FPM-Comment Reducing the Noise Martin Wirth: 3/2024 dated July 10th 2024
The hype in a few stocks is leading to low valuations on a broad scale, while poor politics make for good stock market prospects
- The first half of the year: AI creates euphoria - but not across the board
- Politics is having an impact - bad policies lead to bad election results
- Expectations are low, which significantly reduces the potential for disappointment
- When quality stocks become value stocks: A painful metamorphosis
- Private equity meets publicly listed companies: Dramatic undervaluation becomes visible
- Value investing: ideally avoid downward spirals, invest in upward spirals
The first half of the year: AI creates euphoria - but not across the board
The first half of 2024 was largely positive on the stock markets in terms of the indices, but rather mixed to unpleasant looking at the overall market range. The general conditions are not easy, but they are not getting worse either: inflation is falling, which should also lead to falling interest rates in the future, albeit not to the extent that many investors are expecting, if not longing for. The economy in Europe and especially in Germany appears to have bottomed out. In the USA, where the economy has benefited for some time from a massive increase in government debt, there are signs of a slight slowdown, but there are no fears of a recession. In China and most other countries, there is some growth, albeit lower than has been the case in recent years. In this respect, therefore, everything is moving along cautious lines.
The topic of "artificial intelligence" dominated the stock markets. Almost everything has been said about this by everyone, so we won't go into further detail here. Except that, in our interpretation, this had a significant impact on the stock markets: many investors simply had to be present here. The number of companies playing the theme is moderate, so this could only be done by inflating the market cap. At the same time, these investments had to be financed from somewhere, which was done by selling positions in the broad market, regardless of the respective valuations. Furthermore, former favorites in other sectors were sold on a massive scale when targets were missed: In many cases, we have seen share prices halved and worse over the past two years. This showed once again that looking at the valuation can help to at least limit losses when favorites change on the markets.
Politics is having an impact - bad policies lead to bad election results
This time something about the various elections in 2024, especially those for the EU Parliament and in France: it is obvious that the established parties do not like the election results. What is radical about the new competitors will not be assessed here. However, it is astonishing that the traditional parties have not come up with the idea that they may have made mistakes that their core voters no longer accept. It is always down to the difficult framework conditions or a lack of understanding for what are actually brilliant policies. The fact that politics could have contributed to the difficult framework conditions over the last 25 years: This is not taken into consideration. In Germany, this can still be blamed on the CDU by the government, after the SPD was not represented in the federal government for only four years in the last quarter of a century. Perhaps the SPD has forgotten this, but its former voters obviously have not.
You have to imagine that a company describes customers who switch to the competition, perhaps because prices are too high or services are poor, as being unable to understand the company's products properly, that they obviously cannot afford them and that many switchers are obviously trapped in precarious living situations. And the media then find examples that reflect this as proof. That would be completely absurd. If you lose your customers (here: voters), then you question your own product portfolio (here: politics). And then probably realize that cannabis legalization or the ability to change your biological sex every year might be appealing aspects. But even if a clear majority is not opposed to these options, this does not mean that there is satisfaction with government policy in general. There are enough well-known issues that concern most voters rather than what seems to be the focus of politics.
Also surprising for politicians and their voters seems to be realizing that political decisions have consequences that people actually have to deal with. And it is difficult to find anything that politicians have done that has made life easier for their voters. If they did, then they were only sensible measures at first glance, the consequences of which had to be borne later. Let's start with the shortage of rental apartments: Under these conditions, who should go through the trouble of building anything new to rent out to third parties? Higher construction costs due to additional regulatory requirements, building authorities with weak decision-making powers, higher interest rates thanks to increased inflation, more uncertain income thanks to the one-sided expansion of tenant protection. The fact that production costs are passed on to the consumer is also an unpleasant experience that no one thinks about when energy prices are increased, taxes and CO2 levies are introduced on energy, when there are more and more requirements for producers, and so on. The seven billion euro truck toll is not paid by truck drivers, nor does the gas station attendant pay the fuel tax. Rail tickets are squandered, even on people who can easily afford a fair price and are then surprised that the railroads and the public sector are short of money. Inflation was desirable among politicians for years, until the time came and they realized that someone had to pay the price; unfortunately, it was mostly those they wanted to protect the most. And now increased new debt is supposed to be the salvation? How this is to be paid off in the future under demographically more difficult conditions is completely unclear, but probably not part of the plan either. The problem here is the same: Someone is having to pay the bill, and in real terms it has been the brave savers over the last 15 years.
The bottom line is that constant dripping wears away the stone, and there has been a lot of that since the Lisbon Strategy was concluded a quarter of a century ago. Back then, the aim was to develop the EU into the fastest-growing region in the world. The result is a bureaucratic monster with a permanent underperformance against the rest of the world in terms of growth:
The everyday lives of citizens are regulated down to the last detail, right down to the way bottle caps are attached to plastic bottles (are there any plans for beer bottles?). Despite a shortage of labor, tens of billions are paid out as social transfers (in Germany), the recipients of which are often better off than if they were working - and then don't do so. There is a defensiveness that does not even vaguely correlate with the expectations and the money spent: 60 billion euros may not be 2% of GDP, but it is a lot of money: where does it actually end up? No reasonable immigration policy has been achieved for years; instead, illegal migration is de facto tolerated and in some cases encouraged. Public administration, which is becoming ever more complicated in the face of ever more regulations, does not have the motto "How can we help you?", but "It's not that simple" and, in case of doubt, "If you don't do anything, you don't make any mistakes". All this is garnished with record high sick leave rates. Public sector ratios of more than 50%, at which, according to former Chancellor Kohl, socialism begins. The EU - appalling in view of its economic prosperity - is afraid of being undermined by China and the USA and is not even remotely aware of its own strength. And so on and so forth, energy prices, infrastructure, education, you name it.
All of this costs growth, even if many politicians don't like it: This cannot be avoided if people, instead of working productively and efficiently, have to do things that do not lead to prosperity. If you create incentives to prevent work and investment, then you shouldn't be surprised when these incentives have an effect and these effects add up.
Expectations are low, which significantly reduces the potential for disappointment
The only good thing about this is that the problems are obvious and should therefore be priced in. Whether the fear of the mainstream parties of losing power is greater than the enthusiasm for pursuing special interests for special social groups remains to be seen. As the European population basically prefers things to be more comfortable than revolutionary (apart from a few vociferous "activists", usually from the left-wing spectrum, as well as the eagerly reporting media), it should not actually require any outstanding intellect to bring politics back into line with the interests of the majority. In Scandinavia, the Social Democrats have obviously succeeded in doing this, as can be seen from the election results. And a certain ability to learn can also be assumed in other countries without becoming euphoric.
However, it will be difficult for politicians to undercut expectations in the coming years. At the same time, even parties on the political fringes will have to subordinate their preferences to reality if they are elected. In our eyes, the current hysteria is only serving the purpose of improving one's own election chances rather than actually fearing the demise of the EU: As I said, Europeans like things cosy and not revolutionary. And why it doesn't make sense to just agitate against the EU instead of making it better: The Tories in the UK can deal with that from now on. So as long as the structures in Europe are even halfway the way they are today, the crucial point remains: You should not let political conditions intimidate you. Instead, it is crucial to be invested. After all, the current framework conditions also have positive aspects for investors on the stock market: Less optimism also means less willingness in the real economy to invest money, to intensify competition, to make existing structures obsolete. Rather, it secures existing positions. You only have to look at the real estate companies: Less new construction means less additional competition, which means rising rents while living space remains scarce - it could hardly be more convenient. The same applies to many sectors. And partly explains the still very solid margins despite the weak economic development. In China, we see the opposite: wild investment everywhere, overcapacity, price wars and, as a result, a share performance that does not even begin to reflect economic growth compared to Europe.
When quality stocks become value stocks: A painful metamorphosis
And now to the stock market:
Despite historically low valuations in general, some smaller caps have performed weakly. The main losers this time were not the rather average quality companies, but often the former favourites that fell victim to their previously high valuations. The problem with highly valued shares is always the same: once the trend and enthusiasm fade, it is a very, very long way until a new group of investors, namely value investors, shows sustained interest. If a share is no longer far too expensive, but just expensive, that still doesn't mean there is any buying interest. Not even if it is slightly expensive, or halfway fairly valued, or slightly undervalued, but only if it is significantly undervalued. This in turn often goes hand in hand with an operating business that is no longer as buoyant as it was in more favourable times. In other words, when a falling valuation meets falling results.
The problem for the former growth stocks that have undergone their metamorphosis into value stocks is exacerbated by the fact that there seem to be fewer and fewer value investors. After ten or more years of one-sided investing in quality and growth stocks, but first and foremost chasing price and earnings momentum, the value style has simply run out of steam due to ever-shrinking assets.
Private equity meets publicly listed companies: Dramatic undervaluation becomes visible
Two takeovers last year illustrate the scale of "value" that is now being offered on the market: Software AG and Aareal Bank. Premiums of around 50% each were offered on the stock market price before the takeover announcement, with the assurance that the company had now really gone to the extreme in several steps. Unfortunately, this was not quite the case.
After the takeovers, the development was as follows: Both companies sold the divisions considered to be growth areas, which were supposedly to be further developed outside the stock market without the usual quarterly pressure, after just a few months. And in both cases, although they represented the smaller segment of the companies, a price was realised that corresponded to the total purchase price for the acquired companies. This means a profit of more than 100 % on the allegedly exhausted purchase price within less than a year, after the shareholders had already been paid a premium of 50 % in each case. It is obvious that Software AG and Aareal Bank had low valuations, but they were not alone in this: There are enough other companies at this valuation level.
By the way: In a few years' time, we will probably see the sold divisions being offered at a multiple of today's takeover price in another IPO, and this will probably also take place, see the Douglas IPO. In the words of Warren Buffett: Buy a company, leverage it up, change the accounting, get it back to the market. Then, as in the case of Douglas, after a few medium-sized takeovers and a messed-up balance sheet, these shares come back at significantly higher valuations than when they went public. Sufficient numbers of investors are then suddenly willing to listen to the cheering arias of the accompanying banks. The balance sheet is regularly messed up because a hefty payout is made shortly before the IPO, usually the repayment of a vendor loan, which is officially debt capital but was provided by the owner. The proceeds of the IPO are then used to enable growth, but usually a more or less large proportion is used to repay the vendor loan. In economic terms, this is a sale of a company, with the proceeds of the sale being distributed in advance. These companies only have equity because they capitalise goodwill and other intangible assets up to the pain threshold. It is always fascinating that nobody seems to be bothered by this, unless the share performs badly after the IPO.
There are always lame excuses for not investing in the stock market
All well and good. However, the question arises as to why investors do not invest in companies that are now listed on the stock exchange and often trade at record low valuations. The reasons given are the lack of liquidity, which is also not present in private equity or real estate investments, political uncertainty, which apparently does not affect private companies. The same applies to better growth prospects in the USA, which also no longer seem to play a role for private companies or property. In the end, there are two reasons that are really relevant: Firstly, regulatory causes, such as investors themselves associating share price swings with risk, but above all government supervision. In fact, the first time we read about risks in the Benko property empire was when the structure had already ended up in the ditch. Prior to that, no one had bothered about opaque structures and the valuations were completely stable, so everything was absolutely fine. Fascinating. On the other hand, investing via ETFs, where more and more money flows into the same themes without giving much thought to what you are buying and whether it is reasonably valued. This is momentum investing in its purest form. The main thing is that the headline is thematically correct.
Value investing helps to avoid the risk of a downward spiral...
It only becomes unpleasant when a trend no longer continues and companies that we believe are still doing well but have had a few worse-than-expected quarters lose their supporters. Without the actual quality and business model of the company itself being called into question, profits accumulated over years are wiped out within a few quarters and the caravan moves on to the next topic. To name just a few names that have seemed overpriced to us for years and in which we have therefore not invested, at least not for some time: Aixtron, Compugroup, Sartorius, Carl Zeiss, Hugo Boss, United Internet, 1&1 Drillisch, Evotec, Teamviewer and, unfortunately, in HelloFresh, which we continue to hold in high regard. It is not uncommon for ten years' profit to be lost, and if not, sometimes the share is not yet at the bottom. In any case, the momentum that has driven the shares upwards can mean a fall into what feels like a bottomless pit if it disappears: No value investors (if they still exist), dropping out of indices, deteriorating press, critical, sometimes aggressive and frustrated shareholders, poorer earnings expectations, lower valuation multiples, short sellers.
...and occasionally being invested in an upward spiral
In this respect, we will continue to focus on unloved stocks with solid business models that have a low valuation and are therefore better protected against downward pressure. As long as nothing very dramatic happens. And unloved doesn't mean permanently unloved, of course, but just at the moment. This has applied to a larger, fairly stable group over the last ten years. What has changed over the years: valuations have continued to fall (investors needed the money to chase the Mag 7 and Bitcoin), dividend yields of six, seven or eight per cent are no longer uncommon (yes, and you can cut them, but that applies to all companies), free cash flow yields of well over ten to sometimes twenty per cent are also available, and the best thing is: companies are increasingly using the money to buy back shares. And less to expand their empire, with often overpriced takeovers, as seen in the past, which after ten years lead to (attention, standard excuse:) non-cash write-offs, mostly by the subsequent management. And every write-down is non-cash-effective, but unfortunately the money is gone anyway, namely at the time of the takeover. If Daimler had refrained from taking over Chrysler, and Bayer from taking over Monsanto, and instead occasionally bought back their own shares... oh, let's not go into that.
Of course, the supreme challenge remains finding a few companies that can spiral upwards instead of downwards: rising profits with rising valuations. In a market in which investors are focussing on fewer and fewer companies with ever higher valuations, one thing is pretty certain in our eyes: finding these companies that can spiral upwards is becoming easier thanks to the increasing number of candidates. What you still need to bring to the table is time. However, as mentioned above, this is often compensated for with substantial dividend payments and, in the best case, is further enhanced by share buybacks.
In summary: a lukewarm economic environment, certainly not overheated, inflation tending to fall, which is a prerequisite for interest rate cuts by the central banks, companies with unexciting but largely stable expectations and decent profitability, investors who are rather sceptical when it comes to hype topics and shares with a frequently very low valuation: the outlook is encouraging.
Sincerely yours,
Martin Wirth
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FPM-Comment Reducing the Noise by Martin Wirth: 1/2024 dated January 22nd 2024
The principle "boom nourishes boom and vice versa" is too short-sighted. A differentiated view
- Divided development on the stock markets
- Poor politics costs growth, impairs sentiment and thus determines returns on equity markets in the short term
- Valuation across the board has almost halved in the last ten years
- German investors are letting international investors get the better of them
- Valuations should result in very solid returns
On the face of it, 2023 recorded significant gains at index level. However, the overall picture does not adequately reflect the development. After a broad-based upswing in the first half of the year, price gains in the second half of the year were mainly concentrated on the very large stocks, while the broader market stagnated or even recorded significant price losses. This also applied to stocks that were by no means disappointing in terms of their performance, but where there were negative surprises, the price losses were sometimes drastic. This once again created new opportunities. Towards the end of the year, portfolio adjustments were made which, in our view, clearly overshot the mark. Overall, the indices of highly capitalized stocks recorded disproportionately high gains.
Divided development on the stock markets
What led to this split development and how should we deal with it?
First of all, the economy disappointed. This was particularly true of Germany. The recovery expected in the second half of the year failed to materialize. This had an impact on corporate earnings on the one hand, but to a much greater extent on sentiment towards German equities in general and small and medium-sized stocks in particular. And the problem has a name, even if political stock markets are supposed to have short legs: The German government, which is at least on a par with the governments of other European countries in this respect.
Bad politics costs growth...
It pursues its ideology-driven projects unclouded by professional competence, (unfortunately unintentionally) turns de-growth fantasies into reality and is surprised at the lack of support from voters and their migration to other parties.
The administration is flourishing, as is the bureaucracy, which is by no means the fault of the current government alone, and one of the few sectors in Germany that is constantly expanding its workforce is the state itself. Unfortunately, this is not happening in areas close to the people, but rather in the public administration departments. There, people are obviously thinking of ways to make life a little more complicated.
Shutting down the last nuclear power plants in the middle of the energy crisis was obviously not a masterstroke from an economic point of view either. Especially when you then complain about the patchy availability of French nuclear power plants. It is no wonder that various energy-intensive companies have moved to other locations and don't want to wait for a possible lower and, above all, secure energy supply at the end of the decade. And contrary to what the government is spreading: Prosperity is not primarily earned in healthcare services and through public administration, but in industry. And if this disappears, there will be less to distribute.
The measures to eliminate the housing shortage were also successful, at least for owners of run-down properties, who do not have to fear any new competition on the rental market for the time being: First of all, pretty much every measure that can deter potential investors is discussed and partially implemented, from rent controls, protection against termination of tenancy, tenant participation in the CO2 levy, one set of regulations after another, garnished with rising interest rates, and then people wonder why new construction is collapsing. Since the state also wants to play landlord, it occasionally buys up a property that is then left to rot rather than being renovated due to a lack of money, as can be seen in Frankfurt.
The state always finds someone to blame for the weak development: Last year, the weak international economy, from which the export-heavy German economy suffered. For example, due to the weak growth in China, still only 5%. Oh well. And so, of course, the government continues to believe that the policy adopted is good, but suffers from poor communication. In other words: people are unfortunately a bit stupid, you have to explain it to them better, then they will finally understand the higher wisdom behind it.
All of this is quite entertaining if you are not affected yourself, but it also has an impact on the real economy. And is probably the main reason why Germany was at the bottom of the table in terms of growth last year. BUT: you can also see that a government policy, as long as it moves somewhere along normal, western and liberal lines, has a visible but limited impact on the economy. Assuming that the government's actions have cost a highly estimated 1% of national income, the damage amounts to €40 billion. That is a lot of money, but does not begin to justify the perception that the German economy is trapped in a deep and incurable crisis. A shrinkage of income, if you don't see growth as fundamentally undesirable, as some in the government do (even if you then formulate ever higher demands on the state and the general public yourself at the same time), is not nice. But not the end of the world: Germany generated a higher income in 2023 than in any year in history, with the exception of 2022.
Even if the German and European economies have become rather anemic over the years thanks to bureaucracy, constantly increasing taxes and levies and more and more regulations, a substantial amount of national income is still generated and distributed every year, and fortunately we can also participate in this distribution thanks to equity investments, among other things. Moreover, a further deterioration in government policy is not to be expected, as a lot has already been exhausted. And radicalization is also not to be feared, which is one of the advantages of the Chancellor. In this respect, the risk is very limited. If you want to assess the extent of the fall: at the beginning of 2022, mind you after the start of the Russian invasion of Ukraine, the German Council of Economic Experts was still expecting growth of 3.6% for 2023!!! The result, following a correct estimate for 2022, deviates from the estimate by a remarkable 4 percentage points. And this can be seen in the performance of the more economically sensitive sectors on the stock market since then. Which in turn means that the downward expectations are likely to be quite resilient. What is also ignored in the abbreviated view of "weak German economy = poor prospects for companies" is that listed companies are often globally positioned.
...and affects sentiment, which is the key component for equity market returns in the short term
However, the modest track record of both the German government and the European administration has come at a much higher price for investors in the short term than weak growth: as a result of the deterioration in sentiment, valuations for various market segments have shifted significantly downwards in recent years and in some cases are at all-time lows, which is all the more surprising given the continued availability of modest investment alternatives in the bond sector. This is in contrast to the general perception that equities are expensive. However, if Apple is worth more than the entire German equity market, which may well be the case and does not need to be discussed here, Apple's high valuation combined with its high index weighting does not necessarily mean that the entire US market, let alone the German equity market, is expensive.
A good part of this devaluation is therefore probably due to the perception of an extremely modest state of the German economy. Not only is this exaggerated, even though the sclerosis in Germany, as in Europe as a whole, has persisted for many years, it also primarily affects many companies that rely on the German market alone. Listed companies are generally international, often global, so the location of a company's headquarters does not have a decisive influence on its success. However, this is precisely what is implicitly assumed on the stock exchanges if you look at the valuation discrepancies between German and American companies with comparable products and business models and a similar regional positioning.
Valuation across the board has almost halved in the last 10 years
This was particularly reflected in the valuation of small and medium-sized companies. Due to the aforementioned general conditions, there has been extremely low investor interest over long periods of time and, at the same time, pressure to sell. These companies are also underrepresented in passive products, and as more and more capital is invested in passive products and flows out of active products, companies that are not in the top tier are also being sold, regardless of their actual value. At the same time, despite the recession in Germany, the companies' business was largely stable, in some cases sluggish, but also very good in others. In this respect, we see valuations that are often beyond good and evil and suggest a rather sad future. If you look at the share price performance alone, you don't immediately see that valuations have been falling for almost 10 years. This is due to the rising profits that most companies have achieved during this time. At the same time, the substance of the companies has regularly increased significantly since then due to the retained earnings. On today's basis, double-digit returns are theoretically almost the inevitable consequence in the future, given reasonably stable conditions. It should also be borne in mind that today's results are still being impacted by the lingering effects of the COVID pandemic and the turmoil caused by Russia's invasion of Ukraine, not to mention the soaring interest rates.
Valuation compression has various causes
What were the reasons why German (and other European) equities were neglected? We can only speculate.
Apart from the poor political performance in Europe, the easiest way to explain this of course would be to say that the bull market feeds the bull market and vice versa. Apple and the other American technology giants are worth more than the entire German stock market, so why bother going into detail. Irrespective of the valuation, admittedly, but this currently only plays a subordinate role in many investment strategies.
In addition, the global growth prospects have become rather weaker: Demographics, a more mature economy in China, more regulation, limitation due to the scarcities of natural resources, starting with the CO2 issue.
Excessive and sometimes senseless regulation is likely to play an important role
Then there is the excessive regulation: it also affects many investors in their own profession, especially in risk management, which often means that investments are assessed primarily in terms of their volatility and liquidity, but no longer on the basis of expected profitability, i.e. the valuation of an asset no longer plays the dominant role, if it plays a role at all. (See the willingness, not so long ago, to buy government bonds with a term of one hundred years and a yield of practically zero, mind you, under the watchful eye of the regulator). And with the neglect of valuation, the importance of the core parameters of an asset itself also dwindles, as this is all about assessing the prospects for success, quality and sustainability of a business model. Most companies were not founded with the main aim of generating low-volatility returns and enabling investors to join and leave the group of shareholders on a large scale at any time. We are right there with Milton Friedman: The business of business is doing business. And being profitable at the same time. However, the other parameters liquidity and low volatility are much better served by the bond market. This in turn explains why the change in preferences in this segment of the capital market has led to significant inflows and why there is generally not much activity in equities. And when there is, it is in the large stocks. The hunt for low-volatility investments in an uncertain and unstable world with company-like returns: This contrast offers arbitrage opportunities for specialists like Bernie Madoff.
German investors are letting international investors get the better of them
If you then consider how the stock market is viewed by the public in Germany, you can see another problem. The equity-based pension, which the current government had once planned to introduce, is being scrapped in view of the budget shortfalls, having previously been criticized as a form of gambling from many sides. The German Chancellor is proud of the fact that his savings are shrinking in real terms. The fact that the Quandt family collects dividends in the billions from their BMW shares every year is seen as a scandal and the like, instead of the critics coming up with the idea of buying a few BMW shares themselves and cashing in. In the USA, there have been 401 K plans for decades, which by and large correspond to stock pensions, as well as pension funds that are among the largest investors in the world. For firefighters and teachers, among others, while many teachers here would probably be horrified to become part of the gambling machine. As long as there is no family background, the majority of the largest German companies are owned by foreign investors, with ratios well above the 80% mark. You would have to imagine that in the USA.
Professional market participants are also shining in their attitude towards the companies they follow. While everything was painted in rosy colors at the time of the IPO, the outlook is suddenly rather gloomy after share price losses of 50-90%. The situation is split for established companies. There are companies that have benefited from the upheavals of recent years that are now suffering from the downside. The companies that have suffered, on the other hand, are benefiting from catch-up effects. Companies operating on the Internet were able to acquire new customers relatively easily, who can now spend their money differently again. Chemical and basic materials companies benefited from shortages and restricted supply chains and were therefore able to impose high prices, but today they are suffering from the loss of anticipated demand, higher interest rates and the reduction in inventories across the value chain. The same applies to DIY stores, for example, after "home improvement" was one of the activities that was not prohibited during the pandemic period. On the other hand, companies such as Lufthansa and TUI, as well as car manufacturers, are benefiting from the ongoing normalization, as pent-up demand has guaranteed good prices for more than a year. One could now assume that the current situation will settle down again. However, this is not the case: while it is assumed that the companies suffering from the normalization will hardly see any improvement, this is almost certainly the case for the current winners. There is no other explanation for the current valuations. In this respect, there is therefore no support from capital market participants.
Private equity funds conjure up volatility and therefore do not need liquidity
Private equity funds, on the other hand, are pure magic: here, the volatility of investments is conjured away by updating the purchase prices as long as the general conditions have not changed substantially. This means that there is no longer any need for liquidity, as there is no need to sell something that does not fluctuate in a panic. At the same time, nobody is interested in the fact that the risks are actually increasing significantly thanks to massive borrowing by the companies being "invested" in. And since at least reasonably successful companies have the ability to earn money over the years, the accumulated debt will regularly pay off. In this respect, these vehicles are also in a position to pay prices for companies that are well above the level that is usual on the stock market. And at the same time, nobody has to worry about the fees, which are significantly higher than what is usual for equity funds. In this respect, it is no wonder that this asset class has become increasingly popular in recent years, even if the rise in interest rates may have shaken up some funds.
As a result, the valuation differences between asset classes have grown massively in recent years. While it used to be common for equities to be valued at risk premiums of 3-4% over government bonds, this has long since ceased to be the case, apart from the heavyweights with a first-class business model. Today, these tend to be in the range of 7 to over 10%, without taking inflation protection into account in any way.
This leads to the remarkable discrepancies that can be observed everywhere. Just a few examples that are not necessarily represented in our funds, otherwise we could be accused of bias.
Substantial differences in the valuation of identical assets depending on ownership
And to all those who disagree with the current politics in Germany (according to surveys, two thirds of the population and perhaps some readers too): At the chemical company Lanxess, it is assumed that the joint venture founded in 2022 with a private equity company is actually bankrupt due to the usual level of debt there, that the catastrophic profitability of the chemicals business will not improve in the next few years thanks to record low capacity utilization and that a capital increase is therefore required that is higher than the current market value. It is questionable whether the private equity company has also written down the value of its stake in the joint venture to zero, as the market has done with Lanxess.
HelloFresh, a globally active internet-based food producer and retailer that has been extremely successful in recent years and operates with a sophisticated business model, is valued at 4.5 times last year's EBITDA, i.e. around €2 billion. Two years ago, the food delivery company Gorillas, known for its black-clad cyclists in some major German cities, was valued at a minimum of €3 billion in a private equity financing, without this business model being anything special. The company is now apparently bankrupt.
Software AG was taken over by an American financial investor last year. The offer was more than 50% higher than the previous share price. Six months later, the investor sells a division (you can calculate differently, but it is roughly estimated to be 50% of the group) and receives almost its entire purchase price back in return. Which, as I said, was 50% above the previous share price.
The free float of Telefonica Deutschland is being bought back by the Spanish parent company at 50% of the price of the IPO a good 10 years ago. Thanks to extensive dividends, which were more than covered by the free cash flow, the existing investor came out of the investment without a loss. Telefonica, on the other hand, can currently enjoy a free cash flow yield of 15 to 20%. The sellers can now invest their money in German government bonds at just under 2%, which is now considered attractive.
There are more examples, and probably even more a year from now.
What this will change is open, but ultimately irrelevant: Based on the valuation, there should be very solid returns
So far, so bad. The question remains as to why the situation should change now and what is needed to trigger a turnaround in investor interest. The only answer is that you usually only know afterwards. Valuation alone is not enough, but valuation is inevitably the decisive factor in the long term. With the appropriate horizon, i.e. more than two months, you can invest with a substantial margin of safety. And there are obviously already two groups of investors who are taking advantage of this opportunity. These are the companies themselves via their share buybacks, and financial investors.
After a long period of rejection of share buybacks in general, more and more companies are coming to the conclusion that their own shares are undervalued, right across the market. Most encouragingly, the reason for these buybacks is low valuation and not, as in the US, sufficient liquidity, regardless of valuation; or, worse still, pressure to compensate for dilution from share options issued, the value of which is regularly not taken into account when calculating earnings. An obstacle for smaller companies is often that not enough shares are traded on the stock exchange to implement the programs quickly. The situation is different for larger companies, where progress is also rapid. The total buyback volume is likely to be in the double-digit billion range. And every share bought back increases the stake held by the remaining shareholders, at a price that is currently quite favorable.
And the aforementioned financial investors. At the current level, we see these as more of a threat than an opportunity. Because unlike in the past, when they had to improve a lot operationally in order to achieve their target returns, today trivial financial engineering is sufficient to achieve substantial profits, see the example of Software AG. In this respect, there is a risk that equity investors will be ripped off, even with what at first glance appear to be attractive valuation premiums, if the majority of shareholders accept the investor's offer. Of course, it is still better than losing money, but after a long dry spell it is still not something you want, unlike an aggressive approach to share buybacks.
What is on offer in our funds and what can we expect here? What if everything were to return to more or less normal? Illustrated by some positions in the All Cap Fund:
A service provider that is the cost, quality and brand leader in its industry, with at least mid to high single-digit percentage growth and a P/E ratio of 10, with low required investments and a correspondingly high ability to pay dividends.
A raw materials company whose new site is one of the cost leaders in the industry and whose investment costs today would be higher than the valuation of the entire group, with the new site accounting for only a quarter of output.
A defense contractor whose order backlog exceeds the current year's sales by a factor of 5 and is accompanied by rising margins and which is valued at a single-digit P/E ratio on the basis of incoming orders despite high visibility.
Two banks that will distribute approx. 30% of their market capitalization in the next 2-3 years, fortunately in large part in the form of share buybacks at (today's) half book value, which will automatically cause it to rise further and should strengthen the substance at the same time.
Industrial companies, 50% of whose profits come from recurring services and spare parts and which, with a solid balance sheet, are nevertheless only valued at a P/E ratio of 5-6.
We also see plenty of opportunities in other stocks in which we are not currently invested. This provides additional reassurance that these valuation levels are a broad-based phenomenon and hopefully we have not fallen into the individual traps that look cheap but have a substantial underlying problem. On this basis, we are very confident that the coming years should be more encouraging than the last. Valuations have downside limits, and if they are set by investors who then buy the entire company. And current earnings do not require any growth, not even nominal growth, to justify the share prices. And nominal growth is very likely from the perspective of higher inflation rates alone.
Sincerely yours,
Ihr Martin Wirth
FPM-Comment Reducing the Noise Raik Hoffmann: 2/2024 dated April 16th 2024
Misallocation of capital: Where is the "really smart money"?
- "Private equity" vs. "public equity"
- Irrational valuations
- Modern trends promote valuation discrepancies
- Good reasons for a reorientation towards small and medium-sized enterprises
„Private Equity“ vs. „Public Equity“
I recently read the headline on Citywire: "Family office study: Now is an interesting time to go into the offensive." On reading the article, however, I realized, contrary to my expectations, that an increase in the equity allocation is not being considered, but that the weighting of "alternatives" is to be increased at the expense of equities and cash. Why the allocation is to be shifted from public equity to private equity can probably also be seen as a cowardly act before the owner of the family office. Why discuss the fluctuations of the stock market when you can avoid this problem with private equity?
From an economic point of view, it is more than questionable to invest in private equity at present when large parts of the "public" equity market are trading at historically low valuations, whether based on price/earnings ratios (P/E) or enterprise value/EBIT, or in the case of growth stocks based on enterprise value/sales, after they have lost 80 to 90% in some cases.
There are a large number of companies that trade on price/earnings ratios of 5 to 8 or lower. Investing in low multiples on the stock market with manageable priced-in future expectations is likely to prove superior to private equity. Why? Private equity will not be able to acquire companies on a large scale at lower valuation multiples than are currently demanded on the stock market. Why would anyone sell a financially sound company to private equity for five to eight times annual earnings? Strategic buyers pay higher valuations, or the seller waits a little in case of doubt. As long as the exit multiples, i.e. the valuations that can be achieved on the stock market, do not increase, it is relatively difficult to sell private equity investments, apart of course in special situations. One example of this is the Douglas disaster after a holding period of several years.
With financing costs now higher again and valuations on the stock market lower than in the past golden years, the model can no longer work as well as it used to.
This is a logical consequence of the low valuations for small and medium-sized companies and the slump in the prices of many growth stocks on the stock markets. Private equity investors therefore have no choice but to sell their holdings back and forth to each other in order to keep valuations high and avoid write-downs.
The prospect that the stock market is the better alternative for investing fresh money can also be seen from the fact that private equity is becoming increasingly active there. Examples on the German stock market include Software AG (where the entire purchase price was refinanced through the sale of a division to a strategic investor), as well as Aareal Bank, SUSE and Synlab. These companies had one thing in common: private equity investors were already involved and, due to the depressed share prices, they were able to top up at an attractive price despite a necessary premium on the current share prices, in some cases significantly below the IPO prices not so long ago. If desired, they can also seek a delisting - a bad habit that is spreading thanks to incompetent jurisdiction. It is only a matter of time before companies with a 100% free float are also targeted by corporate buyers.
Irrational valuations
A few examples illustrate just how irrational the valuations of many companies on the stock market are or were. In January, Deutz announced that it intended to sell a division that was no longer strategically necessary (electric motors for boats) to a strategic investor (Yamaha). Deutz received an estimated EUR 80 - 90 million as sales proceeds for 2% of Deutz Group turnover (approx. EUR 40 million), although this division made an EBIT loss of EUR 23 million (!). 15% of the market capitalisation achieved for 2% highly loss-making sales. Despite the jump in the share price following the announcement, Deutz's price/earnings ratio is still 7. Another example is Süss Microtec, which received EUR 75 million for a division that made a high single-digit million loss. Here too: For an estimated 10% or so of highly loss-making group sales, it received just under 25% of the stock market valuation. In both cases, the buyer would have been better off buying the entire company, taking the desired division and selling on the majority of the otherwise profitable company at a profit – the typical playground of private equity investors.
Modern trends are fuelling valuation discrepancies
What are the reasons for these valuation discrepancies? In addition to the growing preference of institutional investors for private equity investments, on the private investor side it is probably due to the trend towards ETFs that has been propagated for many years. No matter what you read, ETFs are recommended almost everywhere. Even if there are of course factor ETFs or ETFs on the MDAX or SDAX, the recommendations are predominantly ETFs on the MSCI World, S&P 500, Eurostoxx, DAX and other indices with highly capitalised shares. The money flows disproportionately into the large stocks, while small and medium-sized companies in particular lack investors. Add to the ETFs a few individual investments in well-known tech stocks and some gambling with Bitcoin & Co. and you have the "modern asset mix" and the explanation for the performance of the "Magnificent Seven". If you then realise that ETFs now have a market share of 60%, you get an idea of the meticulousness with which investments on the stock market are screened. But it gets worse: with newly allocated capital, the market shares are more likely to be 100% than 60%, and net probably even higher thanks to shifts from active to passive vehicles.
Good reasons for a reorientation towards small and medium-sized companies
What could reverse this trend and shift the focus back to German small and mid caps?
1) Small and medium-sized companies are performing above average in the economic upturn. Based on the current situation (recession coming to an end, interest rate cut fantasies, low valuations), the opportunities are likely to significantly outweigh the risks from a historical perspective. Although the economic research institutes have revised their forecasts for 2024 back down to zero growth, the Ifo index has risen for the second time in a row and has now returned to the level of summer 2023. The chemical industry, an important sector, also appears to have found its bottom now that customers have finished destocking.
2) Although small and mid-cap stocks have historically traded mostly at a premium to large caps, this phenomenon has now changed. The absolute valuations of small and mid caps have halved from the valuation highs of the last 20 years and are now trading below the valuations of large caps.
3) Even if the capital markets are possibly too optimistic about the timing and extent of interest rate cuts, the so-called "Fed put" is once again a possible measure by the central banks. A year ago, when inflation rates were high, it would have been impossible for central banks to react to a slowdown in growth or a crisis by cutting interest rates, just as it was impossible when interest rates were zero. This is now different again and, apart from occasional, ever-possible corrections, equities therefore have additional support alongside the valuation and an improving economy. It is possible that investors are relying on this for many highly capitalised stocks with a demanding valuation. This would of course also apply to small and mid caps.
4) Even representatives of the left-of-centre party spectrum increasingly understand that the framework conditions for the German economy urgently need to be improved and are discussing tax cuts and a reduction in bureaucracy, among other things. Even if there is a long way to go, the chances of this happening have probably never been as good as they are today.
5) In view of the massive valuation discrepancies between public equity and private equity, it is only a matter of time before strategic private equity buyers become more active on the stock market.
6) Rich private individuals (in the billionaire category) will also exploit these discrepancies more and more. A good example is Klaus-Michael Kühne, who in addition to his stake in Hapag-Lloyd has now also acquired large blocks of shares in Lufthansa and Brenntag. What is the logical connection? Logistics, that is what he knows best! Daniel Kretinsky and his purchases of shares in listed German companies are another example. I can already hear the whining: the rich are getting richer.
7) When talking about the problems of Germany as a business location, one should always bear in mind that many German companies have a global presence and produce in numerous regions around the world. If you invest in German shares, it is a well-known fact that you do not regularly get companies that operate exclusively in Germany. What you do get, however, is German headquarters and the German legal system, which, despite all the complaints about the various difficulties, is still far above average. You don't have to take Russia or China as a yardstick here; you can also have some unpleasant experiences in the USA.
8) More and more companies are launching share buyback programs. When low valuations and high cash flows come together and these are then used aggressively for buybacks, sooner or later considerable added value is created for shareholders. The major German banks are currently good examples of this. Valued at half book value and four to five times annual net profit, large parts of the profit are used to buy back their own shares. This results in after-tax returns of more than 20%. German car manufacturers such as BMW and Mercedes also fall into this category, as do an increasing number of smaller companies. If valuations do not rise, at some point in the not-too-distant future you will become a proud owner of a company.
9) The concentration of an increasing amount of investor money in always the same stocks increases the risk for these stocks in a correction. What is no longer held (such as many small and mid caps) can no longer be sold by the masses during a correction. In fact, some shares in these segments are shorted by hedge funds and used as a source of financing for investments in the popular companies. Such shares could even benefit from a correction.
10) And last but not least: It remains to be hoped that the political framework conditions will improve to such an extent that the climate for entrepreneurial activity and for investors will brighten considerably after the next general election at the latest.
Since the shares of small and medium-sized companies have underperformed by 30 to 40% in the last three years, depending on the index (SDAX, MDAX), and are already lagging significantly behind again this year, there are at least good reasons to believe that, against the backdrop of a potentially improving economic situation, there may not be an immediate outperformance, but there is at least a more than realistic chance that the underperformance of recent years will come to an end. An investment in this market segment also provides better diversification and the potential to generate alpha through outperformance in the medium term. If the shares do not rise: Then the buybacks will show their effect.
Sincerely yours,
Raik Hoffmann
Experience in German equities: Since 1990
Responsibilities: Fund management, equity analysis and corporate management
Funds: FPM Funds Stockpicker Germany All Cap mutual fund
Institutional special mandate for a single family office
Awards: Numerous awards for the funds managed by him, also multiple personal awards from Sauren Fonds-Research AG, Citywire and others
Career:
- Portfolio manager at Credit Suisse (Deutschland) AG
- Equity analyst at Bank Julius Bär (Deutschland) AG
- Equity analyst at Credit Suisse First Boston
Graduate in business administration from the University of Cologne (Dipl.-Kaufmann)
Experience in German equities: Since 1997
Responsibilities: Fund management, equity analysis and corporate management
Funds: FPM Funds Stockpicker Germany Small/Mid Cap & FPM Funds Ladon mutual funds
Career:
- 15 years at DWS Investment GmbH – managing the DWS German Small/Mid Cap fund, as a member of the European small/mid cap team of DWS and the DWS macroeconomics team and responsible for risk scenarios
Graduate in business administration from the University of Leipzig (Dipl.-Kaufmann)