Conglomerates: the rise, fall and opportunity
Charles Sunnucks
Portfolio ManagerCharles Sunnucks joined OP at the start of 2023, prior to which he was involved in cross-border M&A transactions at investment bank NovitasFTCL. He previously worked at Jupiter Asset Management where he co-managed the Jupiter Emerging & Frontier Income Trust, he speaks fluent Mandarin, and is a CFA/CAIA Charterholder. He manages the emerging markets portfolios and contributes to the overall investment selection.
The following insight piece was initially published by Investment Week and a link to the article can be found here.
Should the value of an entity be more or less than the sum of its parts? It’s a simple question, but as market valuations suggest, with a radically varying answer based on time, market and vehicle. This raises the curious question – who is getting it wrong?
There is of course plenty of nuance in the response, but the degree of decoupling between price and underlying value we believe suggests also a compelling opportunity for bottom-up investors. This is particularly apparent in emerging markets, where already cheap valuations for underlying listed entities can compound into double discounts when held in a structure, such as a conglomerate or holding company, itself at a heavily discounted value.
The rise and fall
Big swings between greed and fear are nothing new in this space. Conglomerates for example enjoyed a golden-age in the post second world war period. Cheap equity had created a boom time for leveraged buyouts, allowing businesses to mushroom out horizontally into differing areas of the economy and attain vast scale. The premise – not without some reason – was that these large companies enjoyed cheaper access to capital, could create operating synergies, enjoyed scale advantages, and were able to diversify an investor’s risk.
Some of these businesses, however, became unwieldly, and many traded at a grotesquely high premium to their book value and multiple of earnings. The result was a market collapse across the space in the 1969-1970 period. Vast business empires such as Ling-Temco-Vought, Gulf & Western, and ATO collapsed over 80% from their 1967/1968 highs. Investors were not just unwilling to pay a premium for the underlying businesses, but valuations dropped to a steep discount. As a result, the sum was worth more than the whole. It was against this backdrop that the notorious corporate raiders of the ‘80s rose, making fortunes buying and dismantling these entities into their component parts.
Deep discounts
Today, in developed markets, most of the major conglomerates have largely been gutted down in size or are that much more aligned across the portfolio. In Emerging Markets however, the structure is still that much more prevalent, perhaps as its benefits are that much more apparent in lesser developed economies where scale and access to capital are still more of a competitive advantage.
What makes emerging market conglomerates of interest, however, is not the structure but their valuations. Focusing simply on those businesses that derive the overwhelming portion of their net asset value (NAV) from listed entities, and using those ‘market values’ for the NAV, there is a whole cohort of names now trading around or below half-price. Moreover, some of these names have underlying market values which are themselves heavily depressed. By means of illustration, Indofood is a key holding for First Pacific, Prosus for Naspers, and SK Square for SK Inc.. A discount on discount.
Back from banishment
The challenging question for an investor is – will this market phenomenon ever change? If recent history is any guide, then it is likely that the level of that discount can close considerably. Returns can particularly be amplified if there is a recovery in the underlying listed holdings. As per the below charts, using book value as a proxy for NAV, pricing can reach extremes in both directions, but does tend to normalise over time. This is a particularly disconcerting phenomenon when there are so many companies in developed markets and certain pockets of emerging markets at the other extreme end of excess.
The catalysts for ‘change’ are less certain. Encouragingly however, some of these firms have started to initiate buyback programmes, taking the opportunity of a depressed price to generate outsized returns for shareholders in the eventuality of an upmarket. What a ‘reasonable’ discount/premium looks like will vary between companies, a symptom perhaps of variables including the strength of governance (namely capital management), the valuation of the underlying, and the level of complexity.
Conclusion
We believe that capital markets are at a fascinating – and potentially quite profitable – crossroads. It is rarely the case that global markets simultaneously exhibit such exuberance and fear both at the same time. Although, as venerated value investor Peter Cundill said, ‘there is always something to do’.
We firmly believe that Emerging Markets holding companies are currently one of the most interesting corners of the global universe, and that some of these conglomerates are a particularly attractive expression of that opportunity. This is not to say that these investments are without downside risk, but the deck should be stacked heavily in one’s favour when investing into businesses on a double discount.
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