Commentary
Foundations of Oldfield Partners
The current high valuations of indices play on two key inefficiencies in equity markets that led to the foundation of Oldfield Partners: the short-termism of most participants and their tendency to hug indices. We aim to avoid these inefficiencies by staying true to our process of looking to make investments based on valuations and building benchmark agnostic portfolios. When buying the S&P 500 today, an investor pays twenty-five times earnings for an average company on peak margins. This runs contrary to our approach as a team.
As value investors we are unwavering in our belief that the best way to deliver long term returns is to invest in a portfolio of lowly valued and out of favour equities. The last decade or so of investing could be referred to as the value winter. But summer will arrive. There are green shoots on the horizon as there have been on occasions through the last decade but as the valuation spreads widen the shoots become more pronounced and the probability of a thaw increases.
The fund rose 1.2% in the third quarter of 2024 while the MSCI World High Dividend Yield Index rose 4.0%. The largest positive contributors to performance were, in order of impact, Alibaba (+56%, total return in local currency), KT&G (+23%) and North-West (+25%). The largest negative contributors to performance were, in order of impact, Pason (‑27%), Ally (‑10%), and BP (-16%).
Where are we finding value?
Despite the overall highs of the market, we are still able to find good companies that are trading at respectable valuations, some are even very cheap by historic standards. Much like in 2000 there are companies that are unloved and out of favour. Some of these companies have generated good long-term returns for investors with a long-term mindset. A long-term mindset from the companies we invest in is not critical, but it helps reduce the probability of a value trap. In the quarter we made new purchases in two such companies ZIGExN and Middleby.
ZIGExNis a Japan-based technology company specializing in online platforms that connect consumers with various services, primarily in the real estate, job, and travel sectors. The company was established in 2006 by Jo Hirao (53% owner) and has grown to become a significant player in the Japanese internet industry. The company has an impressive track record of profitable growth with a successful track record of disciplined M&A. The founder is young and excited about the current M&A opportunity set in Japan. The valuation is attractive, trading near its historic lows, around 12 times earnings after adjusting for cash.
Middleby has more than 115 foodservice brands of commercial and residential kitchen equipment. Over the last ten years, Middleby has grown revenue and earnings per share by 7% p.a. through a combination of acquisitions and organic growth. The business has strong brands, exposure to a resilient market and sticky customer relationships. The company has three divisions: Commercial Foodservice (c.60% of revenue), Food Processing (20%) and Residential Kitchen (20%).
Middleby now trades at just 13 times earnings but from 2010 to 2021 consistently traded at a premium to S&P 500. The discount is due to investor concerns around the company’s balance sheet and weak performance in the Residential Kitchen business. In our view, the balance sheet is acceptable with leverage (ratio of net debt to EBITDA) at 2.3 times against its covenant at 5.5 times and should be down at two times by the end of 2024. Whilst Residential Kitchen has indeed been weak, it represents just 10% of profit. The other 90% of profit from Commercial Foodservice and Food Processing is more resilient and the current trading is solid.
Stocks for the Long Run
Equity investors often anchor their expectations to long-term historical returns of around 9 percent per annum (approximately 7 percent real), as popularized by Jeremy Siegel in his seminal work Stocks for the Long Run. However, it is crucial to recognize that long-term averages can mask significant variability in shorter periods.
In the two decades leading up to 1982 the S&P 500 delivered nominal returns of around 6 percent per annum, with real returns close to zero, while the period from 1982 to 2002 produced nominal returns of roughly 15 percent per annum (about 12 percent real). These differences were not driven by changes in earnings growth or dividend yields but by changes in market valuation.
In 1962, the S&P 500 traded at a price to earnings ratio of approximately 20 times, but by 1982, this valuation had contracted to just eight times. By 2002, the price to earnings ratio had climbed back to around 20x, reflecting the cyclical nature of valuations. We believe that the long run is not best defined by a period of time; but a period in which changes in valuations have little or no impact on returns. In this instance forty years was required to reach a long-term equilibrium with annualised returns around ten percent (five percent real).
Today the valuation of the S&P 500 is higher than 1962 and 1982 and mirrors the frothy valuations seen in 2000. We see this as a warning sign for investors. Whilst the mid-teens annualised returns of the S&P 500 have been incredibly enticing since 2008, we perceive them to be increasingly like the bull market that came to a head in 2000.
Why we are excited about the future
History suggests that the high starting valuation of the S&P 500 today, indicates a reduction in the expected ten-year returns to low to mid-single digits. Since the companies that dominate the S&P 500 also drive the MSCI World we would expect global markets to follow a similar path. However, at Oldfield Partners, we remain excited about the future because of the substantial valuation discount the strategy offers relative to the broader market. This currently stands at more than 50%.
Since the inception of the Overstone Global Income strategy in 2012 it has delivered earnings growth slightly ahead of the MSCI World, including dividends reinvested. However, the relative multiple change over the period has had a material impact on the return that investors have received. The Overstone Global Income strategy has fallen from 12 to 10 times price to earnings and the MSCI World has risen from 12 to 20 times price to earnings; creating a c.4% per annum relative underperformance for the strategy.
Let’s assume the earnings grow in the future in the same way as the past. If it takes a decade for the valuation differentials highlighted above to mean revert, then we will outperform by 4% per annum. If the valuation differentials correct over three years as they did in 2000 to 2003 then we would expect outperformance over that period to be in the double digits.
The strategy is now trading at a record-low absolute valuation, further strengthening our conviction in its prospects. While we understand the impatience of investors who have seen value investing struggle relative to growth strategies over the past decade and a half, we believe the current opportunity for value investors is as attractive as it has been in nearly 25 years.
As Benjamin Graham said, "In the short run, the market is a voting machine, but in the long run, it is a weighing machine." Long-term investing requires patience and discipline, especially when the market is driven by short-term sentiment. At Oldfield Partners, we remain focused on fundamental value and long-term opportunities, believing that this approach will ultimately deliver superior returns to our investors.
Russian holdings
Please note that on 3rd March 2022 the Fund’s investment in Lukoil ADR listed on the London Stock Exchange (LSE) was suspended from trading. Our Valuation Committee considered it was in the Fund’s best interests that the holding of Lukoil ADR be fair value priced (FVP) at zero. In June 2022, we elected for the holding to be converted into local shares (Lukoil PJSC).
Given the current international sanctions on Russian securities and cash balances, we believe that if lifted and the Fund was able to access the local market, the holding in Lukoil PJSC (with a current FVP of zero) would represent 15% of the Fund and cash dividend of 3.8%. On 22nd August 2023 a Reuters article suggested that Lukoil was planning to repurchase 25% of its shares from foreign shareholders. The repurchase price would be at least a 50% discount from the quoted price. We continue to monitor the situation closely.
Transition in Management
Sam Ziff, the Portfolio Manager for the Global Equity Income strategy, has also been appointed as the sole Portfolio Manager for the Global Equity strategy, effective January 2025. Since March 2024, he has served as Co-Manager of the strategy. In recognition, Sam has also been named the firm's Chief Investment Officer.
Commentary
Foundations of Oldfield Partners
The current high valuations of indices play on two key inefficiencies in equity markets that led to the foundation of Oldfield Partners: the short-termism of most participants and their tendency to hug indices. We aim to avoid these inefficiencies by staying true to our process of looking to make investments based on valuations and building benchmark agnostic portfolios. When buying the S&P 500 today, an investor pays twenty-five times earnings for an average company on peak margins. This runs contrary to our approach as a team.
As value investors we are unwavering in our belief that the best way to deliver long term returns is to invest in a portfolio of lowly valued and out of favour equities. The last decade or so of investing could be referred to as the value winter. But summer will arrive. There are green shoots on the horizon as there have been on occasions through the last decade but as the valuation spreads widen the shoots become more pronounced and the probability of a thaw increases.
The fund rose 1.2% in the third quarter of 2024 while the MSCI World High Dividend Yield Index rose 4.0%. The largest positive contributors to performance were, in order of impact, Alibaba (+56%, total return in local currency), KT&G (+23%) and North-West (+25%). The largest negative contributors to performance were, in order of impact, Pason (‑27%), Ally (‑10%), and BP (-16%).
Where are we finding value?
Despite the overall highs of the market, we are still able to find good companies that are trading at respectable valuations, some are even very cheap by historic standards. Much like in 2000 there are companies that are unloved and out of favour. Some of these companies have generated good long-term returns for investors with a long-term mindset. A long-term mindset from the companies we invest in is not critical, but it helps reduce the probability of a value trap. In the quarter we made new purchases in two such companies ZIGExN and Middleby.
ZIGExNis a Japan-based technology company specializing in online platforms that connect consumers with various services, primarily in the real estate, job, and travel sectors. The company was established in 2006 by Jo Hirao (53% owner) and has grown to become a significant player in the Japanese internet industry. The company has an impressive track record of profitable growth with a successful track record of disciplined M&A. The founder is young and excited about the current M&A opportunity set in Japan. The valuation is attractive, trading near its historic lows, around 12 times earnings after adjusting for cash.
Middleby has more than 115 foodservice brands of commercial and residential kitchen equipment. Over the last ten years, Middleby has grown revenue and earnings per share by 7% p.a. through a combination of acquisitions and organic growth. The business has strong brands, exposure to a resilient market and sticky customer relationships. The company has three divisions: Commercial Foodservice (c.60% of revenue), Food Processing (20%) and Residential Kitchen (20%).
Middleby now trades at just 13 times earnings but from 2010 to 2021 consistently traded at a premium to S&P 500. The discount is due to investor concerns around the company’s balance sheet and weak performance in the Residential Kitchen business. In our view, the balance sheet is acceptable with leverage (ratio of net debt to EBITDA) at 2.3 times against its covenant at 5.5 times and should be down at two times by the end of 2024. Whilst Residential Kitchen has indeed been weak, it represents just 10% of profit. The other 90% of profit from Commercial Foodservice and Food Processing is more resilient and the current trading is solid.
Stocks for the Long Run
Equity investors often anchor their expectations to long-term historical returns of around 9 percent per annum (approximately 7 percent real), as popularized by Jeremy Siegel in his seminal work Stocks for the Long Run. However, it is crucial to recognize that long-term averages can mask significant variability in shorter periods.
In the two decades leading up to 1982 the S&P 500 delivered nominal returns of around 6 percent per annum, with real returns close to zero, while the period from 1982 to 2002 produced nominal returns of roughly 15 percent per annum (about 12 percent real). These differences were not driven by changes in earnings growth or dividend yields but by changes in market valuation.
In 1962, the S&P 500 traded at a price to earnings ratio of approximately 20 times, but by 1982, this valuation had contracted to just eight times. By 2002, the price to earnings ratio had climbed back to around 20x, reflecting the cyclical nature of valuations. We believe that the long run is not best defined by a period of time; but a period in which changes in valuations have little or no impact on returns. In this instance forty years was required to reach a long-term equilibrium with annualised returns around ten percent (five percent real).
Today the valuation of the S&P 500 is higher than 1962 and 1982 and mirrors the frothy valuations seen in 2000. We see this as a warning sign for investors. Whilst the mid-teens annualised returns of the S&P 500 have been incredibly enticing since 2008, we perceive them to be increasingly like the bull market that came to a head in 2000.
Why we are excited about the future
History suggests that the high starting valuation of the S&P 500 today, indicates a reduction in the expected ten-year returns to low to mid-single digits. Since the companies that dominate the S&P 500 also drive the MSCI World we would expect global markets to follow a similar path. However, at Oldfield Partners, we remain excited about the future because of the substantial valuation discount the strategy offers relative to the broader market. This currently stands at more than 50%.
Since the inception of the Overstone Global Income strategy in 2012 it has delivered earnings growth slightly ahead of the MSCI World, including dividends reinvested. However, the relative multiple change over the period has had a material impact on the return that investors have received. The Overstone Global Income strategy has fallen from 12 to 10 times price to earnings and the MSCI World has risen from 12 to 20 times price to earnings; creating a c.4% per annum relative underperformance for the strategy.
Let’s assume the earnings grow in the future in the same way as the past. If it takes a decade for the valuation differentials highlighted above to mean revert, then we will outperform by 4% per annum. If the valuation differentials correct over three years as they did in 2000 to 2003 then we would expect outperformance over that period to be in the double digits.
The strategy is now trading at a record-low absolute valuation, further strengthening our conviction in its prospects. While we understand the impatience of investors who have seen value investing struggle relative to growth strategies over the past decade and a half, we believe the current opportunity for value investors is as attractive as it has been in nearly 25 years.
As Benjamin Graham said, "In the short run, the market is a voting machine, but in the long run, it is a weighing machine." Long-term investing requires patience and discipline, especially when the market is driven by short-term sentiment. At Oldfield Partners, we remain focused on fundamental value and long-term opportunities, believing that this approach will ultimately deliver superior returns to our investors.
Russian holdings
Please note that on 3rd March 2022 the Fund’s investment in Lukoil ADR listed on the London Stock Exchange (LSE) was suspended from trading. Our Valuation Committee considered it was in the Fund’s best interests that the holding of Lukoil ADR be fair value priced (FVP) at zero. In June 2022, we elected for the holding to be converted into local shares (Lukoil PJSC).
Given the current international sanctions on Russian securities and cash balances, we believe that if lifted and the Fund was able to access the local market, the holding in Lukoil PJSC (with a current FVP of zero) would represent 15% of the Fund and cash dividend of 3.8%. On 22nd August 2023 a Reuters article suggested that Lukoil was planning to repurchase 25% of its shares from foreign shareholders. The repurchase price would be at least a 50% discount from the quoted price. We continue to monitor the situation closely.
Transition in Management
Sam Ziff, the Portfolio Manager for the Global Equity Income strategy, has also been appointed as the sole Portfolio Manager for the Global Equity strategy, effective January 2025. Since March 2024, he has served as Co-Manager of the strategy. In recognition, Sam has also been named the firm's Chief Investment Officer.