Temple Bar���s Ian Lance and Nick Purves: the essence of value investing
Ian Lance and Nick Purves of the Temple Bar investment trust explain the essence of “value investing” – buying something for less than its intrinsic value and in many cases getting profitable parts of a business thrown in free.
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Merryn Somerset Webb: Hello and welcome to the MoneyWeek magazine podcast. I am Merryn Somerset Webb, editor-in-chief of the magazine, and I just want to tell you before I start that we are recording this on January 11th. Several of you have said to me that it can be confusing not knowing exactly what date we’re on. So, there you go, January 11th.
With me today, I have two great guests. I have Ian Lance and Nick Purves, who are the managers of the Temple Bar Investment Trust. Welcome, Ian. Welcome, Nick. Thank you for joining us today.
Ian Lance: It is a pleasure, Merryn.
Nick Purves: Hello. Hi.
Merryn: Hi. Now, readers, listeners, lots of you will already hold the Temple Bar trust in your portfolio. I know this because it used to be part of the MoneyWeek Investment Trust portfolio and I know that you all suffer from the same kind of apathy as I do and when we took it out of the portfolio, you probably kept it.
Now, that was probably a good thing. We took it out of the portfolio because it was changing manager and we didn’t know at the time which direction it was going to go in. Was it going to become a growth trust like all the other trusts or was it going to stay in the value area?
Now, good news is it did stay in the value area and has done pretty well since. It is still down over two years-plus but up nicely over the last year and quite a week, up 5.78%, obviously I’ve just looked that up, over the last week. Nick, Ian, that has been quite a week. It must feel great.
Ian: Yes, that’s a great start to the year and happened to coincide with a week in which the Nasdaq was down 7%, so that makes it even better.
Merryn: I bet. Now, let’s start by talking, if we can, about what you mean by value. Everyone bandies these words around the market, value, growth, momentum, etc, etc, but even if we were buying growth, surely we wouldn’t buy a growth stock unless we felt that it represented some kind of value. So, how do you define value when you are looking at the stocks that make it into the portfolio?
Ian: We would absolutely agree with that, Merryn. For us, value simply represents paying less than intrinsic value for something, whether that is a stock, a bond, a painting, a house or whatever. As you say, you would have thought everyone would want to do that when they are investing, don’t they, and I think the investment industry has this fabulous way of confusing the issue by throwing out categories like quality and growth.
For us, quality is the attribute of the business that you are buying, whether it is has got a high rate of return, etc, etc. Growth is an input into your calculation of value and value represents simply the price that you pay for something. So, that’s how we think about value investment.
I suppose, just to illustrate that, if you went back a few years, on our portfolios we used to own stocks like Microsoft, which are obviously very good quality stocks. They happen to have high rates of growth but, back then, they represented good value as well. I think we paid something like 8.0x cash adjusted earnings at the point that we bought it, so we have no problem at all with buying high quality, high growth stocks, we just don’t like overpaying for them.
Merryn: So, would we call your style of investing cheap quality, quality at the price?
Ian: We tend to refer to it as intrinsic value. In other words, we’re trying to buy things for less than we think their intrinsic value is but we’re also trying to avoid the dreaded value traps and, of course, we’re not going to do that all the time. But, what we’re trying to do is buy businesses which we think have the ability to grow over time rather than just buying cheap rubbish.
Merryn: Well, that’s interesting, isn’t it, because a lot of people when they look at value, when they talk about value, they talk about it as though it is buying businesses that are in decline and trying to eek a bit of value out of them as they gradually disappear.
Ian: That’s exactly right. It is interesting. Often, if you go back and look at the businesses that people forecast were in decline, it turns out that actually they weren’t and that’s why they were available at good value.
Going back to 2000, right at the top of the TMT bubble, people would have told you tobacco and utility businesses were in decline and some of those businesses went on to be tenbaggers over the next decade and they weren’t in decline at all.
We’ll maybe come on and talk about this but we would say that there are certain industries today which people are again labelling in structural decline. Energy would be a good example of that and where, actually, we would disagree with people. We don’t think they are in structural decline and we think that is one of the reasons that you’re getting the chance that you’re getting the chance to buy these things for good value today.
Merryn: Let’s talk about that in the context you use. Well, you’ve written about it before and you’ve written about it again recently. You call it In For Free, when divisions are effectively for free and another of the business is worth at least the market cap or more, so you get another part of the business you’re effectively paying nothing for when you buy the shares. Tell us how you see that.
Nick: That’s certainly the case. You can often have companies where perhaps have two different parts of the business which are quite separate, probably have quite different characteristics, as you say, where the market looks at the challenged part of the business and effectively values it at nothing, with the result that when you buy the shares the full value of the share is reflected by the intrinsic value that is accorded to the good part of the business.
Of course, in that situation, if it turns out that the profits of the more challenged part of the business prove to be more resilient than perhaps people assume, that can create enormous upside in the share price. Maybe I can give you a couple of examples, one we’ve spoken about before.
Royal Mail is a great example of a company with a challenged part of the business, that’s the UK business of Royal Mail. Many of your listeners might not even be aware that actually Royal Mail has a thriving overseas business called GLS. It’s a parcels business.
Even today, post the very significant recovery in the share price that we’ve seen over the last year or so, we would argue that the UK business, the challenged part of the group perhaps is in the company valuation for free.
Merryn: Now, Royal Mail, you first wrote about this in this context back in May 2020 and it has been a fairly phenomenal performer since then.
Nick: Yes. When coronavirus struck, the share prices that got hit hardest were the companies that were felt to be must vulnerable to a coronavirus-induced economic downturn and Royal Mail was actually in that group.
I think, quite quickly, certainly as you moved into the summer of 2020, it became apparent that actually Royal Mail was actually a net beneficiary of coronavirus because obviously parcels volumes grew very, very significantly because we are all effectively forced to stay at home. Royal Mail overseas business is purely parcels. Royal Mail’s UK business, which again is the challenged part of the business, has a 50% share in parcels in the UK.
Ian was talking earlier about the importance of identifying value. Yes, but identifying value in companies which we think can grow their top lines over time and Royal Mail is certainly one of those company.
Yes, letters will obviously continue to decline but we think that will be more than offset by continued growth in parcels and, as we say, at a time when the UK part of the business which accounts for around 50% of group sales is essentially in the valuation for nothing.
Merryn: What about Marks & Spencer, which was the other one that has performed brilliantly since 2020 when you first wrote about it, saying that there was a part of the business there that was In For Free as well?
NP Absolutely. Again, just think about the two different parts of the business. I think if you asked people on their views on Marks & Spencer, I think they’d probably say to you, oh, it has carved out an attractive niche in food retail, that’s both online with Ocado and obviously store-based sales as well.
You’ll remember, obviously, that Morrisons has recently been taken over by private equity at a pretty impressive multiple. So, it has got an attractive food business, in which it is taking market share in what is obviously a competitive market.
I think that then people will look perhaps at the clothing business and say that they think of a declining store-based clothing business and ascribe very little valuation to it. That is absolutely the case today, again, despite the fact the shares have obviously risen quite significantly from the lows we saw 18 months ago.
As I say, you don’t have to use aggressive assumptions with regard to the Ocado stake, which is obviously online food, store-based food sales and also the online clothing operation that Marks & Spencer now has. It has a target of up to 40% of its clothing sales to be online within the next three years.
Again, that entire clothing business, including the online business, is effectively in the valuation for free, despite the fact that Marks & Spencer continues to be the number one clothing operator in the UK.
Merryn: That’s an extraordinary number and the number two online, you say?
Nick: And, the number two online, exactly. Again, is this a business that’s going to deliver you massive growth over the coming years? No, of course it is not and all retailers face significant challenges with regard to channel shift and changing consumer behaviour, but can it deliver GDP-like growth over time? Yes, we believe that it can and potentially a significant recovery in profits as well, given that the business has been operating quite significantly below its potential for a number of years.
Merryn: It certainly doesn’t sound like a business in secular decline does it?
Nick: Not at the moment, no.
Merryn: Right. So, let’s look at new stocks that you would now say were some way on from when you first mentioned Royal Mail and Marks & Spencer. What companies fit the bill now? Are there new ones in there?
Nick: I think the highlight would probably by Royal Dutch Shell. You might be aware or your listeners might be aware that an activist US fund manager, and I won’t give their name, took a stake in Royal Dutch Shell in the fourth quarter.
Merryn: Why aren’t you giving their name?
Nick: I’ll tell you their name.
Merryn: Who is that going to upset? What was the secret there?
Nick: It’s Third Point and their argument, and I think we’ve got enormous sympathy with it, is that the more challenged businesses, which in this case are the traditional upstream refining and chemicals businesses of Shell are effectively in the valuation for free.
If you accord, let’s say, a more generous multiple to the transition businesses which are, of course, integrated gas, marketing and renewables, you might be interested to hear that the upstream and refining and chemicals businesses, the more challenged businesses, make up 60% of the company’s cash profits and yet, in the stock market, you’re paying nothing for them.
Merryn: It is interesting. You talk about that part of the business as being challenged but is it actually challenged in a business sense or is it only challenged in a reputational sense?
Nick: I think it’s challenged to the extent that we believe that demand for fossil fuels is likely to decline more slowly than perhaps people would hope or imagine but I don’t think we’re going to kid ourselves.
Merryn: Well, if at all. That’s the other thing. Isn’t it not so much that use of fossil fuels is going to decline but growth in use of fossil fuels is going to decline. It’s decades before we see any actual fall in the fossil fuels used around the world, or not?
Nick: It is difficult, obviously. Our guess would be, yes, we probably agree with you. We think demand will probably plateau but I don’t think you can argue that there is significant growth in fossil fuel demand. But, as I say, in the stock market, given the valuation that is accorded to Royal Dutch Shell..
Royal Dutch Shell is the largest privately owned gas producer in the world and given the strength we’ve seen in gas prices and obviously oil prices as well, Royal Dutch Shell and the other energy companies, they’re trading on free cash flow multiples.
So, this is free cash flow to shareholders after all investment, both investment in the existing business and also in renewable. Free cash flow yields are between 15% and 20%, so that’s a cash payback of between five and seven years. So, you really, really need to believe that fossil fuel demand really does decline very quickly from current levels if you’re to argue that there isn’t value in the shares.
Merryn: And if, on the other hand, you were to assume that demand had plateaued but the prices of various fossil fuel energy sources would rise, you’d be mad not to hold Royal Dutch Shell.
Nick: Yes, and again, very crudely and it’s always difficult, one can’t be too precise, but if you were to take the 60% of company profits which are in the so-called challenged businesses and place those on a 5.0x cash multiple or EBITDA, depending how you want to describe it, that crystallises around 80% upside in the share price, that sort of number, again at a time when many parts of the stock market continue to look fully priced.
Merryn: Most interesting. So, on your definitions, you would definitely say that the energy sector as a whole is also not in secular decline, so these aren’t value traps.
Nick: No. On our view, no, and as a result the energy sector makes up between 15-20% of our clients’ portfolios.
Merryn: Do you see that rising? That’s quite a lot but still if you think of these energy stocks as being possibly the most value jammed in the FTSE.
Nick: Potentially, and we continue to look in this area.
Merryn: Interesting. So, might this be the year when suddenly the FTSE is not underperforming pretty much every other market in the world?
Nick: It could well be. Obviously, the FTSE, the UK index is resource-heavy. We haven’t talked about inflation yet at all and we don’t make predictions when it comes to inflation but there has be a significant risk that the inflation that the inflation we’re seeing at the moment is not transitory and it proves to be more stubborn than perhaps some people would hope.
If that is the case, then the FTSE could be a good place to be because, as I said, it has a large weighting towards energy and mining stocks which, of course, would likely benefit from a rising commodity and therefore rising inflation environment.
Merryn: What are the commodities in the portfolio? What commodity stocks do you hold outside energy?
Nick: Anglo American, Newmont Gold and also Barrick Gold, so three commodity exposures.
Merryn: The gold price, that has been disappointing, right?
Nick: Yes, it has, absolutely. Exactly, it has.
Merryn: But, you expect that to turn around?
Nick: Again, not a prediction. One of the things that really attracts us towards the gold mining is actually the capital discipline that has broken out in the industry. Like the energy companies, like the other mining companies as well, these companies have cut back on investment very significantly in the last few years.
In the energy sector, investment is down by between half and two thirds from where it was in 2014. In the mining sector, investment is roughly half what it was at that time, with the result that supply has remained relatively constrained at a time when demand for most commodities has continued to increase quite significantly.
If you think about copper, for example, if we are going to green the economy in the way that we want to over the coming years, then demand for copper is likely to be extremely strong.
Again, you can buy these companies. You’re not having to pay egregious multiples to buy into these types of exposures. You take a company like Anglo American. It is trading on mid-single-digit multiples of the current levels of profitability. So, yes we do see opportunities in these areas, absolutely.
Merryn: Great. Right, let’s move on from what you are investing in, which has been fascinating, into what you are not investing in. There’s another piece that you two wrote a few weeks ago, months ago at this point probably, called Canary in the Coal Mine where you talk about what is going on with tech stocks and how you see that playing out.
Ian: Really, I think what we were trying to do here was answer this conundrum. A lot of people might have been quite confused by the fact that people might have been expecting inflation to pick up. Inflation did pick up last year and yet we finished the year with the S&P 500 up 25%, Nasdaq up 22%, and a lot of people might have been shaking their heads, thinking what on earth has been going on here?
I suppose what we were trying to do was drill down and say, actually, you need to look below the water, really, to understand what is going on. So, a lot of those returns were concentrated in a very small number of very large stocks.
One of the figures that we came up with was that over the last six months of the year something like four stocks generated nearly 70% return of the S&P 500, that was Microsoft, Apple, Nvidia and Google. So, the returns were being very concentrated into those stocks.
Then, outside of that, actually a lot of stocks had started to decline. So, again, to give you another stat, I think something like 40% of the Nasdaq is now down 50% from its 12-month high. So, below the surface actually a lot of stocks had started to react to what was going on in the market. You just hadn’t really noticed it if all you looked at was the headline indices, as it were.
A few other examples we gave was that Goldman Sachs have an index of non-profitable technology companies. That had lost 25% in one month. There’s a very well-known ETF in the US called ARK Innovation which holds, basically, a lot of start-up technology companies. That’s now down 45% from its high.
So, I suppose we were just trying to demonstrate that actually maybe the market had started to react to things like inflation, the potential for interest rates to rise, etc, etc. You just hadn’t really noticed it if all you were looking at was the Nasdaq index.
Merryn: You called the piece you wrote about this, Canary in the Coal Mine. Does that suggest to you these other very big tech stocks will keep falling as well? Is this the beginning of what you might call a proper market correction?
Ian: It could be. I suppose if you go back in history, this is often the pattern that you see, is that the smaller, more speculative part of the market starts to decline first and that it is later followed by the larger, more blue chip end of the market.
Certainly, that was the pattern in 2000. That was why we mentioned at the start of this piece, the fact that John Templeton made a lot of money back in 2000 shorting a lot of the more speculative technology names.
So, yes, I guess we were hinting at the fact that maybe this was a portent of things to come and actually it is quite interesting. I know we’re only a couple of weeks into the year but actually, funnily enough, some of the larger companies have started to now follow down some of the smaller companies.
I mentioned earlier on that Nasdaq was down 7%. At one point yesterday Microsoft was down 9% on the year. Microsoft seems to be everyone’s favourite stock at the moment. There seemed to be a belief that it could just never go down. But, actually, the large end of tech has started to show weakness. So, we’ll see. Maybe that is a sign of things to come.
Merryn: Well, it is interesting, isn’t it? Stocks like Microsoft, as you say, everyone’s favourite stock. This is all part of people believing, as they have for some time, that if you buy a high quality stock, regardless of price, you’ll be okay.
Ian: Yes. Nick and I talk about this a lot, actually. I think when people talk about defensive stocks, they often conflate a defensive business with a defensive investment. The point being here that even if you buy a stable business, if you pay way too high a valuation for it, you can often end up losing money in a stock where the underlying business is okay.
Ironically, Microsoft was a really good example of that before. I think if you bought Microsoft in 2000 or something, it took you about 12 years to get back to your start point despite the fact that the underlying business had done very well throughout that period. It was just that you paid way too high a price for it.
I think we would make the argument that a lot of people are making that mistake today. People are nervous about the economy and I think they are willing to pay up for what they perceive to be high quality or defensive businesses and they’re not really thinking about the risk that you could get from just overpaying for it, the risk of a de-rating.
Another example of this, Merryn, was back in the 70s, of course the obvious point being there, that was the last time that we really had any significant inflation. People had flocked into that area, that was known back then as the Nifty Fifty. So, again, this is a group of high quality businesses, believing them to be very defensive.
Ironically, throughout the 70s, operationally most of them did do very well and yet you lost a significant amount of money in them, again because you just paid way too much for them at the start. We would just caution people not to make that mistake today.
Merryn: I think it is something for all of our readers to bear in mind. In fact, I did put up a Jeremy Grantham quote on Twitter yesterday saying exactly that in a more complicated way, that one should never forget that the main factor in the returns you make is the price you pay in the first place, and that’s been very easy to forget over the last decade.
Right. I think we’re going to have to call a halt there but thank you so much, both of you, for doing this for us. Again, we hugely appreciate you coming on and we hugely appreciate your fascinating insights. That is Ian Lance and Nick Purves of the Temple Bar Investment Trust. Thank you, both.
Ian: Thank you, Merryn.
Nick: Thank you.
Merryn: If you’d like to hear more from them, you can go to rwcpartners.com. I think that’s where you put your blogs up, right?
Ian: I think that’s right, yes.
Merryn: So, listeners go and look there if you’d like more. If you’d like more MoneyWeek, of course it’s moneyweek.com, where you can go and sign-up for our daily email written by the brilliant, John Stepek, that is Money Morning.
Ian: No, unfortunately, you won’t find us on Twitter.
Merryn: That is disappointing because I can just imagine the fabulous Twitter rows you could get into about fossil fuels. You’re missing a trick there for endless fun.
Ian: That is absolutely is why we’re not on Twitter.
Merryn: That’s exactly why you’re not on Twitter. I get that. I’ll do it for you. I’ll go there right now and get started. Finally, if you enjoyed the podcast, please do leave us a review on your podcast provider of choice. It is by you leaving good reviews that enables us to get on the brilliant guests that we do. Thank you very much and we will talk again next week.