Intrinsic Value: Thematics, Disruption, and Active Risk

Miguel Oleaga, Portfolio Manager and Managing Director, recently participated in a presentation to Australian institutional investors organized by Conexus Financial. The following Questions and Answers are extracted from a panel discussion on finding intrinsic value in global equity markets.

C: What is your definition of intrinsic value?

In its simplest form, intrinsic value must value an asset. Looking at intrinsic value offers a useful toolkit because it allows you to value assets from across the equities investment range. You can look at a cyclical name or an emerging growth franchise. It aligns well with what we are trying to do with portfolio construction, which is to focus on businesses that have more durable competitive advantages and that we can buy at a discount to what we perceive to be their intrinsic value.

I think the synergy comes from building a good framework and having an value analysis attached to a business. You should understand how that business works. You need to dig into its revenue models; you should understand its positioning and its markets, which is also the same kind of work you must do and the factors you need to understand to know what that business’ competitive advantage is. The analysis and portfolio construction tend to go hand in hand. We think our approach to intrinsic value helps us focus on where to look in the world, how to value the things we are looking at, and how to optimize the things we are putting into the global portfolio.

C: What are your views on inflation?

We recognize the inflation impulses which are coming through the economy today and that they could have a wide range of outcomes on equities. When we construct our portfolios, we are trying to ensure that we understand fundamentally through an intrinsic value lens what is the value of the assets we are buying and not to let that outcome be driven by our views around inflation.

Ultimately what we want to do is have a fundamental view about why the asset is undervalued. If inflation materializes, is the business defensible or does it stand to benefit? Some areas of the market where we have gained exposure in the last year or so are “old economy,” whether that’s banking, mining or energy names, where we think fundamentally, with respect to what happens with inflation, these stocks should do well given the prospects in front of them. Moreover, if inflation were to be more permanent, as some think, then these businesses should be very defensible. If not, they may benefit from that inflation going through the economy.

C: I understand you are overweight metal, gas, mining, oil, agriculture. Old school industrials you might say. Tell us why.

We don’t short in this strategy, but we do allocate differently around the world. Where you tend to see our shortness is on a relative basis. Our relevant benchmark is the MSCI ACWI and we are well underweighted in the U.S. relative to our benchmark. That’s a reflection of these macro level dynamics that are altering the valuations for attractive businesses, and those businesses tend to be more well-priced or fully priced than they are ex-U.S.

I think one of the benefits of having this intrinsic value type model that we employ is that it does help you appreciate and develop deep understanding around what are better businesses, what are better industries.  That also helps us to understand that while, for example, the U.S. version might be a great industry or business, we may want to see if we can find a similar business structure outside the U.S. with more attractive valuations.

You may have noticed, we do have exposure today to things like e-commerce marketplaces, but we are doing it through investing in businesses such as a conglomerate with an oil and gas subsidiary.  However, less appreciated by local investors may be that there is also has a very attractive new technology business. We can bring our learnings from the U.S. to these markets where we are getting equally if not more attractive growth stories at better valuations over the medium to long term.

C: From your perspective, what is the benefit of having a global manager rather than one who focuses on a particular country or region?

I think there are three points really that show the advantage of having a global manager over one that is more regionally focused. One, the reality is that we have globally competitive markets and the businesses we are looking at putting in the portfolio have to be thought about globally. That forces us as managers to think about the competition. Whereas there might be a small cap version in the U.S., there may be a global supplier in China that may disrupt the global market. There should be an alignment of the opportunity and where the risk originates.

Secondly, I think it’s understanding where the winning business models are. I do believe that if an investor is geographically confined and that geography lacks some of these disruptive companies that we’ve seen do exceptionally well over the last 20 years in the U.S., there is a question of whether they are going to understand, for example, how Amazon works, what the KPIs are, how it wins business. I think a global manager has to think about that because there is a headwind to not owning Amazon. You must understand that and explain why you don’t own it to your clients.

Also, from the framework you get from doing that analysis, (even though our strategy has never bought Amazon), we may understand why the business model is better, why and how the business is going to grow, how and why it has unique characteristics to which we want exposure. However, on a relative value basis, can we find better opportunities elsewhere? There are many other industries where one can also go through that dynamic.

Lastly, it’s a good risk management tool. Oftentimes when you have winning business models, you’ll get these companies popping up claiming to be some version of insert-name-of-famous XYZ company, but from some country in Europe or someplace in Asia. If you have never actually dug into the reference business model that they are claiming to be like, how can you really know if their model is comparable to the one they want you to compare them to? I think a global manager will have some baseline understanding of what really makes the reference company special and then can really translate that both from an opportunity and risk management standpoint to new businesses around the world.

C: Do you see that the market structure has changed considerably as a result of the massive increase in passive index funds over the last decade?

Yes, I do believe it has changed. The reality for most investors in a market like the U.S. where there is passive investing either through their 401K or their financial advisor, is it works for them. I think that’s a reality we have to acknowledge—that more and more assets are going to continue to go in that direction, but I think for an active manager and one focusing on intrinsic value, that creates opportunities.

On the one hand, you get this polarization around a benchmark that wasn’t very historically polarized as we now have happening in the U.S. That means that some of the new economy businesses are in favor and some of the old economy businesses are more attractively priced. A year ago, you could have bought some of the most attractive banking franchises in the U.S. at low multiples of earnings power just because they weren’t in vogue.

Similarly, when you have a lot of investors going into the U.S. market, that means Europe and Emerging Markets tend to get less attention. Good businesses may slip through the cracks of investors’ purviews and that gives us an opportunity to try to identify those and add those to the portfolio before the herd recognizes that these are better businesses than they get credit for being.

C: What do you see as the mega themes of disruption as we move post-Covid pandemic?  What do investors need to look to on the other side of the recovery for opportunities?

There are a number, but one I will touch on now is this energy transition we are going through which is very important. It comes at a time when it is coupled with anywhere from three to seven years of significant underinvestment in commodity production.

If you look at something like copper, for example, it is very essential for us to get where we need to go from a decarbonization standpoint, whether that be EVs or renewable energy generation and transmission. Yet many copper names have been investing less and less over time and have been investing at only maintenance capex levels. However, we are seeing a demand surge coming.

When you couple our need to add supply over the medium term with the reality that when companies make plans to expand capacity, they need to be much more thoughtful about ESG considerations and the impact they may have in the communities where they operate, the timelines to bring new capacity online are elongating. A company like Freeport in the past could develop a new mine in something like four to five years. That’s clearly now pushed out to seven-plus years.

Some of these shortages could stick around for a lot longer as this combination of increasing demand, underinvestment over the recent past and the complexity of bringing new supply on all come together going forward. I believe certain commodity-exposed names are attractive as this plays out and prices rise to incentivize this new capacity to come online.