Adapting to the continually evolving landscape

Steve Romick and Brian Selmo, co-portfolio managers of the Nedgroup Investments Global Flexible Fund discuss how FPA manages the Fund in a continually changing landscape and what it means to be a contrarian value investor in today’s fast-paced environment.

Steve, what is the Contrarian Value strategy all about? And what are some of the underlying investment principles?

Let’s start with the definition of contrarian value which to us means that we are buying something and we are getting more than what we paid for. And that might be because a good business is facing a cyclical challenge or investors don’t fully recognise the quality of that business. Either way buying such a mispriced asset should result in a rate of return that is better than a market as a whole. And the way we’ve expressed this through the portfolio is through equities and corporate debt.

Where does Contrarian Value fall in the spectrum of the more traditional growth and value investing styles? And how important is it to define yourselves in either one of those categories?

We are often labelled value investors but we want to be careful of such pigeonholing. People tend to think of value investing as owning the shares of a proven business in frequently cyclical industries that don’t have much growth; while considering growth stocks to be those shares of businesses that can seemingly grow at a healthy clip for years to come and have less economic cyclicality.

We want to own growing businesses. We want to own them and buy them at a price that can offer a margin of safety that protects our capital in the event that all does not go as planned. Traditionally that protection comes from a company’s balance sheet, that is buying below book value for example, or maybe getting some unrecognised real estate value or some other hidden asset. But blindly practising this time-honoured value investing is dangerous particularly today as many of those types of companies have been disrupted by some of the most prolific technological innovations the world has ever seen. While some companies have adapted, others have not.

So you are not anchored to a narrow definition of what value investing is, you are evolving over time and as the environment changes?

Sure, if we didn’t evolve and recognise that a margin of safety could be established by understanding and properly evaluating a business and not just its balance sheet, we don’t feel that we would have a lot to offer our investors today. Our job is to understand what changes are likely down the road. Who will win and who will lose? It is as important to avoid those losers as it is to find those winners. But it’s also important to avoid overpaying even for a really great company. A winning business does not necessarily translate to a winning stock. Microsoft stock for example was lower in 2009 than it was in 1999 even though it delivered high-teens growth along the way. Price matters and that’s one thing that won’t ever change for us.

What kind of risk-return profile can an investor in the Nedgroup Investments Global Flexible fund expect? And in what kind of market conditions do you expect your strategy to out- or under-perform?
We expect the Fund to under-perform in markets where price doesn’t matter. Particularly those characterised by great faith of what might be but is yet to be proven; those businesses that aren’t earning money today, but people expect them to be earning in 10 years. Their business models are still untested.

The Fund should outperform in those periods where an industry group or an asset class falls from grace. We could do well by avoiding some of the weakness as prices fall and possibly by picking up inexpensive good assets in weaker market conditions.

You have a multi-decade track record in managing the Contrarian Value strategy.  You’ve experienced the Asian crisis of ’97, the Dot.com bubble, 9/11, Grexit/Brexit and more recently, the outbreak of a global pandemic. How have you and the team adapted to this continually evolving environment?

The world is always changing so it’s very important to separate cyclical change from secular change.  In this case we are living through an environment where a global pandemic has stopped many businesses in their tracks and driven some into bankruptcy. The travel industry for example was particularly hard hit - hotels, travel agents, aircraft suppliers, airlines and car rental companies.  But most of these businesses will bounce back, people will once again travel and it’s already beginning to happen. A year ago though, that seemed a remote possibility to those investors who were were fearfully selling their shares. We believe that much of what has happened in the last year has been cyclical.

Secularly, many businesses have benefitted from the changing environment in the last year. Video stream for example was already growing quickly before the pandemic and has taken more share from traditional media as people have been forced to find ways to entertain themselves at home at the expense of movie theatres, broadcast television and cable networks.

We are constantly forced to examine what businesses are more likely to thrive a decade from now and those that could be struggling. Note that I am speaking about the businesses and not the stock prices, which are a secondary consideration. It’s incumbent upon us as your portfolio managers to analyse what changes are taking place in and around an industry that might have either benefitted or harmed the underlying participants. We begin with trying to understand which companies will be good or better a decade from now, and thinking with this mindset forces us to continually adapt to the expected changes that are going to come.

Macro forecasting is not what FPA does but looking out over the next decade, what is it that concerns you and what gives you hope?

The concerns are that interest rates are at 1000-year lows and most people have never seen interest rates rise.  All else being equal, lower rates increase equity values and conversely higher rates equal lower equity and debt values. The other concern is that inflation has been benign for years, we wonder about all the unfettered sovereign borrowing to spend; and if there might not be some inflation down the road and what that might look like; as well as how interest rates will respond and how economies will respond; what kind of pricing power these companies will be able to have in order to sustain margins and continue to generate good free cash flow and maintain a level of return in capital. We are starting in a place today where valuations aren’t cheap and we are dependent on low rates and good earnings growth.  Should one or the other change then there could be some market volatility.

On the other side of the coin, a post-pandemic economic rebound is already happening and society is resilient. We’ve seen bad economies come and go and companies and investors have adapted and survived.  We’ve now lived through a pandemic – it takes a lot to get us down.  Lower rates are a concern, but there is not a lot that seems likely to change on that front in the foreseeable future as governments have incentives to keep rates as low as possible.  This might continue to provide support, if not even fuel for this market.

We now speak to Brian Selmo, who joined FPA in 2008.  Brian is a co-portolio manager of the Nedgroup Investments Global Flexible Fund and is the head of research for FPA’s Contrarian Value Strategy.

Brian, can you tell us about how this “go-anywhere” mandate works in the team and who decides who goes where?  How has the team been interacting in lockdown?

In terms of working together and organising ourselves we have 2 scheduled meetings a week; one is with the analysts to review what everyone’s working on, to ensure people are on task, prioritising what we want to focus on and that projects are getting done in a timely fashion. The other is with the 3 portfolio managers to discuss business and portfolio-oriented issues.

When you think about what we are doing form a research side, there are 2 continuous processes that are going on. We want to identify and follow high quality franchise businesses. Usually they line up in industries and our analysts follow and familiarise themselves with these industries on a global basis so that we are ready to go if or when something goes wrong. The pandemic certainly highlights for us the wisdom of that approach because when everything is going wrong it is very difficult if not impossible to get up to speed and wrap one’s head around a new situation. It’s much easier to go back to something that you spent years paying attention to, to see if it’s at a price that you are now interested in buying it.

Another thing we do on a continuous basis is look for one-off situations or commercial opportunities – we think of these situations as “running towards fires or disasters”.  These are business that are absolutely sustainable and have a viable future even though they are not quite as high quality nor as good a franchise and we buy those exclusively on price and it’s a matter of them being too cheap for what they are.

How has lockdown and working from home impacted the team dynamic?

It’s panned out better than we would have guessed 18 months ago. Our platform of choice, Microsoft Teams, has been a useful way to for us to communicate - we still have our weekly meetings that now happen over Teams. If anything, we have learnt that we can be still be effective remote and like many businesses, will evaluate what the office needs in future.   I expect there’ll be a couple of days a week where everyone comes into the office but there will probably be a lot more flexibility going forward.

Can you give us an insight into how the evolution of the strategy has played out in the portfolio and some of the positions you hold? Have there been some sectors or industries where you’ve been more active in recent years relative to history?

I think there are a couple of key points which are: that price matters; and the margin of safety matters. So that is a framework and an intellectual approach that we’re going to apply to an individual company as well as a portfolio at large.  That’s something that’s evergreen and underpins any sort of sensible investing.

The other thing is that the world has changed a lot in the last 15 years.  So I think as people looking to invest capital, protect capital and deploy it, you have to be continuously learning and respectful of what’s going on in the world. There are a number of businesses that we own in the digital space, some of the internet platform businesses for instance that didn’t exist really as scale businesses 15 or 20 years ago.  And today, they (along with many others) are among the best businesses when you consider them from a return on capital perspective or if you think about businesses that have zero marginal cost to acquire a customer.  Those are ideal business models where incrementally you generate revenue and profit without expending economic effort and that all falls to the bottom line.  So those types of businesses need to be considered through the eye of how they operate. Now we’ve always done that – we consider banks and financials differently to how we would consider a medical device company for example.   We look at different metrics, we look at different margins, we look at different drivers through the financial statements to think about value or to think about sign-posts.  And that will continue to evolve.  It’s about us observing and participating in what is a dynamic world.

Taking a look at the portfolio today, there may be positions in the Fund that some would question as being “traditional” value investments eg. in the IT or consumer services sector.  How do you reconcile these positions with your Contrarian Value approach?

I think the first thing to do is accept that different businesses have different fundamental economic characteristics and ought to trade and be valued on different numbers.  What is a margin of safety in one is going to look very different in another.

In digital businesses for example, you may have very low or no marginal cost of revenue or customer acquisition. What that means is that things like scale advantages, or the likelihood of reaching them are a lot more relevant than what’s on the balance sheet or maybe the historic income statement. There are many businesses that have “winner-take-all” or “winner-take-most” features and if a company in that type of business has recently won the market or most of the market, the fact that they didn’t make money 2 years ago becomes irrelevant to their prospects 5 years out.  And this is really what we think about when valuing these businesses ie. 5 years from now. The balance sheet and income statement reflect what is known about the past – your experience as an investor is dependent on what is going to happen in the future. So the financial statements are useful to get a handle on what you’re paying compared to what’s happened, but you also want to make sure you’re not stuck in a less relevant view of a business or it’s opportunity.

Looking at how the first quarter of 2020 unfolded, were you concerned about how you were positioned and perhaps wonder if you had made any mistakes? How do you retain conviction in a position when things may not be unfolding as expected during a market downturn?

I think if we rewind, we would have reduced some exposure in the 4th quarter of 2019 and would have been below 60%, probably mid 50s or so invested in equities going in to 2020.  A number of our equities performed very poorly in the first quarter of 2020 particularly financials and anything related to aerospace. Without downplaying the gravity of the pandemic, I think one has to stay grounded in the underlying financials and the competitive positions of the companies you own. There was potential for major challenges to balance sheets and near-term earnings for a lot of companies but I don’t think we were in a lot of business that faced secular challenges or faced competitive disruption because of a shutdown in the economy. So that was easier to be comfortable with.

Even if you look at a sector that was directly impacted for instance aerospace parts suppliers where we had a meaningful position, market share wasn’t moving around, it’s just that there was going to be a lot less demand.  So we re-focussed our efforts on a number of new investments and adding to other investments that had the characteristics of what we would say “when…”,  not “if…”.

We wanted to take the balance sheet concerns off the table when we were thinking of buying new names and increasing exposures to businesses that we thought were very strong competitively eg. Richemont. So those were the kind of businesses we were trying to invest in and if you have spent time following them and have gotten yourself comfortable that they could withstand whatever might come, you don’t end up terribly scared with them, or in them.

So we ended up investing a little more and increasing the exposure at that time.  If the logic of what you are doing is sound, having difficult performance periods is part of what will happen, and is to be expected.  We don’t quite know when or why, but it will happen and if you’ve underwritten these businesses in a rational and conservative manner, you’ll end up coming out the other end.

Looking at the pleasing recent performance for periods to the end of March 2021, do you see this as a validation of the strategy?

March 2021 definitely feels better than March 2020 (on many different levels) but I am very reluctant to take validation from 12 months of good performance.  If I think that the strategy is intellectually sound over time, then that’s really what validates it.  We would expect to have good performance over the long term but I don’t think a tough first quarter of 2020 invalidates the strategy and so I am not going to say that a good quarter or a good year validates it.  I think the underlying philosophy is sound over time and we have diligently pursued it and demonstrated that it works.

Do you have any final comments on how you are positioning the portfolio to be resilient into the future?

Over the last three months or so we have been selling down some of the more cyclical positions, some of the financials that have really come back strongly and trading at very different valuations than they did six months ago or even in January 2020. We are gradually shifting into things that are more defensive in nature in terms of their underlying business profile and that’s the shaping that we are doing in the portfolio.

I think that valuations are generally high, we don’t think there’s a huge pocket of opportunity to generate out-sized returns. So with that and the low starting point for yields, our expectations will be pretty modest over the next three to five years.