The Certainty of Uncertainty – Or Is It the Uncertainty of Certainty

Our clients would have noticed that our funds’ exposure to companies involved in cyclical industries has slowly but surely increased over the past few years. At the end of December 2010, Titan Cement was the only cyclical in the RECM Global Fund’s top ten holdings. By December 2013, there were six cyclicals in the top ten.

It seems to us that the market’s current passion for non-cyclical shares is based on their earnings certainty. The market is shunning cyclical industries because their earnings in the short term are unpredictable. Our thesis is that by following the herd into industries with earnings certainty, seemingly at any price, the market is guaranteeing itself uncertainty in another area – investment returns.

This article discusses how the market’s current aversion for cyclical shares has created opportunities for patient value investors to allocate capital. While the earnings of companies in these sectors may be uncertain in the short term, we believe this masks some excellent opportunities for good investment returns in the long term.

When is a cyclical business not a cyclical business?

Firstly, lets clarify our definition of a ‘pure cyclical’ business. This is necessary because all businesses are by definition cyclical in nature – some more so than others. We consider a business a ‘pure cyclical’ when it has unusually volatile revenue and/or profit margins. Often these are firms operating in capital-intensive industries with long life assets and long duration cash flow payoff profiles. It’s exactly the long life nature of their assets that make them cyclical.

In our work, we pay particular attention to capital cycle theory. We’re drawn to industry segments where a period of excessive investment in industry supply is followed by a long period of supply withdrawals. These withdrawals can take the form of outright business failure and/or permanent or semi-permanent capacity closures. Semi-permanent closures are seen in industries in which it takes many years to bring mothballed capacity back online, if it’s even possible at all.

It’s important to realise that it’s not just a matter of simply flicking a switch and starting up an old machine or a mine. Mothballed capital equipment and mines are typically stripped for spare parts, making them particularly hard and potentially dangerous to restart. Mines often become flooded, new customers need to be contracted, products often go through lengthy trials to re-establish quality and people need to be found, hired, trained or re-trained to use equipment. Especially with older technology, the skills required to operate it may be rare or lost completely. While it may not constitute a true barrier to entry, the skills, fixed capital and working capital required to re-start old equipment is often a significant impediment. This may well hold until the business cycle recovery is well and truly mature, and clear to see in the numbers.

Capital funders tend to move in concert in capital-intensive industries, switching the supply of debt and equity capital off during times of uncertainty and back on only in times of certainty. As a result, a long period of undersupply tends to be followed by a long period of oversupply – making earnings for companies involved in such industries very cyclical.

Following many ownership rounds of cyclical firms and related management meetings over the last 20 years, it has become clear to us that successful management of a cyclical and capital-intensive business demands certain attributes:

  • Good cost control – the ability to manage variable costs. This is more important the more volatile the revenues and profit margins of a particular industry are, and the higher the debt on the balance sheet. When times get tough, only the lower cost operators survive.
  • Sound incentive structures – an appropriately long-term incentive system that recognises and rewards management for long-term thinking, actions and outcomes.
  • Patient and contra-cyclical providers of capital – debt and equity capital funders and owners with the necessary patience and understanding to support a cyclical business through the full extent of the business cycle, in particular during the trough. They must also be strong enough to discourage management from making dilutive investments at the top of the cycle.
Table 1: Global Fund Cyclical Holdings by Cluster

Table 1: Global Fund Cyclical Holdings by Cluster

Cyclical (by our definition) companies in the RECM Global Fund total 43% of the equity of the Fund as at the end of March 2014, making this the largest investment exposure we can group into a ‘theme’. However, we can further split these cyclicals into five distinct clusters as shown in Table 1.

Shares in cyclical industries have underperformed the broader market since 2011

Chart 1 plots the equally weighted performance of our cyclical holdings against the MSCI World Index. It shows how cyclical stocks massively outperformed the rest of the market from 2003 to 2008 as the story of the commodity supercycle convinced many investors that this time it was actually different. Of course, it turned out to be no different than any other previous cycle. High commodity prices drove overinvestment, which subsequently led to lower commodity prices as excess supply hit the market. The painful fall of cyclicals during the global financial crisis wasn’t forgotten in the rebound to 2011. From 2011 to 2013, however, cyclical shares underperformed the MSCI World Index, although there has been some improvement since the second half of 2013. We started building our position in cyclicals during the last period of underperformance.

Chart 1: Performance of Cyclical Stocks Owned by RECM Against the MSCI World Index

Chart 1: Performance of Cyclical Stocks Owned by RECM Against the MSCI World Index

Source: Thomson Reuters Datastream

Chart 2: Price-to-Book Ratio of Cyclical Stocks Owned by RECM against the MSCI World Index

Chart 2: Price-to-Book Ratio of Cyclical Stocks Owned by RECM against the MSCI World Index

Source: Thomson Reuters Datastream, Bloomberg

On a valuation basis, as Chart 2 demonstrates, our basket of cyclicals continues to trade below book value and at a significant discount to the average price-to-book ratio of the MSCI World Index. So despite their recent bout of outperformance, our investment case remains intact.

Our investment in cyclical companies is thus still ‘early in the J-curve’ – they’re relatively newer investment ideas in the very early stages of our ownership cycle, which typically extends beyond four years. An exception to this is cement, where our portfolio managers have been harvesting the Funds’ holding in Greek-listed Titan Cement following a successful investment outcome.

Energy businesses don’t strictly meet our definition of cyclicals

It’s important to note that the market myth about energy businesses being cyclical has little basis in reality. These businesses have far more stable revenues and profit margins than is commonly believed. They rarely if ever lose money, even in the worst troughs of their business cycles. Excluding energy from our definition of cyclicals brings the RECM Global Fund’s combined exposure to 25% – still not insignificant, but less than at first glance.

Our second largest energy investment, BP, came about as a result of a company-specific event, the Deepwater Horizon oil spill. Large cap energy reminds us of our investment thesis in large cap pharmaceuticals three years ago – single digit price-to-earnings (P/E) multiples, 5%+ dividend yields, stocks trading near book value and widely agreed to be ex-growth dinosaurs. We discussed this opportunity in ‘Smoke ’em & Dope ’em – The Tale of the No-Growth Ruse’ (REVIEW Volume 17, July 2011) and ‘Smoke ’em & Dope ’em Again’ (REVIEW Volume 26, October 2013).

These energy companies represent very attractive odds – we’re essentially being paid handsomely in dividends to wait. We also know these firms continue to invest heavily in broadening their energy offerings to cover all the bases for future growth in energy demand. This mirrors the continued investment pharmaceutical companies made in their product pipelines during the tough times that eventually paid off in revenue growth and better business prospects.

We invested selectively in stocks that held strong positions in their industry

Our initial screening processes identified the shares of cyclical businesses as being attractively priced and exposed a long list of stocks trading at record low valuations that were actively disliked by investors. Our analysts started detailed assessments of the relevant industries. In each case, we were hunting for companies with certain characteristics. We were looking for low cost producers with high quality long life operating assets, dominant market shares, robust balance sheets (or a clear ability to manage their debt in the event of distress), sensible management, or recent management changes, sensible management incentives, and strong long-term oriented shareholders.

Certain paper companies also attracted our attention

The paper industry faces significant headwinds as demand for paper declines. These companies typically have high financial gearing and most of the industry has already re-engineered their businesses away from paper – some with more success than others. Our clients have a small exposure to paper through our investment in Portugal’s Semapa, which also has interests in the cement sector. The industry headwinds apply only to certain paper grades – luxury paper is in near-terminal decline. But the cut-paper market (business paper) in which Semapa’s Portucel operates is still growing.

Shipping doesn’t meet our requirement for investment

Two pure cyclical industries that are notable for their absence or minimal exposure in our portfolios are shipping and gold. It’s not that we haven’t tried – we just haven’t been able to find many companies that satisfy our mental model (yet!).

The shipping industry currently faces several challenges, including a massive and unprecedented global oversupply. In the shipping industry, supply spikes occur in many small increments – capacity is created in single ship units. Compare this to an industry like iron, where the opening of a single large mine can add a meaningful percentage to total annual global output. The supply spike in shipping has so far been accompanied by a lack of withdrawals. While some ship owners may have gone bankrupt, new owners simply buy their ships out of liquidation and continue operating them. Several other factors make us wary of the sector:

  • significant debt loads and little balance sheet flexibility in the event of short-term debt repayments;
  • a lack of meaningful co-investment by shareholders of reference and insiders; and
  • our inability to date to identify a management team in this industry that has said and done sensible things through a full business cycle.

Gold also holds no glitter

The gold industry is saddled with ill-timed acquisitions made during the boom times as well as large ‘promise’ capital projects that are many years away from profitable production and not fully funded. Most gold companies lack meaningful co-investment by shareholders of reference or insiders, and management does not yet appear to fully understand or appreciate, let alone implement, counter-cyclical capital allocation policies. One senior gold mining executive told us recently ‘the investment case is that the share price can go up very fast at times’ which inspires in us the polar opposite of confidence. As a result, up until very recently, gold shares had not declined enough to offer a sufficient margin of safety for us to consider allocating capital to the sector. When prices fell further however, this hurdle was met to the extent that it justified small initial allocations to Goldfields and Harmony.

Investing in cyclicals requires strong nerves

What makes investing in cyclical businesses so unique is that the very best time to invest in them – from a prospective investment return perspective – is when their future seems uncertain and they are loss-making and closing capacity. It’s exceedingly tricky to make the argument that something is very cheap when it lacks traditional considerations of ‘value’, like a low P/E or a high dividend yield.

The real cherry on top comes when debt and equity capital funders get so nervous about their collateral that they turn from a ‘return on capital’ mode to a ‘return of capital’ mode. They stop funding cyclical businesses at precisely the worst point in the cycle and cause wholesale system failure and bankruptcy, leaving equity shareholders with worthless shares. This is why we try to look for like-minded co-owners in these types of companies.

The market is currently overpaying for certainty

A near-perfect ‘head fake’ is readily observable in the world today. Businesses operating with significant uncertainty are undervalued, disliked and under-owned, while businesses operating with what is perceived to be a high degree of certainty are overvalued and over-owned. Over the last three years, our funds have taken advantage of these unique circumstances by avoiding the overvalued market darlings and purchasing strong companies in unpopular industries. While we may not always get the timing perfectly right, our approach attempts to put the odds on our side by minimising downside risk and maximising upside potential.

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The investment objective of the STANLIB Global Property Feeder Fund is to maximise long term total return, both capital and income growth.