A NEW TOOL KIT FOR EUROPEAN EQUITY INVESTORS

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1 OCTOBER 2016 IS THE PRICE RIGHT? A NEW TOOL KIT FOR EUROPEAN EQUITY INVESTORS Tawhid Ali Chief Investment Officer European Value Equities Nelson Yu Head Equity Quantitative Research IN THIS PAPER: How can investors identify the true bargains in today s European markets those that offer an attractive price for a solid underlying business profile that can deliver outsize return potential over time? Instead of relying exclusively on the traditional barometers of stock valuation, investors must proactively adapt and evolve their tools and tactics to access new kinds of insights, in our view. For Investment Professional use only. Not for inspection by, distribution or quotation to, the general public.

2 VALUE IN THE DOLDRUMS? Most of us find it hard to resist a bargain. But bitter experience tends to teach us that rock-bottom prices don t always deliver good value. All too often, we ll come to discover that there s a simple reason why something is cheap its quality is shoddy. Investors in European equities face a similar dilemma. Stocks that appear cheap often have serious underlying problems. Some languish in sectors with big short-term headwinds and long-term difficulties. Others simply aren t notching up solid, growing profits. Multiple challenges to the stability of markets, industries and individual companies are severely testing the usual contrarian approach of targeting stocks that are out of favor. Instead of relying exclusively on the traditional barometers of stock valuation, investors must find new ways to assess the true worth of stocks, in our view. In this paper, we examine the kind of next-generation tools that can provide more effective ways to discover cheap stocks with real payoff potential in today s European markets. For Investment Professional use only. Not for inspection by, distribution or quotation to, the general public.

3 Investors seeking to identify undervalued stocks have long relied on valuation metrics typically multiples of companies earnings or assets. In particular, they ve focused on price/earnings (P/E) ratios and price/book value (P/B) multiples to guide their search. Passive and smart beta value approaches generally rely on these metrics to construct portfolios. DISPLAY 1: TRADITIONAL VALUE HAS DISAPPOINTED European Large-Cap Stocks: Cumulative Returns of Traditional Value Factors Percent Jan 11 Jul 11 Jan 12 Jul 12 Jan 13 Jul 13 Jan 14 Jul 14 Jan 15 Jul 15 Jan 16 Jul 16 MSCI Europe (Hedged) Cheapest 20% According to P/FEs Cheapest 20% According to P/Bs Past performance does not guarantee future results. Through August 31, 2016 Source: Barra, MSCI and AB But, although these metrics have a successful history over the long term, they ve been severely tested in the years following the global financial crisis in virtually all corners of the world, including Europe. Here, the cheapest 20% of stocks (as measured by forward P/Es (P/FEs) and P/Bs) have meaningfully underperformed the broader European market since 2011 (Display 1). So why have many cheap stocks and sectors underperformed their more expensive counterparts? Some of the answers lie in the macroeconomic backdrop. EUROPE S VOLATILE ENVIRONMENT The aftermath of the euro-area crisis of and sluggish rates of growth have increased the appeal of defensive companies deemed to offer predictable earnings growth. With risk aversion running high and growth in short supply, nervousness about more contrarian stocks has encouraged investors to congregate in a few pockets of solid and predictable earnings growth. Consumer staples in particular have benefited from this trend and trade at expensive valuations. Because these stocks typically offer attractive dividend yields, they re often viewed as bond proxies. Value-oriented investing strategies have been further challenged in recent years by the unusual concentration of financials and energy stocks within value indices. The sectoral dominance of the value universe is exceptional by historical standards: banks account for 9.8% of the European market overall, but dominate the cheapest quintile on P/Bs, where they make up 46%. As a result, investors getting their value exposure on the basis of P/FEs and P/Bs alone will find themselves overloading financial firms and energy groups. IS THE PRICE RIGHT? A NEW TOOL KIT FOR EUROPEAN EQUITY INVESTORS 1

4 Our research suggests that these stocks inherent undervaluation is less attributable to company-specific factors and more and more attributable to the fact that they re exposed to significant secular headwinds. This can be seen by the falling proportion of companies whose share price volatility is the result of highly idiosyncratic controversies. Such controversies typically include company-specific issues such as management behavior or equity and debt issuance trends. At the same time, the proportion of companies whose share price volatility is driven more by systemic considerations like exposure to market beta or macroeconomic sensitivities is growing (Display 2). Banks, for example, are navigating a particularly challenging environment. They re finding that the goalposts are constantly changing when it comes to the capital ratios they re required to hold. At the same time, it s harder for them to make money from lending as interest rates have fallen. EXPANDING THE VALUE TOOL KIT Multiple challenges to the stability of markets, industries and individual companies are severely testing the usual contrarian approach of targeting stocks that are out of favor. Focusing on cheap P/FEs and P/Bs clearly isn t proving rewarding. So does that mean we re at a value stalemate? We don t think so. But investors need to take a broader and more proactive approach to unearth value in stocks. Value should not be defined by current accounting earnings and book values alone. So instead of relying exclusively on the traditional barometers of stock valuation, investors must evolve their tool kits, in our view. The metrics outlined in Display 3 (page 3) form the bedrock of a highly effective next-generation value investing tool kit. Our broader value blueprint combines earnings-based and cash-flow-based metrics, and looks beyond stock prices to examine companies debt profiles. We also think it s crucial to understand exactly how accounting practices can impact some measures of companies intrinsic worth. PRICE TO FORWARD EARNINGS The natural starting point for any value-oriented investor is the price that investors are paying for a company s earnings. Seeing how the DISPLAY 2: SYSTEMIC FACTORS INCREASINGLY DRIVE COMPANIES CHEAP PRICES Key Sources of Risk* for Europe s Cheapest Quintile of Large-Cap Companies (P/B Ratios) Percent Jul 98 Jul 01 Jul 04 Jul 07 Jul 10 Jul 13 Jul 16 % of Cheapest Quintile Whose Key Risks Are Systemic % of Cheapest Quintile Whose Key Risks Are Idiosyncratic Past performance does not guarantee future results. Through July 1, 2016 Systemic factors refer to exposure to market beta, macroeconomic sensitivities and cyclical and/or secular pressures on sectors/industries. Idiosyncratic factors refer to management behavior, equity/debt issuance trends and track records as stewards of assets. *Country, industry, beta, size and other risk index factors from the Barra GEM3L model Source: Barra and AB collective investment community weighs up a company s stock price relative to its future expected earnings can provide a useful indicator of broad perceptions about that company s prospects. However, the lowest P/FE ratios may uncover a glut of companies with few growth prospects, while companies trading at P/FEs above industry norms aren t necessarily poor value. Without greater context, P/FEs have limited efficacy in finding overly discounted stocks which explains why other factors should also be considered. 2 For Investment Professional use only. Not for inspection by, distribution or quotation to, the general public.

5 DISPLAY 3: TRADITIONAL AND NEXT-GENERATION VALUE FACTORS TRADITIONAL FACTORS Price to Forward Earnings Price to Book Value As of August 31, 2016 Source: AB NEXT-GENERATION FACTORS Price to Forward Earnings Price to Free Cash Flow Price to Tangible Book Value Enterprise Value to Sales PRICE TO FREE CASH FLOW Companies cash flows can t be manipulated as easily as their reported earnings figures. In addition, they show just how much cash may be flowing in or out of companies in the form of working capital and capex spending which don t show up in reported earnings. Companies that are cheap relative to their strong free cash flows are often on the verge of delivering good earnings growth. Cash-rich companies are clearly getting lots of things right and are in a good position to invest in their businesses in ways likely to enhance their earnings potential. By contrast, companies that can t generate decent free cash flow can struggle to sustain earnings growth and may even lack the liquidity to stay in business. PRICE TO TANGIBLE BOOK VALUE Over time, the nature of firms assets has changed. European companies intangible assets as a percentage of their total assets have soared over the last 25 years or so. They accounted for only about 5% of total assets in the 1980s; today, the average is about 25%. But it s exceptionally tricky to make accurate calculations about the true value of goodwill and other intangibles. We think it s prudent to take them out of the equation altogether and to focus instead on price to tangible book values. We add the wealth-creating potential stemming from companies research and development (R&D) expenditure to tangible book values. This helps broaden the search for undervalued companies to include names whose R&D costs today could prove rewarding tomorrow. ENTERPRISE VALUE TO SALES Total revenues are one of the most transparent accounting metrics available and are the primary source of cash flows for most companies. They re particularly critical in determining the return potential of asset-light companies whose book values are less meaningful. Companies that are cheap on sales metrics are often generating more revenues than their peers and, therefore, have a higher chance of generating stronger cash flows. So a sales-based metric is an important part of the valuation tool kit. That said, revenues are used for many purposes. They not only generate cash flows for shareholders they also help to service debt. That s why comparing a company s revenues with its overall enterprise value the sum of its market capitalization and debt can be more insightful than simply comparing them with a company s stock-market valuation. This helps avoid the potential value trap of too much exposure to highly leveraged companies that can look cheap on traditional price-based metrics. MULTIPLE VIEWS PRODUCE BETTER SIGNALS Different value factors perform differently in different market conditions and across different sectors. That s why no single quantitative metric alone can be relied on to identify an attractive stock opportunity. Some metrics work better for certain industries and sectors than others. And all will work differently in different situations. Using a range of metrics can provide more reliable signals. Crucially, it can also help investors smooth out some of the volatility associated with the value style. In 2014 and 2015, for example, stocks with low price to free cash flow performed well, even as the performance of other value metrics was disappointing (Display 4). Valuation should never be viewed in isolation. It s also important to incorporate other quantitative metrics into the search for attractively valued stocks, notably those illustrating a company s profitability and IS THE PRICE RIGHT? A NEW TOOL KIT FOR EUROPEAN EQUITY INVESTORS 3

6 DISPLAY 4: DIFFERENT VALUE FACTORS WORK BETTER AT DIFFERENT TIMES Factor Returns: Quintile 1 Versus Market (MSCI Europe)* Price to Tangible Book Value Price to Free Cash Flow Price to Forward Earnings Enterprise Value to Sales % 0.4% 1.7% 1.7% Past performance does not guarantee future results. As of December 31, 2015 *Hedged Returns in USD Source: FactSet, MSCI and AB management quality and the views of other investors. Indeed, over the last five years, stocks that were cheap on P/B alone significantly lagged the broader European market. But a universe of undervalued stocks, based on all four metrics we ve outlined and excluding those cheap companies with weak price momentum and low profitability, significantly outperformed (Display 5, page 5). By creating an integrated quantitative tool kit, investors can gain an edge in the hunt for attractively valued stocks whatever the vagaries of economic and business cycles. But the discovery of attractively valued candidates is only the first step to selecting stocks and building a portfolio with strong return potential. THE HUMAN FACTOR: FINDING FUNDAMENTAL VALUE The next step is to subject investment candidates to fundamental analysis. For this, the human factor is essential to developing appropriately long-term forecasts of companies earnings, cash flows and balance-sheet prospects. Qualitative analysis and hands-on research will always be essential to capturing the most promising opportunities and avoiding the riskiest. Here, too, new tools can deliver stronger results. In particular, we believe that internal rates of return (IRRs) provide an important analytical framework for fundamental company research. IRRs are a key focus for private equity investors, who approach investment as strategic business owners, but have been less commonly used by investors in public equity markets. THINKING LIKE BUSINESS OWNERS IRRs can be used to look at a potential investment in a publicly quoted company as though the whole company were being bought rather than just some of its shares. Our IRRs calculations use our analysts earnings forecasts to derive an annualized return rate from the cash flows that we expect the investment to throw off. These include both dividends and the expected proceeds if the company is sold back to the market after five years. Crucially, we assume, as private equity investors typically would, a conservative exit multiple that s either equivalent to, or lower than, the current multiple. In other words, we look to IRRs to show the return potential from investing in a company based on our forecasts of its cash flows, without the benefit of any expansion of its stock market multiple, or market re-rating of the stock. We believe that this approach can offer a good margin of safety. 4 For Investment Professional use only. Not for inspection by, distribution or quotation to, the general public.

7 Unlike quantitative metrics, which are derived from public market data, IRRs are a product of proprietary research. They are based on the insights of fundamental analysts who are well versed in the specific dynamics of an industry and the business models of individual companies. The IRRs approach can help value investors avoid classic value traps. By focusing on cash flows as the source of returns, it can identify stocks that can unlock value and deliver returns without relying on a change in market sentiment. This has been particularly helpful in an environment where investors are fretting about macroeconomic issues, and traditional value approaches relying on multiple expansion have been less effective. Of course, IRRs are only one lens through which to understand the results of qualitative analysis. Other valuation tools, such as price to normalized earnings and sum-of-the-parts analysis, also provide valuable perspectives on fundamental return expectations. CONSTANT EVOLUTION With traditional methods of identifying bargains sometimes pointing in the direction of stocks with serious underlying challenges, we believe that investors should be proactively reexamining the tools and tactics used to build portfolios. Constantly refining and revising the quantitative tool kit is a vital step in the evolving search for better stock insights. Today, investors in Europe are grappling with complex market conditions. European companies face formidable hurdles to earnings growth, while multiple expansion cannot be relied upon to fuel returns. In this environment, we believe that a broader set of quantitative metrics, combined with fundamental company research and a focus on IRRs, is a winning recipe. In our view, this tool kit can capture strong long-term equity returns, by identifying companies that trade at attractive prices and can also deliver good value. DISPLAY 5: NEXT-GENERATION TOOLS CAN IDENTIFY CHEAP STOCKS WITH TRUE PAYOFF POTENTIAL Cumulative Performance: Next-Generation European Value Stocks Relative to Broad European Market and to Cheapest Quintile (P/B Ratios) Percent Jul 11 Jul 12 Jul 13 Jul 14 Jul 15 Jul 16 Cheapest European Large-Cap Stocks (P/B, P/FCF Ratios) Excluding Companies with Low Profitability and Low Momentum MSCI Europe (Hedged) Cheapest Quintile of European Large-Cap Stocks (P/B Ratios) Past performance does not guarantee future results. Through July 1, 2016 Source: MSCI and WorldScope IS THE PRICE RIGHT? A NEW TOOL KIT FOR EUROPEAN EQUITY INVESTORS 5

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