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Oldfield Partners: The three UK stocks we own for a value recovery

07 March 2017

The global equities team at Oldfield Partners outlines three UK stocks it’s holding and explain why investors should look to add value stocks to their portfolios.

By Jonathan Jones,

Reporter, FE Trustnet

Cyclicals, financials and commodities are where UK investors should be looking for value opportunities, according to the global equities managers at value investing specialist Oldfield Partners.

While many investors have shunned the lower end of the market for many years, the team at Oldfield say now is the time to capitalise on this and they are buying now that sentiment has sent share prices plummeting.

The value style has struggled over the past decade but last year global value stocks outperformed for the first calendar year since before the financial crisis in 2008.

Performance of indices since 2007

 

Source: FE Analytics

Fundamentally Oldfield focuses on one premise: the lower the price-earnings multiple you pay for a stock the higher your potential return.

As such, it avoids the emotion that investors can put behind an investment decision, as chief investment officer and portfolio manager Nigel Waller notes.

“People have said ‘oh you’re just buying the dogs of the market’ and I understand that but that in itself is laden with sentiment because that’s an opinion about stocks,” he said.

“What we are trying to get away from is that sense of emotion that can be generated around stocks and focus on the numbers.”

The firm places a ‘fair value’ price on each company it looks at, and has seen the gap between this and the share prices of its investments widen significantly in the last couple of years, peaking at 80 per cent in February last year, and remains above the long-term average.

“That has never happened to us since we began in 2005. The previous peak was in March 2009 when it was 64 per cent and that has really caught our attention.”

This is due to negative sentiment around value investing, which has been prevalent for more than a decade, but fund manager Andrew Goodwin says there will never be a perfect time to invest.

“Investment in our mind isn’t a science. We don’t believe in perfect markets and we don’t believe there is a perfectly right answer for the price of a stock,” he said.

“The price is determined by the interplay of buyers and sellers and because of this it brings into the stock price human emotion – primarily the emotions of greed and fear.

“What we try to do as value investors is stand outside of that emotional cycle and we want to buy stocks that trade a discount to their intrinsic value.

“Ultimately if we can buy at a discount that gives us what can be described as a margin of safety and it not only protects capital but gives us our best chance of generating strong long-term returns.”

Below, they outline three large-cap UK stocks that fit these criteria and examine the investment case for each.


 

Tesco

“This has been a very painful investment for us - where we’ve been wrong is that the recovery has taken longer than we thought,” Waller said.

The supermarket giant has been on a tough run in recent years, with concerns over the previous management team and the rise of discounters Aldi and Lidl sending investors fleeing.

As the below graph shows, the stock is down 32.88 per cent over the past five years, but the team at Oldfield Partners remain invested and see a turnaround in the near future.

Performance of stock over 5yrs

 

Source: FE Analytics

“People had been overly worried about the domestic business and clearly it’s gone through a hellish time and a period where there have been major concerns over corporate governance under the previous management team,” Waller said.

“We understand all of that but what we have done is stepped back and looked at all the food retailers we could find around the world and looked at their returns on capital through a cycle. Then we looked at the asset turn of those businesses and reversed out their required margin in order to make an acceptable return through the cycle.

“That brought us to for a 3 to 4 per cent operating margin a reasonably good retailer in those local markets.”

He adds that while some remain concerned that discounters will remain a problem for Tesco – and will cap the firm’s margins at 1 per cent – he is not worried as the best sign that there are improvements are the issues beginning to be seen in the discounters.

“If you go back to the worst point for Tesco that was when the like-for-likes of the discounters were running at 20 to 30 per cent per annum. All the money was flowing there,” the manager said.

However, like-for-likes today and discounters are now bordering on negative with cost-cutting measures employed by Tesco like “putting the tanks on their lawn”.

“That has been a dramatic change in the structure of the industry which has not had enough coverage in the press and you see that in the improvement of Tesco’s business but the share price has yet to fully reflect that as there is still scepticism.”


 

Rio Tinto

Commodities have been a big winner over the last year with prices across the board rising from extremely low levels in 2015.

The Bloomberg Commodity index rose 31.38 over the past year, including the iron ore spot price, which the managers say is the key for Rio’s recovery (up 73.21 per cent over one year).

Performance of stock over 1yr

 

Source: FE Analytics

“Again here is an example of a cyclical company which was the world leader in terms of its cost in most of its categories – iron ore being the most important – with a relatively good balance sheet,” Waller said.

“So we knew that we had the lowest cost operator in the market and we had the best balance sheet in the industry.

“If you’re going to be patient you have to let time play out and you have to have the balance sheet that will [provide a buffer].”

The way Oldfield analysed Rio was to look at an implied spot price for iron ore that was significantly below the current $87 per metric ton.

“I think what we tend to do is use a discount to spot prices as our assumption and we use $55 valuations for the most important ingredient which is iron ore,” the manager said.

“Fair value for us is quite a way above where we are today but if you use spot prices of today it would well more than double the upside of the stock as the cashflow it is making today is very attractive.”


 

Lloyds Bank

“We bought Lloyds at the end of last year on post-Brexit concerns about the outlook for the UK market” Waller said.

The stock has (very) slowly risen since 2008 but remains 64.71 per cent below pre-crisis levels, as the below graph shows.

Performance of stock over 10yrs

 

Source: FE Analytics

Goodwin added: “Again it’s this focus on balance sheet because clearly by definition in a financial company you have operational and financial gearing and so the first point for us is the health of the balance sheet.

“Why we alight on Lloyds over other banks is because it has one of the strongest balance sheets in the European financial area.”

Waller added: “Were able to buy it at sub-book value because we feel it is a business that is very dominant in the UK – typically 19-20 per cent market share across its product range – with very high returns on capital.

“And again the headlines were drawn to the big losses on PPI and other things but let’s strip that out and look at the underlying business.

“The underlying business has been phenomenally profitable in parts of the UK and the chance to buy that below book was just too good to miss.

“So financials, commodities and cyclicals – those are the areas we have found value in over the last couple of years.”

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