Our investment approach, which we share with our offshore partner Orbis, is sometimes characterised as ‘looking for cheap stocks’. Jeremie Teboul from Orbis explains why this description oversimplifies things somewhat. He goes on to describe some of the things we look for when we are hunting for the best investment opportunities for our clients.
While we are always on the lookout for large dislocations between share prices and our estimate of intrinsic value, these opportunities can present themselves in different forms depending on the market environment. For example, back in 2009 it was easy to find classically ‘cheap’ stocks in the aftermath of the global financial crisis. The more difficult part was deciding how to allocate capital amongst plenty of ideas.
The situation is very different today. As we have written recently, equity markets in the developed world generally look fully valued to us and there are few, if any, ‘no brainers’ on offer anymore. Many stocks that appear cheap today often come with undesirable characteristics such as deteriorating fundamentals, exposure to significant macroeconomic risks, or the lack of an adequate margin of safety based on the price we pay.
Looking for underappreciated change
That’s not to say we are unable to find attractive investments on your behalf. The world is a big place and even expensive markets can contain individual stocks that are attractively priced relative to our view of their potential. At times like this, we have found it effective to focus on investments in businesses that are either undergoing change or benefiting from it. Examples might include businesses that are improving their operations, repositioning themselves strategically, or simply benefiting from external change. The common thread is that the long-term value of the investment will depend far more on idiosyncratic factors affecting the company rather than broader stock market trends.
Make no mistake: valuation is still critical. We are looking for situations where significant changes are creating additional value that is not yet reflected in the share price. Our job is to identify businesses that can do much better than the market expects – and to avoid paying too much for the shares in case the company fails to deliver.
Internal change: Charter Communications
A good example of a company undergoing positive change is Charter Communications, a US cable operator. In this case, the change that is influencing our investment thesis is the opportunity for Charter’s proven management team to improve the company’s recently acquired Time Warner Cable assets. Whereas the management team was previously focused on fixing Charter itself, it now has the opportunity to fix a company with a much bigger footprint.
It will take time to fully integrate the two businesses, and there will likely be some quarters ahead that fall below expectations. But as long-term investors, we have the luxury of looking past this short-term lumpiness, and we can focus instead on what the company could look like after a successful transformation. Over the next few years, we see a path toward US$25 of free cash flow per share, equivalent to a 10% yield at the current share price. If our expectations for cash flow prove correct, we believe there is a reasonable chance that the company will repurchase shares at attractive prices, benefiting patient investors.
External change: JD.com
JD.com is an example of company that is benefiting from significant change, specifically the rapid adoption of online shopping in China. We believe the company’s combination of deep product selection, convenience and price offers compelling value for Chinese consumers. In particular, its same-day delivery infrastructure is very difficult for competitors to match because there is no equivalent to FedEx/UPS logistics in China; JD has built its own capability from scratch. It is now in the process of filling that capacity which ultimately will lower the company’s cost per delivery. How much of this potential improvement is priced in? Traditional valuation metrics aren’t much help because JD is barely profitable. But at a 50% discount to its (adjusted) Gross Merchandise Value, JD looks compelling to us in light of its positioning and the scale of the long-term opportunity.
In addition to the theme of ‘change’, our Charter and JD investments both play to our strengths as analysts and long-term investors. We believe it is equally, if not more, important to develop a deep understanding of the business and its potential than to time our buy and sell decisions. Our investment horizon allows us to focus on the intrinsic value of each business rather than short-term noise. In our view, that’s the essence of investing with an owner’s mindset – and it’s one of the best ways we can add value on your behalf.