Macro panic creates value opportunities at the stock level (again)

9 marzo, 2022 | 11:00am

Ian Lance

Here we go again. We had optimistically thought that the withdrawal of central bank stimulus would bring an end to a decade in which fundamentals and valuation counted for nothing and the only game in town was guessing the next move from our monetary central planners. But here we are again. The Russian invasion of Ukraine has brought the macro punters to the fore once again with the bet that high commodity prices will lead to a recession and hence the trade du jour is once more to sell cyclicals at any valuation and buy defensives or ‘quality growth’ at any valuation. Whilst this is frustrating to observe, as the share prices of many already lowly valued companies get cut in half purely because they could be loosely described as cyclical, it is also exciting because it expands the opportunity set of very lowly valued businesses in a world in which many asset classes are still very expensive.

This note is not saying that oil at $120 isn’t going to be a challenge for the world economy, it obviously will be. We would also observe that the data is starting to show a sharp slowdown, for instance the initial GDPNow estimate from the Atlanta Federal Reserve for the first quarter of 2022 was 0.9 percent on February 4 and has now been revised down to 0.0 percent. The point we seek to make is that even a sharp economic contraction may have very little impact on the long-term intrinsic value of a sound business providing it is adequately capitalised and hence over-reaction to this creates potential opportunities for long-term investors. This appears to be happening today as investors over-react to short term economic data and value businesses on low multiples of their expected trough earnings.

We believe that our ability to add value as investors results from the fact that we focus on where we think a company’s profits are likely to be in the long term (defined here as five or more years), whilst many other investors will typically focus on short-term earnings momentum (often the next quarter). We try to always remember that when we buy equity in a company, we are buying a share of a very long-term stream of cashflows and that the reduction in one or two years of those cashflows does very little to alter the long-run intrinsic value of the business.

This can be demonstrated using a simple net present value (NPV) analysis, which allows us to see the current value of a company’s future earnings in different scenarios. Below we have simulated different types of earnings declines (chart 1) and noted their impact on the NPV (chart 2). The basic point to note is that, if a short-term earnings decline does not impact the long-term earnings power of the business, it should have relatively little impact on the intrinsic value of the company. Even the deep recession scenario, which halves the company’s earnings in year 2 before taking them to zero in year 3, only reduces the NPV from 82p to 73p, a reduction of 11%. It is only in scenario 4 (permanent impairment) where the earnings are unable to recover to pre-recession levels that the difference is notable.

Despite this, many investors have a tendency towards extrapolation, over-confidence and over-reaction to short-term news flow and earnings trends. For instance, if a company suffers a short-term earnings setback, some investors will often extrapolate this into the future and will over-react by selling the shares and potentially driving the price well below the intrinsic value of the business.

The Value Opportunities

The ‘In for Free’s’ are back

As many readers will know, during the last indiscriminate sell-off in the summer of 2020, we identified a group of stocks that were so cheap that one part of the business accounted for more than the value of the entire group and hence the rest of the businesses were ‘in for free’. The attraction of these opportunities is that it provides a margin of safety since you are getting ownership of businesses that you are paying little or nothing for. Our original note ‘In for free’ explored this topic and the update to this can be found here.

Following the recent sell-off of cyclicals, these opportunities have re-emerged as the following examples show.

Royal Mail

Having peaked at over £6 in the middle of last year, the share price of Royal Mail has fallen by 45%. As we noted in our original analysis, Royal Mail owns a European Parcels business called GLS which made revenues of £4,040m in the year ended March 2021 and Operating Profits of £358m. Even if we valued these historic profits on a low multiple of 10x, the value of GLS would be £3,580m and today the market cap of the entire Royal Mail Group is £3,200m. Thus, the UK business which last year generated £8.7bn of sales and £344m of operating profits is being valued by the market at less than zero. The group trades on 6x March 2022 forecast earnings and has a dividend yield of over 7%. In addition to that ordinary dividend, however, the group are paying a special dividend of £200m and a share buyback of £200m. This £400m divided by today’s market capitalisation of £3.2bn is 13% which added to the ordinary dividend of 7% gives a total payout of 20%. As I write this, a sell-side analyst has moved his recommendation on the shares to ‘sell’ and taken another 5% off the share price. In our opinion, this sort of behaviour should be labelled ’speculation’ rather than ‘investing’.