IQ INSIGHTS. The Value of Time Make Patience an Active Investment Decision

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1 IQ INSIGHTS The Value of Time Make Patience an Active Investment Decision May 215 In the short run the market is a voting machine, but in the long run it is a weighing machine Benjamin Graham by Conor McGorrian, CFA, Portfolio Strategist, Fundamental Equities For much of the recent past, the market has been willing to ignore valuation in favour of perceived safety. However, we know in time this must change. History teaches us so, and it is the bedrock of the value investment approach pioneered by Benjamin Graham and practiced by many investors since. At State Street Global Advisors Fundamental Equities, we have a long heritage as value investors. We look for stocks that have failed, for one reason or another, to capture the interest of the wider market. In this paper, we quantify the depth of value embedded within our Spotlight portfolios and explain why we believe focussing on the intrinsic value of a company, and understanding what s in the price, are key factors in the successful application of our investment philosophy. Although building a portfolio of inexpensive stocks is not particularly difficult, selecting stocks that truly represent value and having the patience to wait for that value to be realised remains a significant challenge. While the recent past has been a relatively difficult period for active value investment managers as the more expensive stocks have continued to be favoured by the broader market, this presents opportunity for the patient investor. Why Patience Matters Patience is a key attribute of the dedicated value investor but it is a commodity that is often in short supply. In the short run, share prices are driven by sentiment and the mood of the market the starting valuation has relatively little impact on the investment return. But in the long run, valuation is a critical factor in the outcome of our investment decisions. The graphs in Figure 1 illustrate the relationship between starting valuation (as measured by the Price-to-Book ratio) and the subsequent share price return for the MSCI World Index from 198 to 215. The graph demonstrates that the relationship between valuation and short-term returns, over one year in this instance, has been very weak, even random. Figure 1: Relationship between Value and Returns over Time MSCI World Index P/B versus 1-Year Returns: MSCI World Index P/B versus 5-Years Returns: Year Return (%) 8 5-Years Compound AverageReturn (%) 8 4 Correlation= Correlation= Initial P/B (Trailing) Initial P/B (Trailing) Source: MSCI, Credit Suisse HOLT, SSGA as at 31 March 215. Past Performance is not a guarantee of future results. The information contained above is for illustrative purposes. The correlation coefficient measures the strength and direction of a linear relationship between two variables. It measures the degree to which the deviations of one variable from its mean are related to those of a different variable from its respective mean.

2 However, we can then see that there is a much stronger relationship between the five-year return and the same starting valuations. The slope of the blue line shows that lower starting valuations have led to more favourable outcomes. In short, to be successful as value investors, not only do we need to buy cheap stocks but we must wait for the reasons they are cheap to go away. Discerning True Value Nearly all of the major equity markets have been on a bull run since the lows of 29 and are now close to, or at, all-time highs. As this performance cycle has become extended, we have started to see a greater divergence of valuations across sectors and geographies. The challenge, as ever, for investors is to identify how best to position for whatever comes next. Should they stick with what has worked recently or try to figure out where the market will go next? We accept that the future is always uncertain. But, by taking a consistent value-based bottom-up approach to stock-picking and always seeking a margin of safety, the team aims to outperform over the long term, regardless of what the markets do. We look for good quality businesses which are out of favour for some reason. The fundamental analysis we undertake helps us to dig deeply into the issues facing the business and allows us to understand why the shares appear cheap. Often we find that the shares appear cheap because there has been some permanent change in the business and the earnings power is thus impaired. For example, regulatory changes in the European Telecoms market cleared the way for new entrants to undercut the incumbents. Although the shares of the incumbent telecom companies looked cheap at first glance, closer analysis revealed declining returns that we believed were unlikely to recover. We consider these situations to be potential value traps and they are to be avoided. In other cases, we find that investors have over-reacted to temporary or cyclical situations. Companies in very cyclical businesses where earnings are temporarily depressed often provide investment opportunities to the patient value investor, as long as the balance sheet gives the company the strength to get through the trough. When Valuations Defy Investment Logic While we believe value investing is always worth pursuing, there have been, and will continue to be, times when it is out of fashion. In recent years, we have seen investors favour yield, predictable growth and those parts of the equity market that are perceived as safe. This has driven valuations in sectors such as healthcare and consumer staples to extremely high levels. To invest in these sectors at these valuations requires a very optimistic assessment of their prospects. This is illustrated in Figures 2 and 3, which compare the valuation and earnings power over time for the consumer staples and industrials sectors of the market. In analysing companies we look at Figure 2: Global Consumer Staples Valuation Feb Feb 215 Valuation ( Economic PE) Earnings Power (ROIC %) Feb Sector ROIC Economic PE 2-Years Average Economic PE Global Consumer Staples Sector economic profits instead of accounting profits. Economic profits are what s left after we subtract the cost of capital. A business can generate accounting profits without generating economic profits, but only economic profits are truly sustainable in the long-run. We use Economic P/E to measure valuation based on economic profits as we believe it is a better guide than a simple P/E ratio based on accounting profits. We use Return on Invested Capital (ROIC) to measure earnings power as it reflects how effective the firm is in deploying all of its capital. Valuation is Key Consumer Staples Feb 215 Source: CSFB Holt as at 28 February 215. As one can see in Figure 2, the valuation of the consumer staples sector has ranged from a peak Economic P/E of 26 in the late 199s to a low of 15 just prior to the financial crisis in 29. Earnings power has only risen modestly over the 2-year period shown so clearly something else has driven the extreme swings in valuation. Through 27 and 28, as the world was still in the full throes of the credit boom, the valuation of the sector fell. Perceived as too defensive with unexciting growth prospects, the staples sector struggled to find favour. To the Fundamental Equity team, however, many of these stocks looked very cheap against their history and we added several to our portfolios. As the crisis swept across the globe through 29, investors sought the defensive qualities of those staples stocks, driving share prices higher. Remarkably, despite little change in earnings power in the past six years, investors have continued to chase stocks in this sector because they are considered safe and their low growth prospects are now deemed exciting. However, as the chart illustrates, investors are now paying valuations that are almost as high as they have ever been in the past 2 years for those prospects. Investors may be right to be worried about the outlook for global growth but we believe that they are overpaying to express that view in this State Street Global Advisors 2

3 manner. Overpaying for any asset, no matter the certainty of the outlook, leaves the investor vulnerable to disappointment and permanent loss of capital when the popularity inevitably fades....in the second half of 214, investors were rewarded for taking a view that the path to investment success lay in buying the most expensive stocks in the market. Industrials Contrast the experience of consumer staples with the industrials sector. The latter still trades at a discount to historic valuations despite evidence of an improvement in returns (Figure 3). As was the case for the consumer staples sector, valuations for the industrials sector have been volatile over the past 2 years, with severe swings through the financial crisis period. Earnings power fell sharply in the slump but has been recovering slowly since (Figure 3). However, investors seem unwilling to acknowledge the recovery, perhaps because they are worried about growth prospects, and the sector remains cheap relative to its history. This creates opportunities for us as value investors to identify and buy good quality businesses at very cheap valuations. Our pursuit of the valuation discipline in investing leads us into many contrarian positions. As investors have rushed into staples, paying high multiples for defensiveness, we have been moving in the opposite direction, selling highly-valued stocks to reinvest in cheaper cyclical stocks. While this approach works over the long term, it can be difficult in the short term when the momentum in the market ignores value. The second half of 214 is a good example of a period when valuations were ignored in the short term. In Figure 4, we have split the MSCI ACWI Index into quintiles by Price-to-Book Figure 3: Global Industrials Valuation: Feb Feb 215 Valuation ( Economic P/E) Earnings Power (ROIC %) Figure 4: Returns vs P/B Return (%) valuation as at the 3th June 214. We show how each of the quintiles performed over the subsequent six months. The most expensive stocks (in the top right) significantly outperformed, while the cheapest stocks lagged. Comparing the orange line here with the blue line in Figure 1, we can see that for this short period the relationship between value and returns was inverted. In short, in the second half of 214, investors were rewarded for taking a view that the path to investment success lay in buying the most expensive stocks in the market. To us, this seems like very risky behaviour, regardless of the lower volatility that many of these expensive stocks might enjoy. Global Spotlight How a Value Portfolio Measures Up So how should equity investors manage their equity risk today? We are confident that our value approach to stock-picking provide us with a margin of safety and will lead to a better outcome in the long term. This is highlighted by the comparison of the metrics for our Global Spotlight portfolio and the MSCI World Index. Valuation Starting P/B (Trailing) Source: Bloomberg, CSFB as at 31 December 214. Past performance is not a guarantee of future results. The information contained above is for illustrative purposes. Global Spotlight MSCI World Enterprise Value/Invested Capital Feb Feb 215 Sector ROIC Economic PE 2-Years Average Economic PE Global Industrials Source: CSFB Holt as at 28 February Returns Cashflow Return on Investment (FY1) (%) Cashflow Return on Investment (1 Year average) (%) Quality Debt/Equity Ratio (%) Source: SSGA, Factset as at 3 April 215. Past performance is not a guarantee of future results. State Street Global Advisors 3

4 Figure 5: Value in the Global Spotlight Portfolio Q Q1 215 Discount of Global Spotlight/MSCI World Global Spotlight Median EcPE (EV/IC and CFROI) MSCI World Median EcPE (EV/IC and CFROI) Source: SSGA, Factset, CSFB Holt and MSCI. As of 31st March Figure 6: Median EV/IC Global Spotlight (Based on Current Holdings) Feb Median EV/IC Global Spotlight Feb 215 Source: SSGA, Factset as of 31st March 215. The valuation of our Global Spotlight portfolio (we use Enterprise Value/Invested Capital to capture the full capital structure) is significantly cheaper than the MSCI World Index (1.4 vs 3.). The portfolio is full of stocks that are trading at a discount to their intrinsic value. Some are simply out of favour. Others may face challenging business conditions; this is evidenced by lower current returns on investment than the market (7.5% vs 12.4%) and by the higher returns our companies earned on average over the past 1 years (1.7%). Thus, the Global Spotlight portfolio includes many businesses going through temporary and/or cyclical difficulties that have depressed their returns. Furthermore, the average Debt/Equity ratio of our companies is lower than the Index, which indicates that our companies have stronger balance sheets on average and, in our analysis, are of better quality. Not only does our analysis give us confidence that a recovery in returns is likely for these businesses, but that they also have the time through balance sheet strength to achieve it. However, the shares are trading on very cheap valuations that would suggest their businesses are permanently impaired. Conversely, investors in the MSCI World Index are paying a high price for businesses where current returns are broadly in line with their 1-year average (12.4% vs 12.8%). In other words, they are paying a high price for businesses which are already performing very well. When considering a new investment opportunity, we ask ourselves: What s in the price? Where investors have priced a stock for a worst-case scenario, we only need one or two things to change for the price to begin to appreciate. Our portfolios have typically been constructed with stocks where a cheap valuation reflects plenty of bad news and a poor outlook. Not surprisingly, given our approach, our Global Spotlight portfolio has always traded at a discount to the wider market. In fact, with the MSCI World Index trading today on a median economic PE of 22.4 and our portfolio trading on 16.4, the six point gap is as big a difference as we have ever seen. This suggests that the portfolio is as cheap today as it has ever been relative to the opportunity set. We have confidence in our approach and believe that our holdings will see their intrinsic value unlocked in time. Taking a long-term view provides additional perspective. Figure 6 illustrates the valuation of our current portfolio relative to history. Even after the significant recovery in global earnings the stocks in our Global Spotlight are as cheap today as they have ever been on an absolute basis. Considering where we are in the market cycle, it is remarkable that we should be able to construct a portfolio of stocks that are so cheap relative to the market and to their own history. As we stated at the outset, the future is always uncertain. But, by sticking to our value discipline and seeking a margin of safety, the Fundamental Equity team aims to outperform over the long term, whatever the future holds. State Street Global Advisors 4

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