Taking Stock Q2 2017 02 THE BIG PICTURE Valuation anomalies continue to uncover investment opportunities, particularly outside the United States. Fundamental Value Equities Concentrating on long-term value 04 Finding Value Stock Highlight: Arconic Formerly part of the Alcoa mining group, Arconic's future as a standalone company presents a strong value proposition. 06 RESEARCH Briefing How We Assess Value Looking beyond price/earnings: The merits of using an Enterprise Value approach to stock investing. 08 Value Strategies Value strategy updates, performance and portfolio characteristics.
Fundamental Value Equities Q2 2017 THE BIG PICTURE Brian Routledge, Head of Portfolio Management Was that it? Is the value rally over? Following a strong year for value in 2016, the erosion of that outperformance through the first half of 2017 has left value returns much on a par with growth for the past 18 months. The period of that value outperformance is brief in an historic context, and particularly so when viewed against a decade of value underperformance. As value investors, we naturally find this unsatisfying but accept that market patterns rarely play out exactly as they did before. Valuation dispersions remain quite high across style, sector and regions. Global capitalisation-weighted equity indices do not appear particularly cheap, but anomalies that benchmark-agnostic investors can exploit continue to exist. One such anomaly is the large US weighting in global indices now 10 percentage points higher since 2010. The higher weight of an increasingly expensive asset makes life difficult for benchmark-aware investors and serves to reinforce our preference for bottom-up portfolio construction. US Stocks Expensive The US market is expensive against both its own recent history and in a global context (Figure 1). Investor optimism about corporate profits or tax and regulatory relief likely plays a part. The makeup of the index itself is also a likely factor with one particular group of large-growth companies seemingly exempt from valuation norms. Facebook, Apple, Amazon, Netflix and Alphabet (Google) the so called 'FAANG' companies account for approximately 10% of the S&P 500, but have contributed about 25% of the index gain in 2017. These stocks also screen amongst the lowest volatility cohort of the market. Rising share prices and low volatility tick the boxes for algorithmic investors who have been drawn to these stocks. And as Bank of America noted: Rarely ones to shun the herd, active funds are now 71 percent overweight in the FANG companies after making the biggest move from value to growth since 2008. 1 In the State Street Global Advisors' Fundamental Value Equity Team, we are just wired a little differently. In the prevailing US market environment, we have observed that some of the biggest detractors from the relative performance of our US equity strategy in 2017 have actually been non-holdings. Many of those non-holdings are found among the FAANGs (and their various derivatives). In the context of the concentrated strategies that we manage, this is quite an unusual occurrence. 1 Bank of America, May 2017. Figure 1: Regional Valuations Enterprise Value/Invested Capital (EV/IC)* 3.0 2.5 2.0 1.5 1.0 0.5 0.0 Developed Emerging 10 Yr Region EV/IC Range Current EV/IC North America Europe Eurozone Asia Pacific ex Japan Japan South Korea Hong Kong Source: Factset, SSGA as at 30 June 2017. Universe is the MSCI World Index. * Enterprise Value/Invested Capital is a valuation metric and is expanded upon in pages 6/7. Please refer to the back of the document for definitions of financial terms. 2
Is This Time Different? We do not know what the future holds. Perhaps a new paradigm of corporate profitability has evolved a winner-takes-all scenario dominated by platform monopolies. But history is littered with new paradigms : Japan had 13 of the top 25 global companies in 1989. Today that number is zero. Technology stocks that survived after 2000 took years to justify a fraction of their peak valuations, despite the success of the technologies those valuations were built upon. Few financial stocks from 2006/2007 maintained their lofty positions. What we do know is that US equity indices and by extension global are being driven by relatively few very large companies that require unprecedented profits to maintain their leadership. European Renaissance The increased weight of US equities in global indices has also been facilitated by Europe s travails since 2008. In the post-financial crisis climate that saw insolvencies at a national level, political upheaval, high unemployment and terrorist attacks, it s no wonder investors shunned European equities even as their discount to US equities increased. European equities also experienced greater volatility, creating another valuation anomaly given the fixation of many investors on minimizing volatility. During this period when our global strategies reflected overweight Europe/underweight US positions many European companies have restructured, cut costs and deleveraged, aided by euro weakness. With economic activity since recovering, positive earnings revisions are now among the strongest in the world. The combination of depressed valuations and cyclically-depressed earnings is a powerful draw for bottom-up value investors, and we have reaped significant excess returns as our expectations for future earnings power have started to play out. In 2017, for the first time in many years, European equities are outperforming the US. Not everything is cheap in Europe. Notwithstanding the fact that they offer highly sought-after traits (stable earnings and low volatility), Consumer Staples are simply expensive. Staples used to be a fertile hunting ground for value investors but their high valuations remind us that value does not remain fixed. We go where the value takes us. Asian Opportunities On many levels, Asia-Pacific markets are the antithesis of Western markets. Asian markets are cheap in absolute terms; at 1.50x, the price/book ratio of the MSCI Asia Pacific Index has rarely been lower. However, earnings power in some Asian segments has eroded significantly, necessitating significant bottom-up research endeavour to unearth value, including rigorous assessment of governance and balance sheet management. Diverging from themes elsewhere, Asian consumer sectors currently present more compelling fundamental value characteristics. Earnings power had been inflated by excessive fixed asset growth in China and capital intensive sectors such as Construction, Chemicals and Steel now appear to be in structural over-capacity. These entities, many with significant state ownership and high debt, pose a potential risk to attempts by authorities to restructure the economy. A regional growth scare had led to a de-rating in adjacent sectors such as Financials, Consumer and Industrials we believe these areas offer a potentially rich seam of value for stock-pickers. We are also finding value in Japan, particularly within the Financials and Industrials sectors. We have done a lot of work around governance, and our balance-sheetfocused investment framework is well-equipped to look at the potential for improving capital efficiency. State Street Global Advisors 3
Fundamental Value Equities Q2 2017 Finding Value James Savage, Research Analyst At a time when North American Industrials have been trading at the higher end of their historic valuation range, Arconic screened as an interesting value opportunity. On closer examination, we uncovered a prospect that satisfies our key criteria for investment. Recently spun out of Alcoa, the company lacks the long-term standalone history that many investors like to see, while there was also a dearth of coverage by analysts in the sector. That low profile and lack of history can prompt many investors to look elsewhere. Attractive long-term drivers such the current stage of the aircraft product cycle and the growing use of aluminium in motor vehicle production appear compelling. We believe scope exists for significant margin improvement through revenue growth, changes in product mix and reduction in overheads. ARCONIC The Company In late 2016, Alcoa Inc. separated into two publicly-listed companies Arconic Inc., which would focus on downstream activities such as high-end metal alloy production, and Alcoa Corp., which would focus on upstream activities such as bauxite mining and aluminium production. Arconic has a footprint that stretches across a broad range of end-markets, with a notable skew towards aerospace and road transportation. Its customers include industry leaders such as Boeing, Airbus, United Technologies, Rolls Royce, Ford, Paccar and Daimler. Arconic is a market leader in most of its end markets, with 80% of its revenues coming from categories where it is a top-two player already. It is now leveraging its experience and capacity to innovate by collaborating more closely with clients to deliver solutions. This is a notably different approach to the build-to-specification model preferred by some of its rivals. Investment View Visibility on Revenues The commercial aerospace sector is going through a significant product cycle, as Boeing and Airbus roll out several new aircraft. Arconic has secured significantly higher shipset values (amount of revenue of content on each airplane) on these new generations than it has on the current ones. That said, this transition will take several years to play out and we know to expect bumps along the road given the overall scale and complexity of what is being undertaken by the sector. However, we believe that the direction is encouraging. The automotive industry is evolving and vehicle manufacturers are expected to continue reducing steel content in favour of lighter, and thus more fuelefficient, aluminium. Average aluminium content per vehicle is expected to grow at annualised mid-singledigit rates over the course of this decade. Competition is strong in this space, but Arconic s new MicroMill technology, which the company claims can greatly shorten the production cycle for auto sheet, offers considerable potential. 4
Figure 1: Expected Evolution in End-Market Revenue Mix Group Revenue (by End-Market) 2015 Other 20% Defence 3% Construction 8% Autos 6% Industrial 11% Forecasted Group Revenue (by End-Market) 2021 Other 13% Defence 3% Construction 8% Autos 9% Industrial 10% Aerospace Engines 14% Aerospace Airframes 24% Margin Improvement Scope for improved margins lies in reducing corporate overhead, further refining of new production processes and gains from operating leverage. Arconic s margins remain some way short of best-in-class peers, although our thesis does not require it to achieve such levels in order for the stock to be attractive. Trucks 14% Aerospace Engines 23% Aerospace Airframes 21% Capital Intensity The company s largest acquisition pre-separation was its $2.9 billion acquisition of Firth Rixson in 2014. While there was a clear strategic rationale for this purchase, the market is increasingly of the view that Arconic overpaid for this business given its subsequent performance. Trucks 13% Source: Arconic, SSGA Fundamental Value Equities as at 30 June 2017. These forecasts represent our estimates for the business, based on our knowledge of the underlying industry and the results of our fundamental (i.e. bottom-up) research. analysis, we believe that this position will correct over the medium term. Financial Strength At the time of separation, Arconic had $8 billion of gross debt and, by our calculation, a relatively high net debt-to- EBITDA (earnings before interest, taxes, depreciation, amortisation) ratio of 3.6 times. Our analysis showed that the company had the capacity to reduce debt through the planned sale of its Alcoa Corp stake (now complete), and through expected growth in core earnings. This will allow the firm to achieve satisfactory balance sheet flexibility, including with respect to financial covenant compliance. Management Arconic is searching for a replacement for its recentlydeparted CEO. In the interim, board member David Hess is at the helm, having held a senior leadership position in United Technologies. The company s protracted dispute with largest shareholder Elliott Management has culminated in a much-transformed board. It now includes members with insights from Boeing, United Technologies, Precision Castparts, Spirit Aerosystems and Delphi Automotive. Our Assessment Based on what we consider to be robust and conservative assumptions around long-term earnings power, and the capital required to support those earnings, we believe that Arconic can deliver a low double-digit ROIC over the long term. The current EV/IC (enterprise value to invested capital) ratio is one times, suggesting to us that the rating of capital (EV/IC) is very attractive relative to the longerterm productivity of that capital (ROIC). Our view is that Arconic has made several large investments that were going to depress its return on invested capital (ROIC) until the associated revenue opportunities came through. As such, based on our State Street Global Advisors 5
Fundamental Value Equities Q2 2017 RESEARCH Briefing William Killeen, Portfolio Manager How We Assess Value As value managers, we believe the cornerstone of successful longterm investing is the purchase of companies at the right price. And by right price, we mean a price materially below intrinsic value. The calculation of the intrinsic value of a company is thus of paramount importance. Traditional valuation methodologies are usually some derivative of the assumption that the intrinsic value of a company is the present value of its future cash flows. Therefore, the key aspect to any valuation methodology is the robustness of the estimate of those future cash flows. In choosing our primary valuation methodology, we have determined that using a combination of Invested Capital (IC), as a measure of the total capital invested in a company and Return on Invested Capital (ROIC), as a measure of corporate performance, gives us the best chance of generating a robust estimate of future cash flows. Deconstructing the P/E The Price/Earnings (P/E) ratio is probably the best known equity valuation metric and the theoretical underpinnings of the ratio are sound (it is simply a short-hand derivation of a single stage dividend discount model) 1. Although no single metric can be expected to perfectly capture all aspects of a company s value, some consideration of what a P/E doesn t do is useful from the perspective of communicating how we think about valuation. Simply put, low multiples do not always correspond to good value. We take a look why this might be: Sustainability of Earnings Company earnings tend to fluctuate over time. So for the multiple to be relevant for valuation purposes, the point in time earnings, or earnings per share (EPS the E in P/E), must correspond to long-term earnings power, something that is rarely the case. Exceptional Items EPS often includes exceptional or non-operating items, which reduce the reliability of EPS as a measure of normalised earnings power. Capital Intensity of Earnings A P/E multiple ignores the amount of investment required by a business in order to sustain earnings. This is a very important variable in assessing long-term value creation. Balance Sheet The P/E doesn t capture the structure of the balance sheet. A simple P/E ratio analysis provides little information as to the amount of debt or off-balance sheet liabilities that take precedence over shareholders claims on cash flow. Our preferred methodology explicitly addresses these issues and more, while also challenging us to improve our understanding of the financials and business models of companies under consideration. 1 Source: A. Damodaran, Stern School of Business, NYU. http://pages.sterm.nyu.edu/~adamodar/new_home_page/invfables/peratio.htm. 6
Measuring Profitability and Performance In our framework, we use Net Operating Profit after Tax (NOPAT) as an alternative to EPS in measuring corporate profitability. NOPAT is also the numerator in the calculation of ROIC (Return on Invested Capital), our preferred measure of corporate performance. ROIC measures the productivity of all capital invested in a company. We believe it is superior to equity-only measures of corporate performance, such as Return on Equity (ROE), as it provides a more holistic and comprehensive perspective. Through the analysis of changes in historic IC and ROIC we can gain valuable insights into the evolving capital intensity, and quality of capital allocation. We have a preference for companies that can sustain attractive levels of ROIC and grow the denominator (i.e. invest in their business), without diluting ROIC. ROIC is a quality metric rather than a valuation metric. Our approach seeks to establish an appropriate price for a given level of quality. We use EV/IC (Enterprise Value to Invested Capital) to figure this out. Enterprise Value is simply the market capitalisation plus all the liabilities of the company. This approach allows us to value equity, not just on a stand-alone basis, but in the context of all claims on capital. The non-equity components of EV tend to be non-operating balance sheet items and in many cases can require judgment to value. We have developed a financial analysis framework over many years to ensure this is done consistently across all the companies we consider for investment. EV/IC captures the multiple of invested capital we are being asked to pay for a company. ROIC captures the productivity of that capital. The chart below plots the relationship between the two metrics for each stock in the MSCI World Index. As the R2 signifies, and as illustrated by the line of best fit, this is a very strong relationship. Intrinsic Value By triangulating our expectations for future NOPAT, IC and ROIC, we believe we can generate more consistent and comparable estimates of long-term shareholder value creation, future cash flow. By introducing discipline into the assessment of an appropriate multiple EV/IC for a given level of ROIC we can estimate the intrinsic value of a company. As global value investors who allocate capital on the basis of upside to intrinsic value, nothing is more important to us than the consistency of our estimates of intrinsic value. Figure 1: The relationship between quality and value Valuation EV/IC 10 8 R² = 0.6796 6 4 2-5 0 5 10 15 20 25 30 35 40 Quality ROIC (%) Source: SSGA, MSCI, CSFB Holt A Trademark of Credit Suisse Group, as at 30 June 2017. State Street Global Advisors 7
About Us For nearly four decades, State Street Global Advisors has been committed to helping our clients, and those who rely on them, achieve their investment objectives. We partner with many of the world s largest, most sophisticated investors and financial intermediaries to help them reach their goals through a rigorous, research-driven investment process spanning both indexing and active disciplines. With trillions* in assets under management, our scale and global reach offer clients access to markets, geographies and asset classes, and allow us to deliver thoughtful insights and innovative solutions. Glossary MSCI World Index A broad global equity benchmark that represents large and midcap equity performance across 23 developed markets countries. It covers approximately 85% of the free float-adjusted market capitalisation in each country and does not offer exposure to emerging markets. Return on Invested Capital (ROIC) A valuation metric that measures the productivity of all capital. It measures the return on investment to all providers of capital. Enterprise Value/Invested Capital (EV/IC) Enterprise Value is the market capitalisation plus all the liabilities of a company. EV/IC captures the multiple of invested capital required to pay for a company. State Street Global Advisors is the investment management arm of State Street Corporation. *Assets under management were $2.60 trillion as of 30 June 2017. AUM reflects approx. $34 billion (as of 30 June 2017) with respect to which State Street Global Advisors Funds Distributors, LLC serves as marketing agent; State Street Global Advisors Funds Distributors, LLC and State Street Global Advisors are affiliated. ssga.com Marketing Communication. For public use. 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