October 2011

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Fears and uncertainty have created a wide range of opportunities in good businesses with healthy balance sheets trading at depressed valuations. A challenging growth environment does not mean low profits.



Fear and Uncertainty Create Opportunity

Investors are tethered to the saga of the European sovereign debt crisis, producing gut-wrenching market gyrations. The threat of Greek (Spain, Italy…) default, European bank recapitalizations, and financial contagion have driven fear and uncertainty to the extreme, and caused investors globally to move en masse away from equities: “highly correlated moves,” in Wall Street parlance.

Expecting the worst, investors have particularly penalized cyclical (or high-beta) stocks, driving valuation spreads between those and stable (low beta) stocks to almost unprecedented levels (Figure 1). On this basis alone, one could conclude that it is an awful time to reposition to low-beta stocks, as they are expensive compared to their cyclical counterparts (Figure 2). Even more importantly, we believe there is significant value opportunity in today’s beaten-down sectors. Over time, managements have demonstrated the ability to adapt, and overcome the obstacles in front of them, and to restore profitability in the wake of significant macroeconomic disruptions. Corporations today are well positioned to deal with near-term shocks should they arise, having de-leveraged their balance sheets and realigned cost structures following the 2008/09 recession. So rather than concluding that equities, and cyclical stocks in particular, are in trouble, in many cases we see a different picture: one of resilience, adaptability and solid financial footings. We see opportunity.



Profitability is Strikingly Resilient

From a global perspective, we find convincing evidence of corporate adaptability to all types of economic environments. Figure 3 presents the return on equity for the MSCI World index over a 37-year period, which includes recessions, high inflation, low inflation, and a myriad of other conditions. Though somewhat variable over the short term, returns on equity have stayed within a reasonably tight band around a long term average of 12%. These data reinforce our on-the-ground observations of company managements taking the necessary actions to meet the challenges of the current economic environment. Most investors were surprised by how quickly corporate profits rebounded after the last recession despite only a muted recovery in GDP. We take encouragement from corporate performance in 2008 as we survey the landscape today.

Stock Prices Overreact

For businesses with good franchises and well capitalized balance sheets, we would expect an economic downturn to affect long term earnings potential very little. The most relevant impact to valuation is the near-term, temporary disruption in earnings and cash flow, as the normalization process occurs. Using a standard net present value approach of discounting the future stream of earnings to calculate the value of a business, we would offer that the impact of a recession to valuation should be modest, as we are faced more with a shift in timing, as opposed to any diminution in long term earnings.

The true risk of recession lies with those companies where a near-term dip in earnings could be catastrophic to the equity holder due to high levels of debt and the attendant risk of bankruptcy, representing real, long term capital impairment. We have studied this issue in depth, and in our recently published white paper “Assessing Risk and Return,”1 determined that limiting exposure to bankruptcy risk by avoiding companies with high levels of leverage, which also tend to display the highest stock price volatility, is additive to long term returns. Today, leverage in our portfolios is extraordinarily low, with debt-to-EBITDA (earnings before interest, taxes, depreciation and amortization) ratios of 0.7x in Large Cap Value and 0.6x in our Global Value portfolios2.

Where We Are Now

From the start of the recovery in 2009 through mid-2011, we experienced a traditional, though short-duration, value cycle, with spreads narrowing and value-based strategies outperforming. Since mid-2011, there has been a dramatic reversal, leading to wider spreads as uncertainty has grown around economic growth, recession, and the potential contagion from European sovereign debt woes. Though this looks like the beginning of a recessionary cycle, there are significant differences from the cycle we most recently experienced, namely:

-The 2008/9 recession started after the economy peaked in 2007. So far this cycle, we have had only a partial recov- ery, with some industries (e.g., auto production, construction) still at deeply depressed levels;

-Corporations have, by and large, de-levered their balance sheets during the last few years, significantly mitigating bankruptcy risk;

-Companies have cut costs and positioned themselves for an extended period of anemic growth, demonstrating their ability to generate normalized levels of profits in a challenging environment; and

-Valuations are already at highly attractive levels, approaching those experienced during the 2008/9 market meltdown (Figure 4).

As a result, we are finding high quality companies with little stress, high returns on capital, strong balance sheets, and high free cash flow yields trading at deeply depressed valuations. Our cyclical exposure has increased, as valuations have been driven down due to recessionary fears, as has been our pattern in past cycles, as these names became attractive (Figure 5).

We now offer examples of portfolio holdings that are illustrative of the types of opportunities we are finding in today’s environment.

Advertising – Resilience Through the Cycle

Advertising is a global industry that has displayed an ability to adapt quickly to changes in the economic environment, as illustrated by Aegis Group plc, a U.K. based global advertising agency focused on media buying. Advertising revenue is historically correlated with corporate profits and the general economy. 2009 was no exception, when global advertising spend fell by 10.8%. Aegis Media’s organic revenue fell 9.7%, but the company’s flexible cost structure allowed it to absorb the revenue decline without a huge hit to earnings. Aegis media’s operating margins fell less than 2% from the peak of 20% in 2007 to 18.2% in 2009 (Figure 6). Over the last year the company has started to re-hire in faster growing economies like China but has continued to manage expenses tightly in slower growing areas like Europe. Should another recession occur, we believe Aegis will react quickly and adjust its labor force accordingly to protect earnings, similar to the last cycle. In addition, the company has a very strong balance sheet, and trades at an attractive 7.2x our estimate of normalized earnings.

Office Products – Positioned for a Rebound

Staples, Inc. is the world’s largest office products company and the second largest internet retailer. The company’s stock price has fallen from a recent high of $23 per share to $14 today, as signs of slowing economic growth emerged. Staples is the clear leader in its industry, with structural advantages that include high store productivity, buying scale, store density, and strong penetration of small businesses, giving it a superior operating structure to its peers. This has resulted in Staples having industry-leading profit margins while its competitors have struggled to break even.

The pace of white collar employment recovery is the biggest revenue driver of the office products industry. As can be seen in Figure 7, Staples’ North American organic sales growth moves almost in lockstep with the change in white collar employment, which has been virtually flat in 2011 after falling during 2008-10. During this time, Staples management has focused on controlling costs and rationalizing operations. As a result, operating margins have held up well, falling to a low of 6.5% in 2010 from a peak of 8.1% in 2007, recovering to 6.9% in 2011. We fully expect that when white collar employment ultimately turns up, Staples, currently trading at 5.7x our estimate of normalized earnings, should be positioned to fully participate in the recovery. Meanwhile, should the economy struggle further, we believe Staples is well positioned to take share, as its competitors close marginal stores.

Defense Stocks – Discounting Austerity

In theory, revenue at defense contractors such as Northrop Grumman (U.S.) and BAE Systems (U.K.) is driven by GDP growth at best indirectly; whereas in practice, revenue is driven more by the allocation of national wealth toward defense relative to other national priorities. Defense spending in the U.S. is not over trend in relation to GDP, with 2010 spending of $691 billion ($528 billion before supplemental spending for Iraq and Afghanistan) representing 4.8% and 3.6% of GDP, respectively, versus a 30 year average of 5.0%. We see similar patterns in the U.K., with the U.K. Ministry of Defense budget of £32.9 billion ($52.6 billion), representing 3.0% of GDP, relative to its 20-year average of 3.1%. In addition, both companies are predominantly exposed to the Air Force and Navy programs, where the installed base of equipment is quite aged and in need of refresh, as illustrated in Figure 8.

Both countries face budget pressures on defense, yet spending cuts would be painful to already aging fleets. Using worst case assumptions ($600 billion of defense cuts over ten years in the U.S. and 8% real cuts over four years in the U.K.), leaves nominal budgets in the U.K. flat for equipment, and a -4.4% reduction in the U.S. over five years, providing contractors adequate warning to adjust their cost structures. Historically, they have been very effective in preserving margins, e.g., BAE’s land business which has fallen 30%+ from its peak and seen incremental margin benefit, not pressure, on aggressive headcount reductions and facility closures. Both companies have highly differentiated products, a limited set of competitors, strong balance sheets and free cash flow, and trade at less than 7x our estimate of normalized earnings.

Paint & Coatings – Leveraged to Economic Recovery

Akzo Nobel is the world’s largest paint & coatings company with decorative paints, industrial coatings, and specialty chemicals each contributing approximately one-third of sales. The decorative paint business is a collection of leading brands primarily in Europe and the developing world. For example, Akzo’s Dulux brand has a 40% market share in the UK. Akzo is also a leader in the industrial coating business, where it is number one or two in almost all its end markets. Industrial coatings is much more R&D intensive than decorative coatings and, as the world’s largest coatings player, Akzo Nobel has an R&D scale advantage versus its competitors. As such, it is the vendor of choice for many companies, as Akzo is viewed as a solution provider. Akzo has its highest margins in those categories where it has the highest market share, specifically in Marine & Protective and Aerospace where is has 30-35% market share.

Over one-third of Akzo’s business is driven by high-growth emerging markets. Importantly, despite investing for growth in these markets, profitability is above the corporate average. Our normal earnings estimate of €6.00 per share does not give Akzo any credit for higher growth from emerging markets. We find Akzo very attractively priced at 5.5x our normal earnings estimate.

Integrated Energy – Investments About to Pay Off

Royal Dutch Shell is a leading global integrated oil & gas company. The company has been investing heavily in exploration and development activities over the last few years. While some of the activities undertaken were very expensive, Shell has positioned the company for strong growth in production volume and free cash flow over the next few years. We believe that the market has not fully discounted the rebound in free cash flow that should materialize at the company. Shell currently has a dividend yield of 5.5%, and based on consensus forecast (centered on an $80/bbl oil price), should generate approximately 10% free cash flow in 2012. We estimate that Royal Dutch Shell is trading at an attractive 6.1x our estimate of annualized earnings.

Financials – Many Differences From 2007

Although Europe is in the grips of a sovereign debt crisis with knock-on effects to its banking system (see our update note on page 16), many global financial firms have recapitalized and restructured, putting them in a much better position to deal with a potential downturn. Citigroup is a good example. Citi is materially better positioned today both in terms of capital and liquidity than it was in 2007 heading into the global financial crisis. Citi now has $468 billion in cash and liquid investments, which is 169% of its short term funding requirements, compared to 85% in 2007. Its tangible capital equity ratio is now 7.4% compared to 3.9% in 2007.

Citi is the most international of the U.S. banks, but its exposure to Greece, Italy, Ireland, Portugal, and Spain is modest at a net exposure of $13.5 billion compared to its overall tangible capital of $115 billion. Citi’s international franchise strength is also beginning to show through with the Latin American and Asian consumer businesses showing growth and moderating credit costs. The transaction services business has also been performing solidly over the past few quarters. The ongoing uncertainty in the North American consumer business and the volatility of the securities and banking business mask some of this progress, but these should resolve over time. Citi’s stock is trading at less than 0.5x its tangible book value, indicating that the market is already pricing in substantial stress.


Fear has created a valuation opportunity in numerous cyclical stocks. This situation is remarkable given that corporate profitability has proven to be so resilient in the face of changing economic fortunes. We are taking advantage of deep discounts available today among cyclical stocks with sustainable business franchises, strong balance sheets, and a demonstrated ability to adapt to whatever the economy has to offer. This is exactly what would be expected of value investors at this point in the cycle - buying cyclical companies, with a particular focus on strong franchises and balance sheets.


1 Pzena Investment Management, “Assessing Risk and Return,” July, 2011

2 Excludes financials and utilities