Dear investor,
A reasonably calm summer quarter has come to an end, although, below the surface, the markets were actually fairly agitated. For example, the performance seen in the equities markets, which recorded slight gains overall, but with very pronounced geographical differences. The gains in the American (+3.0%) or European (+1.0%) indices over the three months contrasted with the sharp declines in markets such as China (-12%) or Brazil (-18%).
Performances of individual companies have also been uneven. While many have done exceptionally well with recurring and visible results, some of the companies that are more closely tied to the business cycle — or where demand for their products is less obvious in the short term — have suffered significant share price declines.
One way to summarise the quarter would be to point out that the purportedly costly stocks have grown even more expensive, while the discounts at which the supposedly inexpensive companies have traded have increased. This would be a somewhat superficial analysis, but it would not be far off from the truth.
Heavy rains but concentrated in certain areas
This summer, the storm clouds that have been looming on the horizon in some sectors finally discharged the rain they have been threatening for months.
Intense and very localised rain in businesses affected by the extension of the Delta variant, for example, which clearly still affects all tourism and tourismrelated activities. Or in many companies that have to change their business plans due to the semiconductor shortage, such as with automakers. And, naturally, food or industrial companies, where the steep rise in some raw materials is increasing their costs very significantly.
This quarter, these types of companies, which have long had dark clouds hanging over their heads, have taken a beating on the stock market. We cannot say why their share prices have started to suffer now and not months ago, when the dynamics were exactly the same. What we do know is that, if at the end of the day these downpours are only temporary — and the valuegenerating capacity of these businesses remains intact — a good number of
these companies are becoming very interesting investment opportunities.
China’s regulatory tsunami
The other big cloud that has rained down on the markets this summer has been China. The Asian giant’s economy is slowing considerably, affected by the withdrawal of stimulus measures by the authorities and also by intense regulatory pressure affecting many sectors, the consequences of which remain to be seen. Education, banking, luxury, and technology are just a few of the areas where oversight has increased and some of the rules that regulate them are being changed. As if all this were not enough, Evergrande (HKSE:03333, Financial), one of China’s largest real estate developers, is in the midst of a liquidity crisis that could render it insolvent.
We recently published an Investment Team Blog post in which we tried to objectively explain what is going on in China’s regulatory environment and why we believe its tech giants represent a good long-term investment opportunity. One that should not be missed.
Signs of normalisation…
Bestinver’s funds have not been unaffected by many of these storms, although their impact has so far been limited. Our portfolios are designed to be balanced, and fortunately we have companies that have behaved like umbrellas this quarter.
We are talking about companies whose businesses have not been affected by the situations we have just described and which in many cases represent a safe haven for investors in an uncertain environment.
All in all, the investment outlook is still relatively favourable. This is despite the fact that growth rates in the major economies are no longer as strong as they used to be and central banks will be scaling back some of the extraordinary stimulus that has underpinned recovery since the outbreak of the pandemic.
We believe that the fact that the strong momentum of the recovery in the economies is easing somewhat, or that some one-off monetary (and fiscal) stimulus is being scaled back, is a sign of normalisation that we should welcome. If the side effect of this return to normality is a decline in valuations, we also see this as good news for the future performance of our portfolios.
…and reinvestment opportunities
The most interesting aspect of the quarter was undoubtedly the good reinvestment opportunities we are finding in companies whose results are temporarily affected by the dynamics we discussed, but whose share prices have discounted a lasting and profound impact that we do not anticipate.
In our last quarterly letter, we explained the importance of keeping the right perspective when looking at corrections. It is about keeping an eye on the link between price and profitability and understanding price declines for what they are: blips and not crashes, which can be inferred from the fact that some share prices have fallen by 30-40% in a short period of time.
From this point of view, the next months could — potentially — be more profitable than the last months. The price and value offered by many companies on the stock market have begun to diverge sharply, and we are seeing safety margins the likes of which we have not had in a long time.
We do not predict stock market falls — we cannot tell if they are going to happen — but just remember that though we may naturally feel some degree of vertigo if they do happen, they are usually a wonderful opportunity to deploy our long-term capital, rather than a real threat.
Allocating capital
This task of directing our resources to the best possible ideas is called “capital allocation” and is a topic we would like to touch upon in this quarterly letter. And we will do so not from an investment perspective, but from the perspective of business management. Business management is far removed from our area of expertise, but we share some dynamics with it (e.g. investments) and the same goal (achieving long-term profitability).
The decision to buy a company on the stock market is made in a similar way as a company’s decision to invest in a new factory or project: “If we pay out an amount today, how much do we expect to get in return in the future”?
Looking at things from this simple perspective, we could say that capital allocation is about directing one’s resources to the projects that will yield the highest possible return in the future. And yes, ultimately it is exactly that, but in reality it is much more complex and not limited to a strictly quantitative area.
The value of governance
Capital allocation is a combination of corporate finance and corporate governance. What do we mean by that? Well, theoretically it is about deciding how to finance a company and what to do with the money it generates. Importantly, however, these decisions are made by people, by individuals who have very different incentives, working in organisations whose corporate culture encourages (or discourages) certain types of behaviour.
Some investors overlook this qualitative analysis of corporate governance when they invest their capital. They focus more on the short-term performance of their companies or on the valuation multiples at which they are listed on the markets. We adopt a different approach. We believe that knowing how a company’s managers think, what makes them tick, what their values are, whether they have a rigorous analytical framework and the right temperament to allocate the resources at their disposal, is an essential part of our investment process.
Outsourcing the management of our portfolios
Before we go any further, we are going to let you in on a little secret about our work that many of you may not have noticed. This is crucial to understanding the importance we attach to corporate governance and the allocation of a company’s capital in our analysis.
When you come to Bestinver, you are entrusting us with the task of managing your savings for the long term (profitably and sensibly), are you not? Of course. Do you know what we do with that capital? We transfer it to the people who run the companies we invest in, so they can manage it.
This is a part of our work that is not always talked about and whose importance, as we said, is absolutely crucial. And it is because we effectively outsource the management of our portfolios to the managers of the companies we own.
Nicholas Sleep, one of the most brilliant investors of this century, described this process perfectly, when he said to his clients: “My job is to delegate the custody of your investments to the right people at the right price.
Sources and uses of capital
Management teams use a basic tool kit when arranging a company’s capital allocation.
First, capital can only be raised in four ways: through the issuance of debt, through the issuance of equity, through the sale of assets, and through internally generated operating cash flow (the cash generated by the business). This capital can then be allocated in five different ways: reinvestment in the company (capital expenditure, R&D and working capital), buying other companies (mergers and acquisitions), distribution of dividends, repurchase of equity or repayment of debt.
We will not analyse each of these levers in detail here, nor will we address how we think a company’s management teams should move them to create (or destroy) long-term shareholder value. This is a topic we will cover in future issues of the Investment Team Blog. However, we invite you to read the management commentaries on the various Bestinver funds, where managers talk about interesting cases of capital allocation for some of the companies they hold in their portfolios.
Capital is expensive…
However, we would like to point out an important principle of the intelligent allocation of a company’s capital. Namely, every resource has an opportunity cost, whether it is procured internally or externally. None of the options available to the management team takes precedence over the others. This is a key concept that not all investors or managers truly appreciate.
Whether capital is raised from operating cash flow, asset sales, debt issuance or equity sales, it must be considered finite and treated as such. Or rather, it is not finite (capital must always be available for profitable projects), but it is expensive.
A common misconception of many business leaders is that operating cash flow is relatively free and has no cost. This is not true. Its true cost is the opportunity cost of other projects that could be undertaken with that money, including repayment to the owners of the business if there are no profitable alternatives.
…And investments must generate value
This last point is very important. If the return on a company’s assets is less than the cost of the funds needed to finance them, what good is it? The value added is zero and the reinvestment in those assets should also be zero. The purpose of any business, at least those we are interested in at Bestinver, is to create wealth for its owners. We are investors, not philanthropists.
However, if the company’s assets generate a return that exceeds the cost of capital, i.e. if it creates value for its shareholders, the reinvestment and financing decisions made are very important in increasing or decreasing that “value”. This is the most important part of our analysis because it determines the difference between a good and a bad capital allocator, i.e. who creates value through their management and who destroys it.
The most important intangible asset of all
For smart capital allocation we need to understand the long-term value of a range of opportunities and allocate a company’s financial and human resources accordingly. It is a dynamic and evolving process in which managers must have certain qualities and a temperament that not all of them possess.
In our Capital Allocation Part I post, published a few days ago, we address the question of what we look for in the managers of the companies we analyse and why we think their work will be even more relevant in the future: Horses or Jockeys?
The decisions management teams make about where to invest and at what prices — the same decisions we make as managers of their savings — largely determine the future of their companies. And also the future of our portfolios. Now that intangible assets are so much in vogue in the markets, we at Bestinver believe that the people we work with in our investments, are the most important assets of all
Best regards,
The investment team
BESTINVER
