Q - You seem agitated by the ultra low bond yields. Maybe you need to make a mental adjustment?
A – Yes. Whether global yields are hovering close to zero due to secular stagnation, low-flation, excess savings, or something more benign, it's unclear how the world’s central banks will retrace their steps back to a “normal” monetary policy without a lot of collateral damage when and if this happens. The Fed, arguably, has had the right plan in being glacially slow to raise rates. That said, the markets are being led by a valuation-expansion for companies that do not possess a lot of growth potential. Rather, these companies offer stable cash flows and reasonable predictability around future cash flows. Historically, paying high multiples for companies with low growth rates has not generated good outcomes. Though markets may seem excessively infatuated by stability and predictability, one can see why. From a more academic perspective, there are precedents that leaving rates too low for a period of years actually contributes to further deflationary potential, as it permits inefficient production capacity to remain in place and forces savers to over-save to offset the poor yields they receive. I believe that Japan’s massive deflationary problem over the last 25 years is evidence of this negative spiral.
But a mental adjustment is in order. If risk-free rates are poised to circle zero indefinitely, what makes a good stock exactly? Is it stable earnings and some form of yield? Consistent excess capital generation should be a priority in general, but market sensibilities have become fixated on stability characteristics. There is probably a lot of value to be had looking a bit afar at companies that generate consistent cash over an economic cycle, but are not as completely predictable as staple and utility stocks are. There are possibly some long term risks to the perceived stability in staples, as disruptive companies like Amazon get into the business of their own brands of household goods. Similarly, utilities are likely to be pressured as the cost of solar power is poised to deflate persistently in the long term.
Q – 2016 had one of the worst starts to a year on record, and stock markets have completely come back. I am a little baffled by this.
A – It looks like the markets had a mechanical breakdown emanating from the high yield market in late 2015 that reached a climax in early 2016. In the equity markets, these liquidation pressures translated into bear markets for most asset classes except U.S. large cap stocks. Notwithstanding ultra-low rates globally, equity market liquidity has declined significantly this decade. There are a lot fewer shares trading on a daily basis. Price dislocations are apt to be larger when this happens.
Part of the intrigue of equity markets is the price-discovery process. Stocks can theoretically trade at any price that buyers or sellers choose to transact. But in practice, for example if XYZ stock falls below a certain level, buyers tend to emerge and sellers tend to disappear. That’s how price floors or ceilings emerge. This process still holds true today, but the market ecology is much different. In the past, individual investors, institutional investors, and mutual funds competed against each other with varying investment priorities and temperaments. In today’s markets there are huge flows to indexes and alternative investments, negative flows to traditional active management, and substantially lower retail participation. Indexes have no reactivity to the price-discovery process – they won’t buy more shares of XYZ however low the price might go. Hedge funds might buy more, but hedge funds tend to employ leverage and often want to reduce leverage when volatility rises (usually this happens in a down-market). Leveraged, performance-based funds also are apt to reduce exposures when stock price trends become erratic, which also tends to happen in volatility episodes or when fundamentals become hard to read. So these funds may just as easily be encouraged to sell when prices fall as they are enticed by falling prices. Net, there are still a lot of “vanilla long” dollars out there, and they will start buying or stop selling if prices fall far enough; yet with a lot fewer active management dollars out there, the price discovery process can require big clearance sales.
Q – What would be some companies that in your estimation have be shunted aside by the markets’ current preferences and challenged price discovery process?
A – There are lots. Unfortunately, some of them found their way into the Cambiar portfolios prior to the complete mark-down process, so to speak.
Starting with our U.S. Small Cap strategy, we have seen losses in Penske Automotive Group (PAG) and Group One Auto (GPI), which are two automotive dealership stocks. Auto dealership companies first emerged in the 1990s as the patchwork of mostly family-owned dealerships in the U.S. and abroad were rolled up and corporatized with more consistent business strategies, pricing models, and management. Although automotive manufacturing, is a classically cyclical business, auto dealers have traditionally been heavily buffered from the cyclicality of the manufacturers. They make about ~70% of profits from used car/trade-ins and from servicing; new car sales really are not that profitable for these companies. To prove this point, our automotive dealership holdings have generated average operating margins of about 2.8-3.0% in the last 12 years, which includes the 2008-09 recession (when new car sales fell by over 50% in the U.S.). Even during the ’08-‘09 time period, operating margins were in the low 2% range, which really is pretty good considering the severity of the economic collapse. In late 2015, some of the luxury car makers began to aggressively push volumes; this led to some problems for both new and used car pricing in late 2015, leading to lower per-vehicle profits. As best we can tell, these behaviors have dissipated, and profitability/margins have largely returned to normal. Yet valuations have fallen by about 45% for both Penske and Group One since the summer of 2015. Both companies have been fairly active in shrinking their share counts through buybacks, such that the market capitalizations are down 50% and 60%, respectively, in the past year. Sentiment is poor because it is late in the economic cycle and auto manufacturers have been notorious capital-destroyers late in the cycle. But dealerships are not manufacturers, and we are having a tough time identifying an obvious glitch in the business characteristics that would be consistent with current valuations.
Q - What are current valuations for these companies?
A – Both trade at around 6-8 times earnings and about 4-5x cash flow, which is roughly where they traded in 2008. You have to use a range of earnings and cash flow figures with these kinds of businesses, as they are not perfectly predictable…but not totally un-predictable either.
Q – OK you have me intrigued. Anything else like that?
A – Let’s stick with forms of transportation; however, flying in the sky and not based in the U.S. Cambiar picked up a position in Aercap (AER) for our International Equity strategy during the Q1 selloff; we bought a little more in Q2. Aercap is the largest publicly traded aircraft leasing company in the world, with about $33 bn worth of aircraft on its books. Most of the aircraft are popular planes, such as the Boeing 737, Airbus A320, Boeing 777, and Airbus A330; the company also has a few blue light specials such as old 747s and 767s, as well as the newer Boeing 787 and Airbus A350. All that Aercap does is lease planes to airlines, who generally lease a large fraction of their fleets. Airlines habitually have erratic cash flows as seat supply does not always line up with seat demand, and ordering a new plane means getting in a very long waiting line. Thus, the ability to lease capacity or to monetize some of their fleet has a lot of value, and the leasing companies have tended to earn fairly strong double digit returns on equity. Historically, the profits of leasing companies and airlines are uncorrelated to each other. Unlike autos, where used car depreciation rates can fluctuate considerably based on the type of car and economic conditions, commercial aircraft depreciate very predictably unless it is late in the lifespan of an older design. Consequently, it is illogical for an aircraft leasing company to trade at a major discount to book value. This did happen to Aercap and other leasing companies in the 2008-2011 time period, as there were concerns about their ability to fund themselves in credit markets. These fears proved unfounded. In 2016, Aercap (and other leasing companies) have again dropped well below book value, ostensibly because of the problems in the high yield credit markets. This dislocation too has passed. Aercap generates more capital than it really needs to fund future aircraft purchases, so they have bought in a lot of stock this year below book value, which winds up increasing book value per share. The multiples of earnings (6x) and cash flow (4x) are similar to the auto dealers. Aercap traded around 78% of book value at the end of June. Realistically it should not trade at a big premium to book value either, but it’s a good business that isn’t valued that way.
Q – Your themes seem to be low valuation and mis-understood/not really so cyclical. How’s that working for you?
A – That would be one way to describe these situations. So far this year, it has not been reliably effective; the markets have not been intrigued by that kind of subtlety in 2016. We seem to see this pattern over and over as yields have fallen since 2010. It’s encouraging that companies like the ones mentioned above can be proactive about their depressed valuations by repurchasing shares, but you have to be an excess capital generator.
Q – Are any big U.S. companies misunderstood, or is that implausible given that U.S. blue chips are leading the world yet again?
A – That’s not an easy claim to prove in either direction. In the Cambiar U.S. Large Cap strategy, blue chip semiconductor company Qualcomm (QCOM) jumps out as being a tricky one to analyze. For that analytical challenge, you get a premium franchise, massive cash generation, and a fairly nice yield. But progress has not been completely linear for the past couple years. Qualcomm has two main businesses: it makes chipsets that go into mobile devices (including mobile microprocessors and cellular radio transmitters), and it also has a technology licensing business, where it licenses its technology patents to mobile phone producers who cannot avoid using QCOM’s technologies in modern wireless communication devices. Qualcomm receives intellectual property royalty payments (IPR) for these handsets. From a raw technology/intellectual property development perspective, Qualcomm is an extremely effective company. However, the nature of its main businesses leads to some peculiar conflicts. In its chip business, Qualcomm sells to the world’s mobile phone manufacturers, who do have some choice in terms of whose chips they buy, though QCOM chip sets and mobile microprocessors are well-regarded. It separately negotiates IPR royalty fees from the world’s mobile phone producers. You can imagine there could be some horse-trading as manufacturers look to lower costs. On the IPR side, Qualcomm invented and refined most of the modern 3G, 4G, and soon to be 5G mobile communications standards. None of their customers really want to pay Qualcomm their “rent” per phone, but this is how IPR value is extracted in the communications field. With Chinese handset makers growing rapidly, they have been particularly difficult to negotiate with, leading to erratic IPR revenue on a quarterly basis. The Chinese generally aspire to be successful outside China, and failing to come to terms with Qualcomm precludes this objective. Qualcomm seems to have made some clear progress on this front in 2016.
Since Qualcomm has been the main inventor of modern cellular standards, it has a much better idea of what technology attributes will be vital to 4G, 4.5G and 5G phones as and when these will reach markets, which gives it a leg up going forward. Other manufacturers would love to displace Qualcomm’s strong market position, and with only a handful of global phone manufacturers left, there is a lot of competition, which leads to erratic chip volumes. There have been some voices urging Qualcomm to split into two companies, but we see advantages to keeping the whole together. It’s certainly very profitable, generating operating margins in the 30% range over the last several years. Normally, companies with that kind of margin structure command high P/E multiples, but Qualcomm has been mired around 10-11x earnings for the last year with a large amount of net cash. The stock has moved up recently after stringing together some positive quarters in a row.
Q – Is there some kind of logical limit to the amount of money that can be indexed before market pricing mechanisms become inefficient?
A – I wish I had a better answer to this question. The urge to index, especially in the more efficient U.S. large cap arena has become overwhelming; and yes, it has been very effective. It is unclear whether low global interest rates have caused indexing to be effective or if it is just a coincidence. There have been numerous major market “mood shifts” since the 2008 Global Financial Crisis; it feels like one or two per year. I don’t recall the mood shifts being nearly so frequent in past market cycles. It certainly has not been easy to invest around. Mechanically, if active managers have big outflows, they will have to sell more of their largest positions. If these outflows are then redirected into indexes, this precise combination of stocks will tend to perform well relative to other options. At some point, indexing means rewarding bigness and whatever got you there. Intuitively, I like the idea that a sentient being is actively making choices about what stocks may be good investments and what stocks to avoid because they are overpriced, have poor management, engage in bad business practices/aggressive accounting, or fail to protect the interests of minority shareholder. I don’t like the idea of deliberately investing in those kinds of stocks just because they are in an index. But this practice has become surprisingly acceptable.
Q – Did the Brexit Vote surprise you?
A – Yes, it did, because the markets and pollsters very much had it pegged to “remain” in the EU, and they were off by about 7-10 percentage points. That is a giant margin of error in a general vote. Normally, you don’t see markets and pollsters get it that wrong. Less educated people and senior citizens apparently wanted out of the EU, while younger and more educated people wanted to remain. There is a palpable sense that the “leave” voters are troubled by immigration into the UK, and are fearful of what further immigration flows would yield. I have heard anecdotes that a large number of younger and better educated people were voting for “leave” so that it would not do too badly in the aggregate vote(!), but they themselves were not actually in favor of an exit from the EU. If true, that’s a strange thing to do. The Brexit vote caused an immediate 12% devaluation of the British Pound against the dollar. Having been through currency dislocations in the past, I have found that such events can lead to some very counter-intuitive investment conclusions. UK stocks are up sharply since the Brexit vote. When the UK left the European Exchange Rate Mechanism in the early 1990s (this pre-dated the Euro as a means of monetary integration in Europe), it similarly marked a bottom in UK stocks. But this whole episode suggests that politicians, voters, and polls are not in sync with each other.
Q – Does this mean you think U.S. elections could generate a similar surprise?
A – They already have! No President has ever been elected with an “unfavorable” rating of greater than 50% prior to the election. At the last set of polls, Hillary Clinton had a 55% unfavorable rating, and Donald Trump a 57% unfavorable rating. Whoever prevails will automatically be the least popular elected President in U.S. history – at least on Election day. It is unclear what this will translate into in terms of a Presidential mandate from the people. It would seem to make for a weak President. Hillary Clinton had a difficult time beating back only one serious challenger who is technically a Socialist, not a Democrat. Donald Trump repeatedly makes comments that would be considered unmentionable gaffes by traditional politicians, and yet these statements don’t seem to affect his polling numbers. Like the Brexit vote, professional pollsters and the financial community may not be reliable indicators of the outcome. At least expectations will be starting at a low point.
It is not my intention to make more specific political comments in quarterly stock market discussions. I would make one point though, which is that these votes do matter and do have long term consequences for financial markets and for world events. A decision to abdicate this civic responsibility, politically or financially, does have consequences. Yet a lot of investors and voters have tuned out. In the wake of the 2000 Presidential election between George W. Bush and Al Gore, there was a flurry of discussion about voting, and the fact that it did matter a great deal because the 2000 election was razor-close. It also affected history profoundly. Something similar may be brewing in the U.S. politics and financial markets. Apathy, complacency, a balkanized media, and a willingness to accept what others have already determined have led to this very peculiar situation. The Presidency may be decided by who is less unpopular among those who actually show up to vote. Index investing, a free ride on others’ efforts at price discovery, has already crept deeply into all corners of finance. As the beneficiary of a gigantic shift in investment flows, the public wisdom embedded in index composition decides for investors what is and is not valuable without accountability or active choice, diluting the value of the information embedded in what to vote for – financially or otherwise. Remarkably, financial and political representation mirror each other.
Q – So you are equating indexing with voter apathy?
A – Effectively, yes. But I remain fairly optimistic about the capacity of businesses to adapt to their circumstances. Politics tends to do the same.
Certain information contained in this communication constitute “forward-looking statements”. Due to market risk and uncertainties, actual events or results, or the actual performance may differ materially from that reflected or contemplated in such forward-looking statements. Securities highlighted or discussed in this letter have been selected to illustrate Cambiar’s investment approach and/or market outlook and are not intended to represent the performance or be an indicator for how the accounts have performed or may perform in the future. Each security discussed in this letter has been selected solely for this purpose. The securities discussed herein do not represent an entire portfolio and in the aggregate may only represent a small percentage of a client holdings. The portfolios are actively managed and securities discussed in this letter may or may not be held in such portfolios at any given time. Nothing in this letter shall constitute a recommendation or endorsement to buy or sell any security or other financial instrument referenced in this letter. Prices of securities reference June 30 2016.