to deliver drivers that can rerate the stocks. For example, when we invested in Hitachi, our thesis included management's plan on cutting cost, exiting non-core business, and improving cash conversion, in addition to low valuation.
This attention to shareholder returns is also reflected in our new investments in Japanese company Mitsubishi Electric. The Company is a leading provider of factory automation, automotive parts and air-conditioners. It has strong market shares in most of its segments and the company continues to invest in new technologies to maintain its leadership position. Its factory automation business contributes about 40% of the company profits. We believe this market has significant room to grow in the long run driven by the need to reduce labor cost, improve quality and reduce raw material waste. With its leading position in programmable controllers, inverters and AC servos, Mitsubishi Electric is well positioned to benefit from this growth opportunity. The automotive components business has above industry margins with exposure to electric vehicles—given the company's leading position in inverters, motors, and high-voltage power components. The airconditioning business should benefit from growth in ductless installations as governments seek to reduce emissions and corporations seek to improve building energy efficiency.
Mitsubishi Electric has no net debt, with 277 billion yen in net cash. Management has delivered dividend increases as one of the drivers of shareholder returns. Dividends have increased to 40 Yen/share in F2018 from 27 Yen/share in F2017. This was the first increase since F2015, when management increased the dividend from 17 to 27 Yen/share. In addition, in F2016, the board started using return on invested capital (ROIC) as a performance indicator to improve asset efficiency and working capital efficiency in all business units. This helped increase an important profitability measure, Return on Equity, from 10.9% in F2017 to 12.6% in F2018.
What catalysts do you anticipate to drive your value style?
We believe what we saw in Q4/2018 was a "global growth scare". Although global growth is slowing down, recession risks remain low. As the costs of the trade war increase on both sides, we believe the U.S. and China are incented to reach a deal where both sides can claim victory and provide businesses and consumers with more confidence. Such a deal should bring relief to the markets.
We view the following catalysts will help the value style.
- U.S. - China trade negotiations
- Base case is that we see resolution that will provide certainty to the market
- Delay could increase uncertainty causing volatility
- OPEC cut 1.2 million barrels of oil equivalent/day
- Expiry of Iran sanction waivers to eight countries - early May
- Sentiment change
- Chinese government stimulus and further rate cuts
- Continued strong labour markets and strong banking sector earnings dismiss fear of recession
- Depressed valuations in our holdings getting re-rated to reflect underlying fundamentals
Why should investors invest in Cundill Value or the other Cundill mandates?
We believe that valuations matter and ultimately investors will recognize the significant disparity between growth and value stocks. Value investors have taken their lumps in the past decade. However, if history is any guide, we believe the return to value investing will come.
We have not changed our process. We continue to uncover stocks that are unloved, underappreciated and out of favour. The stocks in our portfolios are delivering on the catalysts we expected to see and we are waiting for sentiment to change to drive share prices.
For more information about the Mackenzie Cundill Funds, please contact your financial advisor.