Don't believe the labels

Source: GMO to 30 June 2021

Misdiagnosed structural decliners offer opportunities for value investors

Knowing in advance which businesses are suffering a temporary setback, and which are in long-term decline is not as easy as many would seem to believe. Returning to our Microsoft example, the shares became cheap because many investors had convinced themselves, wrongly as it turned out, that it was going to be disrupted by firms such as Apple and Google. This demonstrates how investors can frequently under-estimate the ability of businesses to adapt and change. Hence, lowly valued shares which investors have written off as secular decliners, often turn out to be more resilient than expected and hence produce strong returns as views change and they ultimately re-rate.

Are energy stocks in secular decline?

This leads neatly on to a discussion of the energy sector, which is a great example of an industry that has been written off by many investors that believe it is in secular decline as the world transitions to a carbon neutral future. Fund managers taking this view have sold their holdings of energy companies, whilst others have excluded them from their funds for ESG reasons. We are obviously very mindful of the ESG issues surrounding the sector but our approach to sustainable value investing favours engagement over divestment. This is something we intend to write more about in a future issue of this quarterly newsletter but, in the meantime, the actions of other market participants do appear to have contributed to an attractive long-term opportunity, with valuations driven down to their lowest level in years. To give some idea of how dramatic this decline has been, in 2000 the energy sector accounted for 30% of the S&P 500 Index. In 2009 this figure was 15% and today it is 3%. To put that in context, the Technology sector is now 28% of the S&P 500 and both Apple and Microsoft individually represent more than 5% of that index.

The irony of the energy sector being out of favour is that it comes at a time when the fundamentals are looking very promising. In response to falling energy prices as well as environmental pressure, energy companies have slashed their capital expenditure, with the 43 largest listed oil & gas producers having reduced aggregate exploration & production spending by around a half (source: JP Morgan). Some believe that as Covid subsides and world economies re-open, there may be insufficient production to meet rising energy demand and, as we write, this thesis seems to be playing out with Brent crude oil at $83 per barrel, up 120% over the last year, and natural gas at 300p per therm which is up 700% in the last twelve months.

The information shown above is for illustrative purposes only and is not intended to be, and should not be interpreted as, recommendations or advice. No investment strategy or risk management technique can guarantee returns or eliminate risks in any market environment.

Needless to say, this rise in prices is having a positive impact on the profitability of the energy companies. If we use BP as an example, management has guided that at an oil price of $70 per barrel, the company will produce free cash flow per share of $0.73 which, at the current dollar share price of $4.50, equates to a 16% free cash flow yield (note, this is after all the capex required to transition the business to renewables production). At $60 per barrel, the company expects to be able to deliver share buybacks of around $1bn per quarter and have capacity to increase its dividend by around 4% each year through to 2025 (source: BP). These plans imply that approximately 10% of its current market cap (split broadly equally between a c. 5% dividend yield and an annual cut of c. 5% to its share count) can be returned to shareholders each year. In other words, investors can expect BP to return more than 55% of its current market cap to its shareholders by 2025.

Conclusion

Across the fund management industry, investors seem to have drifted away from value investing, a discipline that has worked in the long run but not recently, towards a style now labelled quality or growth investing, which has worked recently but not in the long run. This style drift is often justified by claims that the investing world is now polarised between the winners and losers and yet, as we have seen, the data does not seem to support this thesis.

We continue to believe that valuation provides the best guide to future returns and given some of the low valuations available today, we believe investors will be handsomely rewarded by sticking with value investing.

Yours sincerely

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