Fund manager viewpoint: the only value plays are in natural resources
In our experience, failing companies or stressed industries typically follow a standard cycle of behaviour. Companies move from being superficially cheap, to being value trapped, to ultimately becoming investable. At Ardevora, we look to exploit this pattern.
This cycle usually occurs when businesses or industries have experienced an unusually strong period, encouraging management to get overly optimistic and take on too much risk. Analysts feel great about the company through this period and continuously upgrade the stock, while investors feel good, enjoying the rising share price and long run of good news.
Often, however, there comes a tipping point – as management try to keep growing when the opportunity to grow is ebbing away. Growth is no longer easy and the tone of news starts to change. Forecasts start to get missed on the downside, management typically blame ‘macroeconomic headwinds’ or ‘market volatility’. Blaming external factors starts to take over from self-congratulating success.
Once the tide turns, share prices sometimes fall quicker than underlying fundamentals. While these companies appear cheap, value opportunities can be dangerous for investors. There can come a time, after prolonged bad news, when the seeds are sown for a proper value opportunity. But patience is required.
As investors, we all need to sit on our hands for an extended period of disappointment until we witness real signs of distress – preferably stress across an entire industry. Then we need to gauge how management responds to this distress – is it just a shuffling of the deck chairs, or is it taking ownership in a genuine fight for survival?
Many value traps still remain
Unlike many other market participants, we do not see a general value rally in the near term. To us, there still remains a lot of value traps.
In our view, only one area of the market is currently exhibiting severe stress – natural resources. Management language was ‘excuse, excuse, excuse’ – until six months ago.
Recently, though, some companies have changed. Only in companies facing the most acute stress have management accepted the need for radical change – whereas management for the stronger companies, which made the least mistakes, still look to us to be in denial.
Hence, despite superficial similarities, stocks such as Rio Tinto and Anglo American look completely different to us. Rio Tinto, for example, looks like a value trap. Management still looks to be in denial, believing current difficulties are transient and little needs to change from its side. However, most investors view it with relative calm, because of its less aggressive pursuit of growth in the past.
Conversely, Anglo American looks like a value opportunity to us. It causes most investors far more anxiety than Rio Tinto, because of what has already happened. Crucially, in our view, management know changes need to be made, or the company will face extinction. This means offloading assets and becoming smaller. Anglo American may feel the riskier of the two, but management is behaving in the least risky way. Anglo American’s management is looking to offload risk, whereas Rio is more tempted to take risk on.
This makes the mining industry a curious place. For every company trying to shed risk, another wants to take it on. So the past excessive investments in new mines, which have caused so much trouble, are still not being shut down.
Most investors have a jaundiced view of the mining sector. Happy to believe in the ‘commodity super cycle’ just five years ago, they now find the sector very uncomfortable. For us it is worth the effort if you can believe you can find stocks able to do well even if commodity prices go nowhere.
Following similar logic, we are happy to dislike BP, for example, and go long on companies such as Weir Group and Amec Foster Wheeler. Following a similar logic, we are happy to dislike BP, for example, and go long on companies such as Weir Group and Amec Foster Wheeler.
In a global context, we see opportunity in some US shale gas names, for example Southwestern Gas and Range Resources. US gas is an interesting pocket of the market, because the bottom fell out of the gas price three years ago. Unlike many of the oil names, gas companies have been struggling with a low commodity price for an extended period of time, which means many companies are further down the restructuring path. We can also see some interesting management behaviour in some US shale oil names.
Jeremy Lang is the founder of Ardevora and manager of the Ardevora Global Equity fund