Quest Operation style twist - UK Quest helpline +44 (0) Nigel Sedgley +44 (0) th June 2012
Page 1 Operation style twist: Summary and conclusions all over again? Whats new? New quarterly backtest Feb-May 2012 There are lots of similarities between events in 2008/9 and recent patterns. During the 2008/9 trough style performance was volatile but Value ultimately dominated. The trough in Value in 2008/9 was before the market bottom. Value rallies tend to be short/sharp events (2-3 quarters) – if you are late, its easy to miss them. Although the market does not look especially cheap, valuation divergence is high. Lots of stocks are trading near their trough valuation of the last five years. The run to safe stocks has left some valuations looking overextended – more than in 2008/9. During times of profit and cash flow volatility you need to assess Value using stable measures: eg Quest market to book, EV/Sales. Similar Value approach in Nov 08 Quest Newsletter delivered strong performance. Volatility means there will be opportunities. Our screens assess the risk/reward trade off.
: Factors and composition triAngle ValueQuality Momentum 33% Page 2 CFROC spread Capital growth Equilibrium growth Fixed charge cover CFROC change Quest valuation Quest market-to-book EV/sales rel. LRA Dividend yield rel. LRA P/E rel. LRA 9m-relative trend 100/200-day switch 12m-relative range 30/90 day switch Earnings momentum Baskets are dynamic: They vary over time depending on what currently represents Value, Quality etc.
UK large cap – 3m to end May 2012 Source: Top quintile minus bottom quintile on each factor on an equally weighted basis. Non-financials. Page 3
Longer term context: triAngle quarterly backtest – updated to May 2012 Best for 3 yrs 3 rd Best in a decade 9 neg quarters in a row 2 nd best in a decade 3 rd Worst ever Worst for 3 yrs Equal weightings dangerous at turning points Top quintile minus bottom quintile on each factor on an equally weighted basis. Non-financials. Quarterly backtests place recent trends in long-term context – Quality has been strong, Value weak. Value rallies tend to be short/sharp events (2-3 quarters) – 2010/11 saw 9 negative quarters in a row. Page 4
2 nd best ever Best since 2003 Best ever Worst and 3 rd worst ever Previous extremes were before mkt rally Top quintile minus bottom quintile on each factor on an equally weighted basis. Non-financials. Europe ex UK small Worst in a decade Worst for 3 yrs Equal weightings dangerous at turning points Increased volatility Quarterly backtests place recent trends in long-term context: Feb-May: Quality best ever, Value worst ever. Value rallies tend to be short/sharp events (2-3 quarters) – 2010/11 very negative for Value. Europe even more extreme Page 5 2 nd best ever
Market beating stock-picking tool Company scores updated daily on Combining Value, Quality and Momentum Quest metrics mixed with conventional data Style analysis and themes triAngle Escalator: Whos moving up and down Excellent 12- year track record – 3-pronged approach improves consistency – UK Large – 42/54 +ve quarters, +3.9% average – Pan-Euro – 37/49 +ve quarters, +3.2% average – UK Small – 35/43 +ve quarters, +6.2% average – North America – 18/35 +ve quarters, -0.3% average (Value and the Escalator dominate in the US) Over 12 years of live experience assessing style trends. UK large cap triAngle performance Top quintile minus bottom quintile on each factor on an equally weighted basis. Non-financials Page 6 : What is triAngle? Equally weighted triAngle is the most consistent, but there have been a few short/sharp value rallies
History rhymes: Comparing with The trough V,Q neutral, Mmtm -ve Crisis developing Value –ve, Qual +ve, Mmtm +ve UK Largecap Now ( ) to 22 nd June 2012 Then ( ) Market rallying Value +ve, Qual neutral, Mmtm -ve Top quintile minus bottom quintile on each factor on an equally weighted basis. Non-financials. Value made an absolute low in Nov 2008, but there was lots of volatility around the trough. Page 7 Current pattern looks most like Sept 08
Performance: Global Style Matrix: Risk off again – but signs of stabilisation Data to 22nd June 2012 Source: Top quintile minus bottom quintile on each factor on an equally weighted basis. Non-financials. Page 8
UK end Nov 08-end Feb 09: Value rallied before the market More stable value measures leading the way Fixed charge cover: Feb-May %, May-Aug % A sign of rotation Quality held up Page 9
Kept outperforming after the other value measures waned. M&A, just –in-time capex support a sustained rally Which value measures? Price to book worked well (Pan Euro) Market to book headed the Value charge and sustained performance Mkt trough March 09 Mkt peak Feb 11 During times of profit/cash flow volatility you need to assess Value using stable measures: eg Quest market to book, EV/Sales. Page 10
What is Quest market to book? Total market capitalisation (equity + debt + quasi debt) Quest market-to-book = Estimated replacement cost of assets Quest market-to-book A variation on Tobins Q which compares market value of a company to the replacement cost of assets. (EV/Invested capital) Profits, sales, cash flows and dividends are all unpredictable at present. Valuation relative to the asset base is more stable. Excellent track record at market turning points. (Time to get into the Q note – November 2008) Page 11
But how much is now priced in?... market valuation charts Median valuation not far off the trough but close to the new normal Stock dispersion is high – lots of cheap stocks and expensive stocks look dearer than in 08/09 Corporate action, policy response less likely to be as helpful this time, but less solvency risk Page 12 Prices as at 6 th June New Normal? Expensive stocks have held up relative to 08
Quest market-to-book: What is the opportunity? Level + dispersion Europe ex UK small UK Large capAs at May 24 16% below LRA12% below LRA Market level Uses average market cap for the year Dispersion Page 13 Time to rejoin the Q Who is still left in the Q? Slowly moving up the Q Jostling about in the Q CITN/ Newsletter articles Time to get into the Q As at May 24 There are as many cheap stocks as summer 2009.
Quest market-to-book strategies 1) Buy cheapest companies on market-to-book 2) Consider pricing relative to a long-term view of assets productive capacity over their lifetime. Take Value AND Quality into account. 3) What if no mean reversion? – need to consider valuation relative to the new normal Desire to avoid Value traps: Solvency, asset write downs (badwill) Quest market-to-book Q-discount (10yr) = Cyclical average CFROC / WACC Quest market-to-book Q-discount (+12m) = m CFROC / WACC Page 14
Value screen I: UK Quest market-to-book – Time to rejoin the Q? Updated weekly on Q-files. Page 15 Our favourite screen which links Valuation with Quality – worked well in 2008
Value screen II: Trough valuations Stocks trading with 10% of five-year trough valuation on Quest market to book Ranked by mkt cap Priced 12th June A potential source of ideas: Some stocks will be cheap for a reason. Others will be genuine opportunities Screen also available for EV/sales and other triAngle metrics Page 16
Value screen III: Superscreen Criteria Page 17 Mkt to book below LRA Quality filters (optional) triAngle Value score Upside on Quest and cheaper than usual 15% more upside than 10y average A broad based value screen using the Quest website screening function
Value screen III: Value superscreen stocks Ranked by mkt cap 27 June Quality filters. 1) Lots of debt/quasi debt. 2) Negative EPS momentum. Signal of risk of a profit warning? Full screen on Page 18
Over-extended valuations: The other side of the Value trade Page 19 Outperformed Lacks value support Other risks Compare with EV/sales Companies which have outperformed but now lack value support
Over-extended valuations: The other side of the Value trade Page June If EV/sales is higher than historic (long-run average), is that justified by higher margins. If so, is that margin sustainable?
Margins – not so stable? – Danone / Procter cutting guidance Page 21
UK margin screen Page 22
Value tools: Quest LBO FCF yields Corporate balance sheets supportive of a pick-up in M&A High level screening metric of the type favoured by private equity – identifies pre-tax cash flow yield on EV. Assesses cash flow available to prospective purchasers, after meeting its operating and capex needs but before financing costs or tax May be compared with required rates of return to see if company initially meets its funding cost Uses historic and consensus forecasts of EBITDA, capex and working capital needs to estimate normalised cash flow IRR models – 25% bid premium, 60/40 debt equity, 7% interest rate, 3-years consensus, 10-year exit multiples. Good track record when there is a pick-up in M&A activity ( first introduced by Quest in Newsletter #11) LBO FCF yield calculation LBO spreadsheet data updated weekly Page 23
M&A Hotspots UK technology hotspot – 3 takeovers by North American counterpart in a year: Logica/CGI, Autonomy/HP, Misys/Vista Equity Partners Sector has high Cash flow returns + net cash. Top 30 US tech names have potential US$430bn of cash outside the US. Could buy top 10 European tech names twice including 30% premium. Deal rationale varies. To save on R&D, scale – global customer base, synergies, valuation. Global CFROC +12m Global (debt+other)/EBITDAR Page 24
UK Technology LBO FCF Logica pre bid = 19% 6 June Page 25
The Finance Directors dilemma LBO framework: Summary of considerations What to do with the cash? Increase investment – Capex or M&A (just in time capex) Remain cautious – Hoard/run ungeared balance sheet Return to shareholders – Increased dividends / buybacks Not all good news Increased capex will reduce free cash flow yields/cash flow returns Beware overpayment for acquisition/integration problems DIY private equity toolkit – LBO superscreen Identify companies which could generate significant value either off or on-market Page 26
Performance of the Q-discount screen from Nov 08- Source: Datastream Rel to WIEROP$ Q discount screen worked well In Source: Quest Newsletter Nov 2008 Page 28
What is Quest ? Decision support tool for equity investors Impartial corporate financial analysis Idea generation and idea validation Combines conventional and proprietary metrics Glass box, not a black box Web-based products – Helping investors make money since 1996 Page 30
What is Cash Flow Return On Capital? Cash Flow Return On Capital (CFROC) – Real (replacement cost) – Post-tax – Return On Gross Invested Capital Better insight into corporate performance and valuation (takes into account all the capital used, asset life, asset mix, return of capital) IRR calculation not A/B (A) Gross cash flow = 10 (D) Asset life = 14 years (B) Gross invested capital = 100 (C) Non-depreciation asset release = 15 Cash Flow Return On Capital (IRR) = 6.0% Wealth creation Screening Risk management tools Value toolsPerformanceM&A Stocks & Products Page 31
Quest valuation overview Cash Flow Returns in a DCF model Use consensus forecasts – 2-years forward Forecast gross cash flows– existing assets wind-down Forecast growth rate – reversion to mean Forecast Cash Flow Return On Assets– future investment returns (reversion to mean) Forecast net cash flows– implicit Discount back using WACC for Enterprise Value Reversion to the mean High CFROALow CFROAHigh growth Page 32
A broad-based view Five Value factors: Quest valuation Quest market-to-book EV/sales rel LRA Dividend yield rel LRA P/E rel LRA Mix of absolute and relative measures Value Tesco: Quest valuation Centrica: Dividend yield relative to market and history Page 33
Aim to emulate the Quest Strategy page Is it a good or a bad company? High return/ growth stocks Five Quality factors: CFROC spread (5-year average) Real capital growth (3-year average) Equilibrium growth (3-year average) Fixed charge cover (solvency FY1) CFROC change (FY1) Measures ability to generate shareholder value : Quality Tesco PLC: Cash flow returns Tesco PLC: Invested capital and equilibrium growth Page 34
Combination of price and earnings Five Momentum factors: Nine-month relative trend 100/200 day switch 12-month relative range 30/90 day switch Earnings momentum (consensus) Mixture of long, medium and short-term measures : Momentum Page 35
Each stock is compared to its universe All 15 factors ranked in deciles – 10 = good, 1 = bad Add the five measures in each category and divide by 1.5 – Gives scores for Value, Quality and Momentum (/33) Add together category score to get overall triAngle score Rank all the stocks in the universe, then re-decile How the triAngle score is calculated Page 36
triAngle history: Value, Quality and Momentum 12 years of live triAngle history Value works in short sharp burst – normally when valuation dispersion is high. During the credit crunch, and in H2 2011, Quality and Momentum were the main drivers Top quintile minus bottom quintile on each factor on an equally weighted basis. Non-financials. Page 37
Pan-Euro market-to-book performance Page 38 Quality filters dont help when the market takes off To 23 May 2012 But, will there be a dash for trash this time? Q discount has lagged behind Or did we see it in January?
UK large cap – Impact of Miners UK Mining sector underperformed by 16% in the quarter. End Feb-End May 2012 Source: Top quintile minus bottom quintile on each factor on an equally weighted basis. Non-financials.
Pan Europe: triAngle value scores (/33) Page 40 Canaccord Genuity Quest. Sept 2007 – May Europe (ex UK Small) universe. Sector scores are an unweighted average of company scores within that sector.