Bestinver 2nd Quarter Investor Letter

Dear investor,

Imagine someone proposes the following investment to you: invest EUR 100 today and received EUR 96 including coupons 10 years down the line. Not very attractive, right? In IRR terms, this investment would be generating a 0.3%… negative return! This is what the German government is offering to lend it money over 10 years. And as
surprising as this may seem, there is currently over EUR 13 trillion (12 times Spanish GDP) invested in fixed income with negative IRRs.

What would you think if your bank offered you a mortgage where instead of paying interest you received it. Lenders paying borrowers and depositors paying banks… This is already starting to happen in some European countries.

While our funds ended the second quarter with positive yields – Bestinver Internacional: 11%, Bestinfond (Trades, Portfolio): 9% and Bestinver Grandes Compañà­as: 13% – the German bund hit an all-time low this quarter. The so-called “financial repression” is punishing savers and only rewarding those investors who are prepared to ride out period of volatility. In light of this, we need to ask ourselves the following questions:

1- What are the negative bond yields telling us?

2- What does this mean for equity investors?

3- What does this mean for value investors?

The first question leads to an even more transcendental matter which is to try and determine if bond prices reflect the fundamentals of the economy and an issuer’s exposure to credit risk or if, on the contrary, the IRRs on bonds are an anomaly caused by central bank intervention.

The negative bond yields could be an indication or warning of many things. Economists are talking of a possible recession, the threat of deflation and the effect of central banks’ expansionary policies. At Bestinver, we are not experts on the macroeconomy but we do have our own thoughts on it.

The recession could clearly hit at any time; the challenge is knowing exactly when and how deep it will be. Figures patently show that the global economy is slowing, although is not yet in a recession. Whatever the case may be, past evidence shows that predicting recessions and staying ahead of the game by selling and then buying more cheaply is rarely successful.

Deflation is a worry for those who see similarities between the Japanese economy after the 1990s and the current state of western developed economies. However, even though we are aware of the serious problems of deflation, as savers and investors, we, are more concerned about inflation.

Lastly, the measures taken by central banks, which have undoubtedly had a major impact on the performance of the main assets (financial and real), do not appear to have changed sufficiently in recent months to explain the constant decline in bond yields over the year.

It is difficult to interpret, at least for us, what the negative bond yields are signalling, but not knowing how to read them does not mean that they do not have significance. We must continue to try and understand them.

What does this mean for equity investors?
The effects on equities are numerous, although two stand out from the rest. The first: an increase in volatility at all levels. Volatility in the years before 2018 was abnormally low. Since the end of 2018, it can be said that volatility has returned and is back to stay.

The second impact derives from how the market selects the companies in which to place its trust. With bond prices at an all-time high, it is not surprising that precisely those companies that are most similar to bonds have performed the best.

What can currently be seen is that the companies deemed to have stable fundamentals in defensive sectors such as food, stable consumption and others have seen their share prices shoot up due to market uncertainty about the trade war, the threat of lower global economic growth, and the search for returns at a time when interest rates are at historical lows or even negative. Central banks have been the ones to force investors to increase their tolerance to risk in their search for returns. But is this justified? Companies such as Diageo,
Nestlé, LVMH, L’Oreal, etc. have, in some cases, seen their shares rise by over 40% during the year, causing their valuation multiples to spike, with investors paying more than 30 and even 40 times the earnings of these companies. And not forgetting well-known tech companies such as Amazon and Netflix, with multiples of 80x and up to 100x, respectively. High-quality companies continue to drive the upward market movements, but are also safe havens during periods of weakness. On the other hand, cyclical companies quash the confidence of investors who do not see sufficiently attractive valuations to take positions, without differentiating between high-quality cyclical companies at a low point in the cycle from other companies that are both cyclical and low quality and should not feature in long-term investment strategies. We believe caution is needed given the current situation. We must not be washed along by the overriding current in the market and must carefully weigh up our options to avoid assuming more risk than we should. The path ahead will not be an easy one but, sooner or later, the market and its valuations tend to return to the middle ground. A stable business does not necessarily mean a stable share price.

Sometimes we have the feeling that the current market climate has been seen in the past. The current period reminds us of the 1970s. The “Nifty fifty” was a group of companies that became the favourites of investors because of their record growth, increasing dividend payouts and high market capitalisation. These included Xerox, IBM, Polaroid and Coca-Cola. They were called one-decision stocks: buy and never sell. Exorbitant prices were paid for them; at a time when the US market traded at PER multiples of around 19x, this group of companies traded at a multiple that doubled this (the most striking being: Polaroid with an earnings multiple of 91x, McDonald’s, 86x; Walt Disney, 82x; and Avon Products, 65x). These companies’ shares sky-rocketed during the 1970s until the market crash of ‘74, After that the prices of these “buy and never sell” stocks started to plummet, with 90% of them generating negative returns over the following nine years. On average, the return was -46%. As Howard Marks (Trades, Portfolio) says in one of his letters, just because a company is good today does not mean it will continue to be tomorrow and even less so a good investment.

What does this mean for value investors?
In June, the Spanish tennis star, Rafael Nadal (perhaps the best of all time) was crowned champion at Roland Garros. After his win, I read in an interview with his former trainer – his uncle Toni Nadal – that Rafael Nadal’s strength was not his skill at hitting the ball, rather his ability to withstand the pain and suffering during the bad times. Value investors are similar. An investor’s success depends on their ability to stay faithful to their investment strategy when things appear to be in a state of flux.

The current period for value investors is not one of suffering, since the YTD returns of over 10% are attractive. However, value investors are facing an especially demanding scenario. Companies offering the greatest value today are not those that have performed best in recent months. In this context, the easiest option would be to abandon our convictions and choose to jump on the train of the highest quality companies, even paying a price that we know restricts the potential for revaluation as it sits only slightly above net asset value. Investing today in certain high-quality companies but at very high prices may be as unattractive as investing in German sovereign bonds with negative yields. Both investments may bring success in the short term, but do not appear to be the most sensible option for value investors who, by definition, are long-term investors. Keeping faith in cyclical companies that may not be at the best point in the cycle but offer attractive investment potential is, without doubt, bolder and, we believe, wiser.

For instance, we have been investing in Andritz (WBO:ANDR, Financial) (a supplier of plants, equipment and systems for the production of paper and pulp, turbines for hydroelectric generation and presses for stamping in the automotive sector) for just over a year. The market has heavily penalised this company’s share price during the year because of falling pulp prices and the sharp decline in car sales in China. Nevertheless, we consider this will be short lived and does not affect our investment thesis. When we analyse Andritz, we find a well-managed company with a clear owner committed to creating long-term value and a leading position in its respective oligopolistic segments. This type of example is precisely what leads us to believe the market is inefficient in the short term and encourages us to look further ahead.

A significant part of Bestinver’s portfolio comprises high-quality companies (and why not say it) with high, albeit not excessively high, share prices. These are the positions that have enabled us to post returns that comfortably remained in positive territory over the course of the year. That said, we do expect the market will afford us the opportunity to shift from these companies to ones with greater potential returns. We are in no hurry to make this move; we will wait for the right moment (and valuations).

Last but no less important, I do not want to finish this letter without talking about liquidity risk and the problems it has caused some renowned fund managers. It will soon be five years since I joined Bestinver after almost 20 years in London. One of the things that drew my attention at that time was the lack of interest, and even disdain, shown by some fund managers to liquidity risk in Spain. For me, it has always been a fundamental part of managing risk. It is crucial to be clear that the companies we invest in must have a liquidity profile that fits with the fund’s liquidity. Investing in companies in which we could hold a large and disproportionate share of their total capital could lead to undesirable effects on the returns of our portfolios, both when building positions (pushing prices up) and reducing them (pushing prices down). Cases such as Woodford in the UK cause us to be even more committed, if one can be, to managing illiquidity which, as I have said, is and will continue to be a cornerstone of our investment strategy.

Dear investors: transparency is undoubtedly one of our core values. And this transparency leads me to point out to you that investing will be uncomfortable for equity investors, and as is normally the case, will be subject to extreme volatility. However, it will be even more uncomfortable for value investors, who will have to wait patiently until the market offers the right opportunities, while other companies run by you much faster. However, as well as discomfort, this market will bring long-term returns for us value investors, as has happened
in the past. I’d once again like to take this opportunity to thank you for your trust in Bestinver. Best regards

Beltrán de la Lastra
CEO and Chief Investment Officer