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Quest™ Pan Euro themes update – Operation Style Twist 16 th January 2012

Quest™ Pan Euro themes update – Operation Style Twist 16 th January 2012. Nigel Sedgley +44 (0)20 7523 8497 nsedgley@collinsstewart.com. Quest™ helpline +44 (0)20 7523 8493 questclients@collinsstewart.com. Quest™ framework and tools. 2008 - 2009 all over again?. Operation Style Twist

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Quest™ Pan Euro themes update – Operation Style Twist 16 th January 2012

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  1. Quest™ Pan Euro themes update – Operation Style Twist16th January 2012 Nigel Sedgley +44 (0)20 7523 8497 nsedgley@collinsstewart.com Quest™ helpline +44 (0)20 7523 8493 questclients@collinsstewart.com 1

  2. Quest™ framework and tools 2

  3. 2008 - 2009 all over again? Operation Style Twist • The run to safe stocks in H2 2011 was more extreme than in 2007/08 • Value has seen its longest stretch of UK weakness • How much bad news is priced in? • Value approach in November 2008 Quest™ Newsletter delivered strong performance • Value started working before the trough in 2008/09 • Which Value tools to use? (Stable measures) • Stock screens to find value opportunities and overextended (expensive) situations 3

  4. Q-files *New* *New* 4

  5. Q-files performance also highlight the exponential shift to quality Europe ex UK small (to 3rd January) Quest™ Risk Rater High Q-score companies outperforming Aggressive Defensive indicator • Identifies the most/least cyclical and volatile companies • Based on three measures: EBITDA stability CFROA stability Share price volatility • Measured over 12 years (including forecasts) • High deciles (10) indicate defensive, more stable stock Aggressive Defensive indicator Volatile companies underperforming 5

  6. Factors and triAngle composition • Value, Quality and Momentum ‘ baskets’ are dynamic – driven by current rankings CFROC spread Capital growth Equilibrium growth Fixed charge cover CFROC change Quest™ valuation Quest™ market-to-book EV/sales rel. LRA Dividend yield rel. LRA P/E rel. LRA Value Quality 33% 33% triAngle 33% Momentum 9m-relative trend 100/200-day switch 12m-relative range 30/90 day switch Earnings momentum Quest™ triAngle Excellent 12- year track record 3-pronged approach improves consistency UK Large – 42/52 +ve quarters, +4.3% average Pan-Euro – 36/47 +ve quarters, +3.2% average UK small – 34/41 +ve quarters, +6.4% average 6

  7. 2008/09 all over again? • 11 years of live triAngle history • Value works in short sharp burst – normally when valuation dispersion is high • During the credit crunch, and now… Quality and Momentum are the main drivers Top quintile minus bottom quintile on each factor on an equally weighted basis. Non-financials. 7

  8. Factor by factor in H2 2011 – Quality and Momentum strong Pan-Euro May-Aug 2011 Aug-Nov 2011 2nd worst ever 2nd best ever Yield holding up best ever best ever best since 2003 best for over 3 years Top quintile minus bottom quintile on each factor on an equally weighted basis. Non-financials. 8

  9. triAngle H2 2011 in historic context: Highlights Best in a decade Best since 2003 2nd best ever Previous extremes were before mkt rally 8 out of 9positive quarters Best for 3 yrs 2nd worst ever UK Value: 9 successive negative quarters: A record Top quintile minus bottom quintile on each factor on an equally weighted basis. Non-financials. 9

  10. History rhymes – where are we now? Pan-Europe Value made an absolute low in Nov 2008 Then (2007 - 2009) Crisis developingValue –ve, Qual +ve, Mmtm +ve The troughV,Q neutral,Mmtm -ve Market rallyingValue +ve, Qual –ve, Mmtm -ve Now (2010 - 2012?)to 13 January 2012 Top quintile minus bottom quintile on each factor on an equally weighted basis. Non-financials. 10

  11. Pan-Euro end Nov 08-end Feb 09: Value rallied before the market Top quintile minus bottom quintile on each factor on an equally weighted basis. Non-financials. 11

  12. Style matrix Data to 13th January 2012 Source: Top quintile minus bottom quintile on each factor on an equally weighted basis. Non-financials. 12

  13. But, how much is now priced in?….. market valuation charts • Markets as cheap as October 2008 - April 2009 • Corporate action, policy response less likely to be as helpful this time Prices as at 5 January 13

  14. Finding value I: Cheap on Quest™ for the first time in a long time Criteria >3 >1 >4 16 January Rank by market cap 14

  15. Finding Value II: Time to rejoin the Q • Quest™ market-to-book • A variation on Tobin’s Q which compares market value of a company to the replacement cost of assets • Profits, sales, cash flows and dividends are all unpredictable at present. • Valuation relative to the asset base is more stable. • Excellent track record at market turning points.(Time to get into the Q note – November 2008) Total market capitalisation (equity + debt + quasi debt) Quest™ mkt-to-book = -------------------------------------------------------------------------------- Estimated replacement cost of assets 15

  16. Quest™ market-to-book: the market recovery and beyond 2003 - 2006 Kept outperforming after the other value measures waned.M&A, just –in-time capexsupport a sustained rally 2009 - 2011Market to book headed the Value charge and sustained performance 1992-4Price to book worked well Mkt troughMarch ‘09 Mkt peakFeb ‘11 Mkt = Eurotop 300 16

  17. Quest™ market-to-book: What is the opportunity? level + dispersion As at Jan 16 Market level Uses avg mkt cap for yr Europe ex UK small UK Large cap Dispersion CITN/ Newsletter articles “Time to get into the Q” “Slowly moving up the Q” “Who is still left in the Q?” “Time to rejoin the Q” 17

  18. Pan-Euro companies closest to 5-year trough market-to-book 5 Jan Rank by market cap Updated regularly on Q-Files 18 <10%

  19. Quest™ market-to-book strategies • Cheapest companies on market to book • Current pricing relative to a long-term view of asset’s productive capacity over their lifetime (Nov 08 note) • Quest™ mkt-to-book • Q-discount (10y) = ------------------------------------------------------ • Cyclical average CFROC / WACC • Avoid value traps: Solvency, historic average may overestimate future potential, asset write downs/ badwill • What if no mean reversion? – need to consider valuation relative to the ‘new normal’ • Quest™ mkt-to-book • Q-discount (+12m)= --------------------------------------------- • +12m CFROC / WACC 19

  20. Pan-Euro market-to-book performance Quality filters don’t help when the market takes off Trough? To 9 Jan 2011 20

  21. Finding Value II: Quest™ market-to-book: Time to rejoin the Q? Updated regularly on Q-Files 21

  22. Value Superscreen – using Quest™ screening Cheap on Quest™ for 1st time in a long time Mkt-to-book below LRA Quality filters (optional) 22

  23. Value Superscreen Criteria >3 >1 >5 <0.8 Quality Ranked by mkt cap 16 January 23

  24. Value Superscreen with Quality filters Criteria >3 >1 >5 <0.8 <3.5 >-10 Ranked by mkt cap 16 January ? 24

  25. Overextended valuations – the other side of the value trade Outperformed Lacks value support Mkt to book above LRA Other value metrics Mkt to book/returns analysis Other risks 25

  26. Overextended valuations – the other side of the Value trade >12 <5 >1 16 January Rank by market cap 26

  27. Margins bite, leverage hurts – Reporting season poses risks • Designed to explore the risks associated with over-optimism in analysts forecasts. • March/June articles: GDP slowing, commodity prices rising. Peak margins screen combined full valuation. • Forecasts and valuations have fallen but consensus forecasts show forecasts remain high. Consensus forecasts down c.8% for 2011, 7% for 2012 (3m, median), but…25% of companies still forecast to be at peak margin. • Output: Q-files. Regularly updated Excel spreadsheet (searchable) + CITN articles 23 June CITN • Original articles March/June: 79 names. CITN article highlighted Siemens, Volvo, Aker, Daimler, WH Smith, Philips, PPR, Fiat, Ferrovial, Clariant, Cookson, Lanxess, Sandvik, Pernod Ricard, ABB. • Margin stability definition: average historical EBITDA margin (10 years) divided by standard deviation of EBITDA margin over the same period (minimum 5 years required for calculation). 27

  28. Updated peak margin screen + other risk factors Pan-Euro Screen as at 9th Jan 28

  29. Performance of the Q-discount screen from Nov 08- Source: Datastream Rel to WIEROP$ 29

  30. Appendices 30

  31. What is Cash Flow Return On Capital? • Cash Flow Return On Capital (CFROC) • Real • Post-tax • Return On Gross Invested Capital • Shifts from accrual accounting towards cash • Better insight into corporate performance and valuation(takes into account all the capital used, asset life, asset mix) 31

  32. EBIT + Investment & non-operating income + Interest income –Current tax ≈ NOPAT + Dep’n & Amort’n + Rental expense – Tax shield on interest & rent + Monetary working capital adjustment Cash in € Operating income € Gross cash flow = € Operating assets Non-depreciating assets Land & investment property Fixed asset investments Stock Monetary working capital + Depreciating assets Fixed assets at gross cost Fixed assets current cost (adjusted) Capitalised operating leases Intangible assets Cumulative goodwill w/off € Gross investment Cash out CFROC: Step 1 – Accounting to cash 32

  33. CFROC: Step 2 – Asset mix and asset life Net Income Gross Cash Flow (A) DONE Net Assets Gross Invested Capital (B) DONE Return = A/B ? NO. In order to calculate the cash flow return we need to know: • Asset mix — how much is non-depreciating (C) • Asset life — how long will the cash flows last (D) 33

  34. CFROC: Step 3 – Internal rate of return (C) Non-depreciation asset release = €15 (A)Gross cash flow = €10 (D)Asset life = 14 years (B)Gross invested capital = €100 Cash Flow Return On Capital (IRR) = 6.0% 34

  35. Quest™ valuation Cash Flow Return On Capital in a DCF model • Use Consensus forecasts — 2-years forward • Forecast Cash Flow Return On Capital — existing assets • Forecast growth rate — reversion to mean • Forecast Cash Flow Return On Assets — future investment returns (reversion to mean) • Forecast net cash flows — implicit • Discount back using WACC for Enterprise Value 35

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