Two public stocks with private equity pedigree
Co-Authored by Adrian Warner, Chief Investment Officer and Sam Morris, Senior Investment Specialist the following article featured on Livewire on the 18 November 2020.
Do we just give up on traditional value investing processes, like looking at comparable financial multiples (e.g. EV/EBITDA, Price/Sales, Price/Earnings, Price/Book), calculating intrinsic value using discounted cashflow analysis and seeking a margin of safety? In simple terms, no. But what we think is required is the fortitude to hold a concentrated portfolio, high confidence in your analysis drawn from deep diligence, and the patience to hold investments for long periods of time.
The broader issue we see is that it is increasingly easy to purchase a backward-looking, so-called ‘value tilt’ portfolio from any number of providers, including smart beta ETFs. As such, the debate around value versus growth, and the starting point for many active investment or index construction processes starts with inherently mechanical screening based on relative characteristics of companies to each other.
Because investors frequently judge fund managers based on their short-term performance relative to an index, many fund managers respond by controlling risk relative to the factor or broad market benchmark, holding so called ‘risk positions’ that they don’t really believe in or understand, but that have high weights in their benchmark. This serves largely to protect them from short-term investor angst about tracking error (deviation of returns from benchmark returns).
So how do we at Avenir Capital think about value?
Our heritage is in the private equity industry and it is there that we draw inspiration in applying our investment approach to public market equities.
Firstly, we think that the original investing concepts that underpinned the growth of private equity, before it become an asset class with too much capital chasing too few deals, are sound starting points. Private equity firms spend a considerable effort and time analysing companies before they invest as they must live with that investment decision for a long time given the illiquid nature of private firms. They are also opportunistic, looking at business model diversification, management track-record and taking advantage of what opportunities the market gives them with strict filters around return hurdles and downside risk rather than mechanically focusing on benchmark driven factors by sector or geography.
Like private equity, we look for under-valued but proven businesses with robust, analysable track-records through varying market conditions but that have highly defensive business models and ideally, excellent growth outlooks. However, where we think differently is thinking through value investing from a business model perspective, paired against broad categories of valuation mispricing drivers. We think this is more logical than starting a systematic process simply using accounting metrics, which don’t efficiently get to the core question of why a stock is mispriced and what place it should have in a portfolio. To this end, we think there are 5 broad categories of private equity-style valuation mispricing’s that can be applied methodically to searching for a diversified portfolio of good value investments across a broad variety of industries and geographies. Here we examine one of these categories: undervalued franchises.
An Undervalued Franchise is a very high-quality company with a deep and enduring competitive moat and a long runway of growth that is not being fully appreciated, and thus, not fully valued by the market.
Undervalued Franchises often have monopoly or duopoly type characteristics and operate in industries with long-term secular growth. We should be prepared to pay a higher price for Undervalued Franchise companies but should still demand a large mispricing and margin of safety. Such businesses have highly defendable revenues and margins, thus giving them excellent defensive characteristics.
Undervalued Franchise investments may not drive excessive short term returns in the portfolio but can be the engine room for compounding over time and provide stability and robustness in turbulent times.
Stock Case-study: Infineon (ETR: IFX)
Infineon is a power semiconductor manufacturer with a significant electric vehicle opportunity. They dominate various niche categories that are difficult to substitute.
EVs have promised much but, apart from Tesla, mostly disappointed to date, hurt by poor product variety, high prices, range anxiety and long charging times (and poor charging infrastructure). That short-term disappointment has presented an opportunity to own what we believe is one of the biggest beneficiaries of this transition, Infineon Technologies.
Power semis are a niche sub segment of the broader chip market that has very different market dynamics to the memory and logic chips most think of when they think of semiconductors. The products are less commoditised, end markets tend to be less competitive and prices more stable. Technological barriers to entry are very high and the very different manufacturing process makes the risk of competition, even from other chipmakers, very low.
We believe the conditions are right for the transition to EVs to surprise on the upside – emission standards are becoming increasingly strict in Europe and China, whilst pricing is rapidly becoming more competitive with traditional cars and driving ranges and charging times have improved significantly. Infineon is arguably the dominant manufacturer of the components that control the flow of electrons from the battery to the electric motor and back again. Each EV is potentially USD400 or more of incremental revenue opportunity for Infineon and it’s in products where the reliability and performance trumps price, unlike the commodity materials such as lithium or nickel used in the batteries.
Caption: There is almost $800 of semiconductor content in an EV, twice that of a traditional combustion engine car. As autonomous driving features become more common, there’s potentially a doubling again of content.
To conclude, we see Infineon as a leading manufacturer of power semiconductors, a market that in turn has characteristics that make it attractive to long-term investors, such as few substitutes, significant IP barriers to entry, yet low capital requirements – all the characteristics of a franchise business. It has significant growth opportunities from the shift to EVs but is supported today by diverse and stable income streams from existing automotive, industrial and consumer end markets. Recent short-term market concerns around automotive weakness in China and elsewhere has presented an opportunity to own the company at much cheaper multiples than in recent years.
Stock Case-Study: Wuliangye Yibin (SHE: 000858)
Wuliangye is one of China’s premium baijiu (spirit) brands. Wuliangye is a very strong consumer brand in China due to its premium quality and 600+ year history, enabling the company to have strong pricing power and allowing the company to generate very high gross margins of 74% and EBIT margins of 45%. Margins are expanding with today’s 45% EBIT margin up from 35% in 2016. These margins are still below those of the industry leader, Kweichow Moutai, who is delivering gross margins of 90%+ and EBIT margins of 68%, offering upside potential for Wuliangye.
Wuliangye is likely to benefit from significant growth in the premium baijiu consuming population in China, which should drive growth in premium-quality baijiu consumption. Wuliangye is well placed to grow in the ultra-premium baijiu segment as its flagship product is more affordable than Moutai, its chief competitor.
Wuliangye is a Chinese majority state-owned operation (SOE) and is benefitting from SOE reforms that took place in 2017. These included issuing equity to employees, distributors and domestic investors. The increased alignment of interest has already provided a boost to performance as the company has worked to drive through material price increases and flatten distribution by doubling its sales and marketing team and encouraging distributors to sell directly to end-users.
The SOE reforms provided an inflection point for the company which has shown improved financial performance since then. Earnings growth is accelerating with EBIT increasing over the past ten years at roughly 20% per annum, over the past five years at 26% per annum, and over the past three years at 41% per annum. The company earns a return on invested capital (ROIC) of roughly 150% and ROE of 35%.
Wuliangye is an incredibly strong consumer franchise with almost unmatched history and brand power providing a strong economic moat. The company is delivering improved operating performance in a secularly growing market and Wuliangye has the potential to compound its intrinsic value at an attractive rate for many years.
We see our job as active equity investors to plot a course through an uncertain world by assembling a portfolio of high-quality businesses that offer a margin of safety between the price paid and the fundamental value of the business, the prospect of attractive returns and a diversified and controlled set of investment risks. Irrespective of how one defines and calculates value, we believe these principles are common sense.
The type of businesses our private equity influenced approach seeks to invest into are high-quality but appropriately priced businesses as opposed to businesses priced for perfection in the current uncertain environment. We believe value-oriented investors don’t have to simply buy ‘cheap’ companies. Robust, well-capitalised, undervalued businesses that can grow intrinsic value are out there and the increased concentration of benchmark aware capital into fewer and fewer mega-cap tech stocks means these opportunities are multiplying.
The following article is an extract of our original piece, 5 key investment models to identifying opportunities.
Read about our four other categories of private equity-style mispricing opportunities that we look for, including examples of stock that fit these criterias.