Equity markets have moved higher and as usual, participants are desperately searching for reasons to justify it. Apparently economic news is improving (depending on your chosen statistic), equities are cheap (providing you do not mind using a company’s peak profits to come to this assessment) and sentiment is good (we prefer sentiment to be poor). We wonder if equity markets are moving higher on fear rather than greed: the fear of missing out on returns when other asset classes appear extraordinarily unattractive.
The Temple Bar Investment Trust focuses on stocks which are significantly out of favour, but which offer hope that a recovery in operating profits and share price will be generated. We hold a mix of stocks from diverse sectors and the performance of the Fund is typically more dependent on individual companies being run better rather than strong underlying economic conditions.
Our current strategy is, as ever, company focused, looking to buy out of favour, cheap stocks on normalised earnings (i.e. adjusted for cyclical ups and downs in the economy). Given the relative strength of corporate earnings and still fairly expensive normalised valuations, we have chosen to apply this strategy patiently. However, the rate of profit warnings (i.e. companies advising they will not meet analyst expectations) worldwide is now increasing, which gives us confidence that our investment universe is set to grow.
One of the exercises we typically conduct as potential investors in an underperforming company is to speculate over the likelihood of the company’s performance reverting to mean. We are particularly aware of the risks of this approach — that the past is no guide to the future, and that the company we are investigating might need to accept a lower level of profit as the new standard.
What we, and others who share our investment philosophy, have possibly spent insufficient time considering is when the future may actually be better than the past. Perhaps a company or industry has generated disappointing levels of profitability for many years due to overcapacity, onerous regulation or irrational competition. Conditions finally change and create an environment for higher levels of profits and the shares respond positively. We usually regard these companies as the ones that got away and the lost opportunities as simply a function of what we do. Given our reluctance to forecast the future, certainly compared to our peers, why should we believe we can successfully build, to steal a business management cliché, a ‘blue-sky scenario’?
So having identified a company, or an industry, which may break out of its historical profitability range and the range of its peers, how can we estimate the new normal and consequently a fair value for the shares? The obvious answer is we cannot; it is a guess. However, we can set a few ground rules.
First, it may be worth watching a company’s profit forecasts. Historically, we would be sceptical about this approach as company management is typically excessively bullish, but in the instance of management suggesting a (deep breath) new paradigm, the market often adopts an ultra-sceptical stance with arguing that an industry is structurally hampered, uninvestable and incapable of ever generating decent returns for investors. These company forecasts are unlikely to be extraordinarily bullish, so may well set a good base case; after years of disappointment there seems little point in a management team making outlandish forecasts.
Second, it may be possible to find less obvious peers – perhaps industries with similar levels of capital intensity or market structures – to determine what returns may be possible. The market is structured to encourage a silo mentality; investment bank analysts tend to focus their attention on companies in their own sectors and opportunities for cross- pollination are perhaps not maximised.
Finally, and perhaps combining the first and second points, we should try to detach ourselves as much as possible from the industry, and the biases that come with the years of disappointment. Ask ourselves what returns an industry or company with certain characteristics could generate given the barriers to entry and exit, cashflow requirements, market share and pricing power. Some value investors may question whether this approach moves us into the sphere of growth investing. It is a fair point, but it is just as important for investors to keep an open mind about most things. Just as putting too great an emphasis on the past as a guide to the future can lead to great losses, it can also lead to missed opportunities.