STRATEGY UPDATE

The road to recovery: Part 2

21 August 2020

The coronavirus crisis has led to turbulent market conditions so far in 2020, but the RWC Continental European Equity Fund has delivered positive returns to its investors. Fund Managers Graham Clapp and Russell Champion discuss why recovery stocks are forming a major part of their portfolio for the first time in more than a decade.

Volatile conditions like those that have prevailed so far this year can change the opportunity set dramatically. Recovery situations become much more abundant in times of market stress. It should not come as a surprise, therefore, for investors to learn that the fund’s exposure to recovery opportunities has increased over the last few months, to the extent that it is now the largest segment of the portfolio.

The last time this was the case was in 2009 as equity markets troughed in the aftermath of the global financial crisis. Then, recovery stocks such as ASML, British Airways (now IAG), Rational, Saipem and Temenos collectively accounted for approximately half of portfolio assets, driving the significant outperformance of the funds we managed during that year.

In effect, we have been dusting off the 2009 playbook in recent months, to see what tarnished treasures we can unearth.

Source: RWC Partners, July 2020

What to look for in recovery stocks

Recovery investing involves companies that have experienced some sort of trouble. Sometimes, there can be very few of these opportunities around, but in times of crisis there will tend to be many more.

For us, when analysing recovery stocks, it is of primary importance that we understand what has gone wrong at that business and why. Then we try to assess what can be done about those problems and what impact the actions of management are likely to have.

The time to buy a recovery stock is when all the bad news has already been factored into the share price. This is harder than it sounds, but by looking at companies in detail, we try to ascertain whether the market has been too critical in its assessment. If it has, there is an opportunity to build a contrarian investment case.

As with all our analysis, we are looking for asymmetric risk and reward. An investment thesis is built around what could happen to the share price in different scenarios, ranging from worst case to best case outcomes. If our analysis suggests the share price already largely reflects the worst-case scenario, then we can have confidence in our ability to tilt the probability of success in our favour.

Ultimately, our decision to invest in a recovery opportunity may hinge on our ability to identify change. It helps if we can build confidence that something will positively influence sentiment towards that stock, be it a change in management or strategy, a business restructuring, or perhaps something external that will improve demand.

Timing, however, can be tricky. Recovery stocks tend to trough quickly – they don’t typically languish at depressed levels for long. In times of stress, share prices tend to fall quickly and then recover rapidly. This applies as much to entire markets as it does to individual stocks, as the experience of the last six months demonstrates. Timing, therefore, can be difficult to get right precisely. Consequently, it helps if we already know a business well, so our recovery positions tend to be in companies that we have invested in before. That way we already have a good understanding of the intrinsic value of the business, and can build confidence in an investment thesis quickly, to exploit undervaluation while it lasts.

This also has implications for holding periods and position size. We tend to hold recovery stocks for shorter periods, sometimes a matter of months rather than years. If they do persist as holdings in the portfolio, once the recovery phase of the investment case has played out, they will typically be re-categorised to another segment of the portfolio. At the outset, individual position sizes will tend to be smaller to reflect their relatively high-risk characteristics.

Looking forward

Thus far in 2020, we have delivered positive returns in difficult market conditions. This provides further evidence in support of our disciplined approach to stock selection. We have continued to adjust the shape of the portfolio to ensure it is positioned appropriately for the future. This means more exposure to recovery stocks now than at any time since the global financial crisis. Collectively, these recovery stocks did not contribute positively to returns during the first half of 2020, but they are in the portfolio for their considerable future potential.

Below we have provided three case studies to give you some further insights into what we look for in recovery stocks. Obviously, not all recovery opportunities will work out as positively as these examples. In aggregate, however, this exposure can contribute significantly to the fund’s future performance, as has been the case in the past.

Recovery case study 1: Pandora – unearthing tarnished treasure

Pandora is a Danish jewellery business founded in the 1980s, which became famous in the early 2000s for its customisable charm bracelets. Danish private equity group, Axcel, bought a 60% stake in the company in 2008 and listed it on the Copenhagen Stock Exchange in October 2010, in one of Europe’s biggest initial public offerings (IPO) of that year.

Life as a listed business started positively, with a more than 40% increase in its share price in a matter of weeks. As 2011 progressed, however, the stock started to lose its shine. Pandora’s share price slumped by more than 80% as growth slowed and amid the rising cost of its key raw materials, gold and silver. Strategically, in an attempt to increase profit margins, Pandora had priced itself out of the comfort zone of its core customers in the affordable mass market. Pandora’s chief executive resigned and, in less than a year, one of Europe’s most hyped IPOs had turned from Danish fairy tale to a gothic horror story.

Our team had followed the IPO in detail but did not find the investment case appealing enough to wish to participate. Following the profit warnings of 2011, however, the team maintained a close watch on the business, to understand the steps being taken to turn it around.

After a series of interim appointments, Allan Leighton, formerly head of ASDA and Pandora’s chairman at IPO, agreed to take on the chief executive role in 2013, to oversee the company’s rehabilitation. Sensing the potential for a contrarian opportunity with scope for recovery, Graham met management in November 2013 and came away with a positive impression of the business and its recovery prospects. However, the threat of litigation from shareholders that had bought at IPO was hanging over the business, and this was viewed as too much of a risk at that stage. Meanwhile, a key question that the team consistently returned to on this stock, concerned the sustainability of the franchise. Was demand for Pandora’s charm bracelets the result of a fad? And could the company successfully diversify into other areas of jewellery?

Over the subsequent weeks, the risk of litigation started to diminish, and a position was initiated in January 2014. Bracelet sales were starting to recover by this stage, with Europe and Australia delivering much better rates of growth. Meanwhile, margins were improving as metals prices normalised, with the prospect of gross margins above 70% for 2014.

At a further meeting with management in February 2014, Graham continued to build conviction in the recovery thesis. Leighton’s strategy was based on doing the basics well, with sensible initiatives designed to deliver controlled growth. If the strategy was to prove successful, Pandora could have enormous recovery potential in its core territories. Meanwhile, China was seen as a massive opportunity and the Australian experience in rings looked positive from the perspective of product diversification. This helped to reduce the team’s concerns about charms, still two-thirds of revenues, being a fad. Assuming that management didn’t mess up again, Graham saw the potential for significant growth, driving a positive earnings upgrade cycle and a re-rating of the shares to at least 16x earnings. In combination, this was expected to drive the share price towards DKK 350 in the near term, and DKK 450 over the following 12-18 months. In fact, the shares reached DKK 1,000 in May 2016, with strong sales momentum driving organic growth of over 20% per annum for three years. The stock re-rated to 18x earnings as a result of this sustained strong growth.

Source: Bloomberg July 2020. Past performance is not a guide to the future. The price of investments and the income from them may fall as well as rise and investors may not get back the full amount invested.

By the summer of 2016, the team started to become less confident about the prospect of continued earnings upgrades, however. With the benefit of hindsight, this proved astute; estimates were broadly flat from 2016 to 2018. The period of exceptional growth and gross margin expansion was over. With the recovery complete, the position was sold in July 2016 at c. DKK 870. Pandora therefore represents an excellent example of how the team’s endeavours to find tarnished treasures can sometimes unearth real gems.

Pandora experienced further operational issues in 2018 and 2019, with weakness in charms raising the “is it a fad?” concern again. Pandora’s diversification into other areas of jewellery such as rings and necklaces, however, means the fad risk is less now than it was in the past. As it happens, the team now view Pandora as an attractive recovery stock once more – it was added to the portfolios again earlier this year. They say that history doesn’t repeat itself – but it often rhymes…

Recovery case study 2: Carlsberg – probably the best case study in the world

In 2012, we alighted on the international brewing company, Carlsberg, as a recovery idea. At the time, it was experiencing problems in its Russian business, Baltika, which it had taken full control of through its acquisition of Scottish & Newcastle in 2008. Baltika had a strong market position, with a 38% share of Russian beer sales, but attempts to modernise the business in 2011 had backfired, leading to internal disruption and a loss of market share. Meanwhile, rising prices (a result of increased raw material prices and progressively higher excise duties) had put a dent in profit margins and caused the overall Russian beer market to shrink from 80 litres per head in 2008 to 65 litres per head in 2011.

This share price weakness prompted Graham and Russell to take a closer look at the investment case and a meeting with management was arranged for February 2012. The market had become increasingly obsessed with Russia and many analysts were extrapolating the problems into the future. With the consensus uniformly focused on the negatives, this had many of the hallmarks associated with a classic contrarian investment case.

At the company meeting, it became clear that management believed they could improve operating margins in Russia back to the 25% level that had prevailed before the problems arose. This was seen as the key to unlocking real upside in the shares. Carlsberg, as one of the lowest cost producers in Russia, looked well positioned to benefit from higher margins as and when costs, particularly malted barley where successive poor harvests had driven prices higher, started to normalise. At the time the market was clearly sceptical about Carlsberg’s ability to improve margins, despite management having a good track record of doing so elsewhere in Europe.

Although the investment case was built around a more positive view of the Russian business than consensus, several other positive aspects of Carlsberg were also being under-appreciated by investors. In valuation terms, it was considerably cheaper than other listed brewing companies, in part because it had less exposure to the fast-growing regions of Asia and South America. However, it did have a small presence in India and China, which management was starting to talk positively about as a future growth opportunity.

A position was initiated soon after the February meeting at a share price of DKK 437– not quite at the lows, but still in the early stages of a share price recovery that had commenced in September 2011. Initially, the investment thesis appeared to be developing reasonably well, with Russian beer volumes and market share ahead of expectations in the first half of 2012.

Source: Bloomberg July 2020. Past performance is not a guide to the future. The price of investments and the income from them may fall as well as rise and investors may not get back the full amount invested.

News flow in 2013 and a series of meetings with management, however, delivered progressive evidence that the investment case in Russia was not developing as positively as anticipated. Beer volumes remained under pressure and Carlsberg had found itself much more vulnerable to a ban on beer sales from road-side kiosks than it had expected. Graham and Russell’s thinking at this point was that there was still upside to margins in Russia, but it was becoming dependent on a return to volume growth which was looking increasingly elusive.

Nevertheless, Carlsberg’s shares had performed reasonably well over this time, but this was more a function of progress outside of Europe, with Asia emerging as a ‘stealth growth story’ for the group. The valuation was still attractive relative to other brewers, but despite early signs of success in Asia, Carlsberg’s higher relative exposure to the mature markets of Europe, was deemed likely to hold the shares back. With conviction waning, Graham and Russell elected to sell in November 2013.

With a return of approximately 35% on the investment, it can be deemed a relative success, albeit for reasons somewhat different to the ones originally identified. With the benefit of hindsight, holding on to the shares would have delivered an even more impressive return. We now know that Asia has been a huge success story for Carlsberg, with a profitable business in China that is growing strongly. Profit has started to move forward in Europe too, but eastern Europe still hasn’t recovered to the profit levels of 2011.

This all means that Carlsberg’s geographic profit mix has improved dramatically. Almost 90% of profits came from Europe and Russia in 2012 and in 2019 it was 65%, with Asia now representing 35% of profits. This transformation has been rewarded with a re-rating from a 25% valuation discount to peers, to a modest premium. Meanwhile, the whole sector has become more highly valued.

Recovery investing is always about trying to identify opportunities where substantially all of the bad news is already reflected in the share price. Getting this right inevitably means downside risk will be much reduced, so when investing for recovery, there will always be opportunities to be right for the wrong reasons.

Recovery case study 3: ASML – investing when the chips are down

ASML is a Dutch technology business that Graham and Russell know very well. It has formed part of their portfolios several times since they started working together in 2005, normally as a cyclical opportunity, but twice as a recovery idea: first, in 2009 as the world emerged from the global financial crisis; and more recently in 2018, as this case study reveals. As a result of its commercial success, ASML is now a very large company, but Graham and Russell believe they still have an analytical edge on the business, through this historic knowledge and multiple meetings with management over many years.

In 1965, a young American technologist called Gordon Moore famously predicted that the number of transistors on a computer chip would double every year for the next decade. At the end of that decade Moore, who had by now co-founded Intel, downgraded his expectation for growth from 1975 to a mere doubling every two years (a compound annual growth rate of 40%!) for the next ten years. Despite its death knell being sounded at regular intervals, ‘Moore’s Law’ as it has become known, broadly persists to this day.

The key to this exceptional and enduring exponential growth is miniaturisation. As chips have become smaller and lighter, the number of applications in which they can be used, increases. Chips have now become so small that we are entering the age of the “internet of everything”, where even ordinary household items can be connected digitally, in order to collect and exchange data.

ASML’s technology has been instrumental in assisting the perpetuation of Moore’s Law. Its market leading lithography machines, through which light is projected, shrunk and then printed onto photosensitive silicon wafers, have become embedded in the manufacturing process for a broad range of semiconductor nodes and technologies. First, its deep ultraviolet (DUV) technology and more recently its extreme ultraviolet (EUV) platform, which uses light with a wavelength of just 13.5 nanometers (nearly the level of x-rays), have helped to push the productivity and performance of the most advanced logic and memory chips ever closer to the boundaries of physics.

Nevertheless, within the long-term growth that has opened up as a result of this innovative progress, there is a cyclical pattern to demand, which can be problematic for all parts of the semiconductor supply chain. Understanding where we are on that cycle has always been an important factor in Graham and Russell’s thinking on ASML, alongside valuation. This cyclical view led them to exit the stock in 2017, at a time when the shares looked relatively stretched in valuation terms, and amid their fears that a prolonged cycle would eventually crack.

Source: Bloomberg July 2020. Past performance is not a guide to the future. The price of investments and the income from them may fall as well as rise and investors may not get back the full amount invested.

With the benefit of hindsight, the cycle held firm for longer than anticipated, helped by car demand being brought forward prior to the introduction of new vehicle emissions tests, investment in hyperscale data centres, and the boom in cryptocurrency mining. However, downgrades started to hit the sector in the second half of 2018, as the cycle began to assert itself. Semiconductor stocks severely underperformed during this period, amid market concerns about the magnitude and duration of this cyclical slowdown. Sentiment towards ASML was also negatively influenced around this time by further delays in the roll-out of its new ground-breaking EUV technology platform.

Following a meeting with company management in December 2018, the fund managers concluded that ASML was now back into attractive valuation territory and that the time to own it was “when this macro downgrade cycle is over.” Graham and Russell continued to view this as a very attractive business to own, with an almost monopolistic market position, strong pricing power and great cash generation.

Additional work on the investment case was instigated, with a view to identifying the right time to buy the shares for recovery. In January 2019, at a share price of €143 the fund managers bought back into ASML, feeling more confident that the downgrade cycle was starting to turn. This proved to be good timing – earnings upgrades recommenced shortly after this purchase and the share price hasn’t looked back. The shares currently stand at €317, making ASML one of the portfolio’s key alpha generating positions over the last 18 months.

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