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Rational Exuberance - The Equitile Blog

24th May 2019

Posted by: Andrew McNally

Is the UK really going cheap?

Warren Buffett had juices flowing in the UK earlier this month when he announced that, despite Brexit, he was still looking to make acquisitions here. His comments were immediately seized upon as evidence that leaving the EU won’t impact Britain’s standing as a key investment destination. Moreover, it was the strongest endorsement yet, given Buffett’s reputation as a value investor, of the idea that UK companies have been left extremely undervalued in the wake of the 2016 referendum. Once Brexit is sorted, the logic goes, international investors will come flooding back to UK equities.

We are not valuation obsessives at Equitile – in practice value investing has been a tale of woe in the UK for a number of years – but we thought it worthwhile taking a close look to see if there are bargains to be had. Especially as the UK stock market has lagged the US significantly since the June 2016 Brexit vote – the S&P 500 is up 39% whereas the FTSE 350 is up just 18%.

Surprisingly, despite the 20% underperformance, general market valuations suggest only a marginal discount of UK equities relative to the US; the trailing Price Earnings Ratio for the FTSE 350 is slightly below 18 times earnings while the S&P 500 trades at 18.5 times earnings, down from approximately 24 times earnings one year ago.

Averages, as ever, only tell us so much and the distribution of value across each of these two markets paints a more meaningful picture.

The chart below shows the percentage of S&P500 and FTSE350 companies in each range of Price-Earnings multiple.

                                                                                                           

Although the distributions are not identical, a statistician would be hard pressed to prove the two distributions were statistically different. To our eyes it looks like the valuations of both the US and UK companies could have been sampled from the same population. 

That said it does appear, superficially at least, that the UK index has a higher percentage of companies with a Price-Earnings multiple between 10-15X, which could reasonably be categorized as ‘value’ companies. The S&P500, nevertheless, still has more than 20% of its constituents i.e. more than 100 companies, within this ‘value’ range so there’s no shortage of options to buy relatively cheap, low PER, companies in the US.

When adjusted for growth at the company level, the distribution tells a very different story. The second chart shows the distribution of Price-Earnings-to-Growth (PEG) ratios for the constituents of the two indices. Although the UK has a slightly higher percentage of companies with a PEG ratio of less than one, in the still modest 1-2X range the US offers a much higher percentage of opportunities.

 

                                                  

Despite much talk of UK PLC being up for sale it doesn’t seem, adjusted for growth, that the UK stock market offers more value than the US. In fact, despite its higher recent returns, the US still offers more value at this stage.

The so-called home bias is a well know phenomenon that continues to distort the way investors approach the stock market. People tend to invest in what they know and so, if you’re sitting in the UK, it’s natural to spend too much time thinking about the opportunity that UK equities present. A report from Charles Schwab last year found UK investors are especially prone to the home bias with three out of four of them looking to invest most of their assets in the UK. Brexit, if anything, has accentuated this tendency by focusing attention on a region which in fact represents just 6% of the global stock market.

The US continues to provide the most dynamic and positive backdrop for investing. US economic growth maintains a long-term trajectory well above that in the UK – the most recent quarter showed annual growth of 3.2% versus 1.8% in the UK. Moreover, when adjusted for earnings growth, the US market offers more than enough value opportunities relative to the UK – despite Brexit.

 

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6th March 2019

Posted by: George Cooper

Pension deficits and dividend payments

The British Pension Regulator has just issued its latest Annual Funding Statement and the section on dividend payments relative to pension deficit repair contributions is noteworthy:  

“As the pension scheme is a key financial stakeholder, we expect to see it treated equitably with other stakeholders. In last year’s annual funding statement we highlighted our concerns about inequitable treatment of schemes relative to that of shareholders. We remain concerned about the disparity between dividend growth and stable DRCs [Deficit Repair Contributions]. Recent corporate failures have highlighted the risk of long recovery plans while payments to shareholders are excessive relative to DRCs. We are also concerned about other forms of covenant leakage which may be occurring in preference of higher DRCs and shorter recovery plans for schemes.

In 2018, we contacted a number of schemes ahead of their upcoming valuation, where we were concerned about possible inequitable treatment. The trustees of these schemes were asked a number of questions about their previous and current funding approaches and negotiations. These interventions continue and we are committed to continue our interventions on those schemes where we do not believe that their valuations reflect an equitable position relative to other stakeholders. We will continue to focus on this area when engaging with schemes in 2019. Our intention is to broaden our grip in this area to cover a larger number and greater range of schemes (regardless of covenant). We emphasise the key principles behind our expectations as follows:

Where dividends and other shareholder distributions exceed DRCs, we expect a strong funding target and recovery plans to be relatively short.

If the employer is tending to weak or weak [sic], we expect DRCs to be larger than shareholder distributions unless the recovery plan is short and the funding target is strong.

If the employer is weak and unable to support the scheme, we expect the payment of shareholder distributions to have ceased.”

Basically, the Pension Regulator is saying it is not prepared to tolerate companies paying out cash to shareholders when those payments leave the company unable to service its debt obligations. Doubtless this has been prompted by the BHS pension debacle.

The regulator is undoubtably doing the right thing here. Nevertheless, it does highlight an ongoing risk for equity investors and for how businesses deploy their capital to grow their businesses. Companies with large pension deficits are being obliged to divert their capital into pensions from where it is then invested in low-yielding government bonds.

At the aggregate level, the need to plug the hole in these pension deficits together with the fashion for pension funds to invest in low-yielding bonds risks undermining investment spending and therefore future economic growth. As we have said before, high dividend yields are often a sign of weak underlying companies (See – Depressed lobsters and the dividend yield trap).

In light of this latest warning from the pension regulator UK focussed dividend investors should tread especially carefully.

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1st March 2019

Posted by: Carsten Wilhelmsen

Organic Matters

Warren Buffett, in his ever-humble way, mused this week that he had overpaid when he teamed up with private equity firm, 3G Capital, to fund the Heinz acquisition of Kraft in 2015. The 27% fall in Kraft Heinz’ share price last Friday was a big hit for Berkshire Hathaway who, on the face of it, had found a new strategy for deploying capital - a pressing problem given its significant and growing cash pile.

In many ways the collapse is surprising.  A global player with a portfolio of leading brands should, in theory at least, offer a quiet life for long-term holders like Buffett. By selling products we consume every day into a growing population, companies with negative earnings surprises this large shouldn’t really feature.

The world is changing in all respects however and eating habits are no exception. Processed packaged food, a core segment for Kraft Heinz, no longer has the same tailwind it did. A cursory look at the global food mix brings this structural change into sharp relief. Kraft Heinz has been using old brands to roll out new products such as Mayochup, but a structural shift in the food industry indicates they might be focusing on the wrong sauce.

Figure 1 below shows the US packaged food market in structural decline relative to healthier preferences. The market has been growing at just 2% over the last few years while the organic food segment has been growing at six times that rate.

Figure 2 shows the US organic food market in dollar terms against Kraft Heinz’s stagnating revenue, we believe this is core to their challenge, and the future projections remains bleak.

Now Kraft revealed additional, more specific, problems last week. The merger hasn’t been handled well from an operational perspective, manufacturing and logistics costs are higher, goodwill write-offs were much bigger than expected and they announced a pending SEC investigation into their accounting policies. The structural shift in consumer habits, however, offers a more interesting lesson - the buy-and-hold mantra that pervades much of the investment industry is being challenged, even in traditionally stable industries.

Quickening dynamics in all markets are making business life more challenging than ever, not only for companies managing a merger on the scale of that between Kraft and Heinz, but for all companies large and small. From an investment point of view, betting on indefinite success – even in the most stable industries - is becoming a dangerous game.

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