It’s easy to get caught up in market narratives. When news flow is good and sentiment positive, investors tend to buy popular securities at any price, paying lip service to valuation and risk.
Strong negative sentiments a precondition for buying quality companies at cheap valuations
It’s easy to get caught up in market narratives. When news flow is good and sentiment positive, investors tend to buy popular securities at any price, paying lip service to valuation and risk. When news is bad and share prices fall, fear of loss makes investors retreat — from real risks but also those that may be unfounded or overstated. While it is important to avoid getting swept up in the prevailing hype or gloom, it is equally important not to ignore the narrative altogether.
Some of the best investment opportunities come from strong negative narratives; in fact, they are a necessary precondition to buy quality companies at cheap valuations. Consider Microsoft, a company whose products many use daily. In 2012, Microsoft’s share price had been flat for a decade, trading at $20-$30.
Over that period, earnings per share had continued to compound by more than 10%. The popular narrative then was that technological advancements such as mobile, cloud computing and the move away from upfront software licences would significantly impair Microsoft’s business model.
This view was simplistic given the company’s considerable moat in enterprise computing and the fact that its consumer segment only accounted for a small part of the overall business. At the time, it had $50bn in cash on its balance sheet and was generating about $24bn in free cash flow.
But a wind-down of the business had already been discounted in the share price, making it available at a compelling price-earnings (PE) ratio of less than 10 times.
Fast-forward five years: Microsoft has transitioned into the cloud and subscription services, and doubts about its continued relevance are long forgotten. Now, at a share price of $76, it trades at a PE ratio of well above 20 times.
A significant tightening of regulations in the aftermath of the financial crisis presented a similar opportunity. US banks were forced to degear their balance sheets in a time when generationally low interest rates and rising compliance costs were already squeezing profits.
The narrative was that increased regulations would permanently affect the sector.
However, a bank such as JPMorgan had repaired its balance sheet and could, in fact, have been expected to benefit from heightened regulation over the long run as this would deter competition. The market’s fears were discounted in the share price, and one of the strongest franchises in global banking was available at a large discount to book value, less than 10 times earnings and at a total payout yield (dividends and buybacks) of almost 10%.
What are the narratives now? A strong prevailing narrative is the predicted demise of brick-and-mortar retailers, particularly in the US, due to the growing dominance of Amazon and other online players.
As such, share prices in the sector have come under significant pressure. While the “death by retail” narrative may generally hold true, its broad application across the retail sector has created the potential for significant mispricings.
Niche, vertically integrated brand owners such as US-listed L Brands are attractive. L Brands has a direct-to-consumer business model and is the market leader in the US lingerie market, with well-known brands Victoria’s Secret and Pink. It is also the owner of the highly successful US fragrance and skincare business Bath & Body Works.
Concerns about the company’s recent slowdown in trading can largely be attributed to discontinued product lines, while its international business is expected to gain significant traction over the next three to five years. The L Brands share price traded at a record high of just below $100 less than two years ago, but dropped as low as $35 in August. This decline offered a great opportunity to acquire a high-quality and relevant business in an unloved part of the market at a cheap valuation and large discount to our estimate of intrinsic value.
Investors are understandably concerned about the effect Brexit will have on UK markets. As a result, domestic-facing UK companies, which are likely to bear the brunt of any potential economic fallout, are trading at levels last seen in the 2009 recession when compared with the broader UK market.
Yet again, an overarching negative narrative — “death by Brexit” — has created the potential for mispricing.
We do not claim expertise in predicting the outcome and economic consequences of Brexit negotiations. However, it’s likely that quality companies managed by able individuals will continue to be good long-term investments if bought at sufficiently cheap valuations.
Consider Babcock International, the UK’s leading engineering outsourcing firm, which provides critical, complex and cost-effective solutions to clients, many of whom lack the in-house capability. The company has strong barriers to entry and a number of unique assets.
Its marine services department owns two British dockyards, operates two of the UK’s three naval bases and is contracted by the Royal Navy to support its entire submarine fleet and maintain three-quarters of its surface fleet. It is also the main support partner to the British Army and Metropolitan Police Force and owns the world’s largest helicopter emergency services company. It is a diversified business with longterm service contracts and a steady stream of annuity income, so the opportunity to invest in the company at low valuations is very attractive.
As fertile a hunting ground as negative narratives may be, investors should be careful to avoid companies that are out of favour for good reason.
Quality and valuation are equally important considerations, both when prices may be inflated and when they may be justifiably low.
A … NEGATIVE NARRATIVE — ‘DEATH BY BREXIT’ — HAS CREATED POTENTIAL FOR MISPRICING