CIO Insights 1Q2024

Widely followed global stock market indices keep setting record highs, buoyed by impressive growth delivered by its largest constituent members. Most passive investment vehicles are designed to track these indices no matter what expectations they discount in terms of valuation and hence future return potential. At least as long as markets keep trending up, this may not be an issue. However, concerns typically arise whenever positive price momentum wanes.

Deep value investing remedies this problem by explicitly forming an opinion about expectations. That is, the aim of our active security selection process is to identify and invest in companies whose current equity prices reflect low expectations with respect to their true economic worth. This discipline should produce an attractive aggregate discount at portfolio level that lays the foundation for the generation of solid long-term compound rates of return.

We currently see four main situations where our portfolio benefits from low expectations. First, we estimate that numerous of our companies have more robust cycle-adjusted pricing power for their products and services than their current stock quotation suggests. For example, firms in industries such as engineering, transportation and wholesaling are customarily able to set cost-plus pricing terms. Recent adversities such as the pandemic, supply chain disruptions and input inflation have rendered the management of order flow, output and shipments extraordinarily difficult. These challenges in many cases caused significant temporary mismatches between costs incurred and prices charged. As business conditions gradually stabilize, pricing will find a new base at which attractive normalized gross margins can be achieved going forward.

Second, our portfolio holdings have substantial yet deeply underappreciated means to improve the price/volume mix by enhancing the scope of their product and service range. For example: pulp producers expanding cellulose applications into the manufacture of clothing, biofuels and advanced materials in addition to tissues, paper and cardboard; building materials firms evolving from supplying single components such as cement and glass to providing entire “building envelope” solutions; real estate owners repurposing brownfield properties into projects with higher-and-better use; consumer goods makers shifting from private label to branded; or traditional media providers rearranging distribution platforms and content bundles.

Third, in the case of portfolio companies in industries where growth is structurally weak, we find that they tend to be more effective at cutting their cost base than they are being credited for. Especially in sectors with a high degree of commoditization such as steel production and agriculture, our firms look beyond the cycle and work towards improving their resource and labor productivity under the assumption that business conditions will be continually challenging.

And fourth, our companies’ relentless drive towards achieving better capital efficiency is being underestimated. Our operators in high fixed-cost industries such as telecommunications, utilities and capital-goods manufacturing must continuously improve their return on invested capital, especially in times where interest costs are on the rise. Here we believe that the asset-heavy nature of the business may turn out to be a blessing in disguise: managers are commonly incentivized to right-size the company’s capital employed relative to the normalized earnings power of the business.

In sum, we propose that our firms’ business models bear more versatility to unlock value than meets the eye. As delineated above, recent operating dynamics for our companies have created substantial catch-up opportunities in terms of (1) a recovery in pricing power (2) a more favorable price/volume mix, (3) a leaner cost structure and/or (4) increased capital efficiency.

Over the years our approach has been able demonstrate that significant and recurring upside can be captured by investing in select equities where consensus opinion has “thrown in the towel.” Most advantageous of all, such deliberate low-expectations investing does not depend on a view whether a passive equity exposure at current index levels represents an attractive return proposition going forward.

Sincerely,

Gregor Trachsel
Chief Investment Officer SG Value Partners AG