Dear investor,
We would like to begin our third quarterly report by remembering the victims of Covid-19 and their families, and showing our gratitude to everyone who continues to fight against the virus. We would also like to send out a message of hope to those members of society most affected by the pandemic. The scientific community is closer to finding a solution so we can overcome this threat, protecting not only our lives but also returning life to normal. At a time like this, it seems fitting to recall the French writer Luc de Clapiers who said that patience – deriving from the Latin word patiens (one who suffers) – is the art of having hope.
Turning to our analysis of the economic situation, we can see how the major fiscal and monetary stimuli rolled out since the start of the pandemic are making a difference, and the economic rebound continued to gain traction over the summer months. Nevertheless, recent warnings from the heads chiefs of the European Central Bank and US Federal Reserve suggest that additional measures will still be needed in the coming months to maintain the current rate of recovery.
In this respect, at the end of July the European Union approved the largest budget in its history, allocating EUR 1.1 billion for the period 2021-2027 and launching a recovery fund of EUR 750,000. This fund will be financed by the Commission which will issue bonds on the international financial markets on behalf of the Union. In effect, this sale of joint long-term debt – exploiting the Union's triple A rating (highest quality, lowest cost) – sees the arrival of eurobonds or the anticipated mutualisation of European debt. It is too soon to evaluate the impact of this move. The market has too many concerns (a surge in cases, delays in approving vaccines and their ultimate effectiveness, the US elections, Brexit) to calmly analyze its consequences, but it is undeniable that on this occasion, the European Union has not squandered the chance to do something fundamentally positive.
The second wave of cases and fears about a possible new lockdowns have been noticeable in the markets since August. Small drops have been seen for the first time in a long time, which have been more intense in the US than in Europe. Similarly, stocks in the global value indexes have also outperformed those in the growth indexes, weighed down by the setbacks of the US technology sector.
At our recent 19th Annual Investors Conference, we reflected with you on "growth" and "value": two concepts that are totally complementary despite the fact that prevailing differences in their valuations make them appear to be opposing. As we said then, for Bestinver value is a pre-requisite and growth is a fantastic attribute, and thanks to our investment team's fundamental analysis, we are capable of identifying opportunities in both fields. Our investments in HeidelbergCement (XTER:HEI, Financial), GSK (LSE:GSK, Financial), HelloFresh (XTER:HFG, Financial), Tencent (HKSE:00700, Financial), Grifols (XMAD:GRF, Financial), Arco Platform (ARCE, Financial) and EDPR (XLIS:EDPR) are a great example of this.
In this report, we would like to examine with you some of the reasons that could be behind this disproportion that we observe in relative valuations. As you can imagine, this is not an easy task but we think it is worth reflecting on them and try to understand the difficulties encountered in value investing in recent times.
This time, we are going to focus on the consequences of low interest rates. First, one needs to understand the effect of a drop in interest rates on an asset's value. A company is worth the free cash flow or dividends it is capable of generating over its lifetime, discounted at a rate or cost of capital that should incorporate a series of appropriate variables (a reasonable inflation rate, the inherent risk of investing in a business, etc.). From this perspective, equities are not that different to fixed-income securities; a share would be similar to a bond with an indefinite duration.
Conceptually, a lower discount rate makes an asset more valuable, although this effect is not the same for all assets. The longer their duration, i.e., the more their future returns grow or are more visible (cash flows, dividends, coupons), the greater the positive impact of this lower discount rate. To a certain degree, this would explain the increase in the valuations of certain company profiles. If, in addition to this, we consider that global economies have shown moderate and erratic growth over the last few years, it is easy to understand why the market has valued and given so much weight to this type of attribute (growth, stability, visibility).
As well as this theoretical impact on valuations, in practice low interest rates have also had other effects in practice that are decisive when it comes to explaining the difficulties encountered in value investing. An environment of persistent zero rates causes the gradual disappearance of the so-called "creative destruction", made popular by the Austrian economist Joseph Schumpeter. This process -necessary condition for economic progress, through which companies unable to generate value tend to disappear leaving only those that can respond to consumers' needs and therefore produce more wealth for society-, has been one of the most important allies for value investors throughout history.
Identifying a profitable and well-managed business in a sector with overcapacity and low productivity was historically a smart way of investing our capital. The passage of time, lack of profitability and poor business decisions (excessive borrowing, for instance) led to an inevitable purge that created a new and favourable environment. In this context, the survivors were able to see their earnings and wealth growing, while we – as value investors who had done their homework and had patience on their side – could benefit from this process of natural selection. Those of you with a good memory will remember Viscofán (XMAD:VIS) in Spain or Samsung (XKRX:005930) in South Korea as two examples that perfectly exemplify the dynamic we have just described.
The proliferation of "zombie" companies or sectors leads, to a certain extent, to the neutralisation of capital cycles in the economy and a disconnection of the value of analysis and patience as essential contributors to successful investment strategies. When zero interest rates prevail, any project appears to be profitable and high leverage does not pose an immediate threat, resulting in oversupply that would not otherwise be possible. The subsequent poor allocation of capital and perennial increase in borrowing and refinancing end up being especially damaging in sectors with a high level of competition. When demand falls, as it does in a recession or crisis such as we are facing today, there is a particularly severe destruction of value in companies and sectors that operate with overcapacity. The oil and gas and banking sectors are good examples of this extremely harmful process.
Obviously, low interest rates are not the only factor behind the poor results of value investing over this period, but we do believe that their influence has certainly been remarkable. In parallel, we are witnessing an authentic digital revolution that is transforming many business models, and many of these changes are happening at an unprecedented speed. This requires not falling into dogmatism in our analysis, but also developing a new way of investing that reconciles the profound changes taking place now – trying to avoid the famous value traps (and also growth traps) – with the huge opportunity of value investing today.
Here at Bestinver, we are aware of this complexity. We have been living through a decade of ultra-aggressive monetary policies, and the economic crisis caused by Covid-19 has meant that the appropriate fiscal stimuli needed to soften the pandemic's impact have had to be financed through central bank support. In turn, this has led to the printing of vast amounts of money. The risk of currencies losing their purchasing power in subsequent years (inflation) or interest rates beginning to climb to underpin and protect these currencies is by no means trivial.
At Bestinver, we believe the best way to protect ourselves from these threats is to own quality assets that are well managed, prudently financed and, above all, purchased at attractive prices. We work for you with this goal in mind. A reference shareholder that provides solidity and permanence, an eclectic and committed investment team in search of value, and and investors with knowledge, prudence and patience – who are our greatest asset – represent a formidable combination to exploit existing opportunities and those that may be presented in the future.
We would now like to mention a number of new developments at a corporate level. We have launched a new fund: Bestinver Deuda Corporativa, which completes our range of fixed-income products. This is a fund with a recommended investment term of two to three years, which invests in high-yield bonds and subordinated debt.
We have also completed the transition and on-boarding at Bestinver of the team from Fidentiis Gestión. This integration has been a model of success and has meant the assumption by Ricardo Seixas of all responsibilities for the Iberian equities arm and enhancing the efficiency and optimisation of the investment team's resources.
Lastly, we are pleased to announce that from now on, you will be able to to find the management commentary for each of our funds in the quarterly reports. We believe that having the opportunity to know individually the vision of its managers and the main movements made in the portfolios could benefit you when it comes to choosing those that are best suited to your preferences and needs.
Sincerely,
The investment team
BESTINVER
