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Quest™ : UK themes update – operation style twist November 2011

Quest™ : UK themes update – operation style twist November 2011. 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™ : UK themes update – operation style twist November 2011

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  1. Quest™ : UK themes update – operation style twistNovember 2011 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 over the summer was more extreme than in 07/08 • Value has seen its longest stretch of UK weakness • How much bad news is priced in? • Value approach in Nov 08 Quest Newsletter delivered strong performance • Value started working before the trough in 08/09 • Which Value tools to use? (Stable measures) • Stock screens to find value opportunities and overextended (expensive) situations 3

  4. Factors and triAngle composition • Value, Quality and Momentum ‘ baskets’ are dynamic – driven by current rankings Quest™ valuation Quest™ market-to-book EV/sales rel. LRA Dividend yield rel. LRA P/E rel. LRA CFROC spread Capital growth Equilibrium growth Fixed charge cover CFROC change Value Quality 33% 33% triAngle 33% Momentum 9m-relative trend 100/200-day switch 12m-relative range 30/90 day switch Earnings momentum UK large caps Quest triAngle Excellent 12- year track record 3-pronged approach improves consistency UK Large – 41/51 +ve quarters, +4.3% average Pan-Euro – 35/46 +ve quarters, +3.1% average 4

  5. 2008 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. 5

  6. Latest Quarter – UK May-Aug 2011: An extreme quarter I 8 negative quarters in a row UK Large 2nd best in a decade Yield holding up 3rd best in a decade 2nd best in a decade best for over 3 years 6

  7. triAngle historic context – UK May-Aug 2011: An extreme quarter II 2nd best in a decade 3rd Best in a decade 8 out of 9positive quarters Best for 3 yrs 8 neg quarters in a row In Europe: Value, 2nd worst everFixed charge cover, best since 2003Quality 2nd best everEarnings Momentum: best for 3 yrs 7

  8. Q-files performance also highlight the exponential shift to quality UK large caps (to 3 Nov) 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 8

  9. But how much is now priced in?….. market valuation charts • Markets as cheap as Oct 2008-May 2009 • Corporate action, policy response less likely to be as helpful this time, but less solvency risk. Prices as at 31 October 2011 9

  10. UK end Nov 08-end Feb 09: Value rallied before the market Quality held up More stable value measures leading the way A sign of rotation Fixed charge cover: Feb-May 2009 -13%, May-Aug 2009 -7% 10

  11. Style matrix – what’s working now – Value spike in October Data to 28th October 2011 Source: Top quintile minus bottom quintile on each factor on an equally weighted basis. Non-financials. 11

  12. History rhymes – where are we now? UK Large Value made an absolute low in Nov 2008 Then (2007-2009) The troughV,Q neutral,Mmtm -ve Market rallyingValue +ve, Qual neutral, Mmtm -ve Crisis developingValue –ve, Qual +ve, Mmtm +ve Now (2010-2012?)to 11 Nov 2011 Top quintile minus bottom quintile on each factor on an equally weighted basis. Non-financials. 12

  13. Finding value I: Cheap on Quest for the first time in a long time Criteria >3 >0 >4 11 Nov Rank by market cap (>$250m) 13

  14. 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 14

  15. Quest™ market-to-book: the market recovery and beyond 2003-6 Kept outperforming after the other value measures waned.M&A, just –in-time capexsupport a sustained rally 2009-11Market to book headed the Value charge and sustained performance 1992-4Price to book worked well (Pan Euro) Mkt troughMarch ‘09 Mkt peakFeb ‘11 15

  16. Quest™ market-to-book: What is the opportunity? level + dispersion As at 8 Nov 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” 16

  17. UK companies within 10% of 5-year trough Quest™ market-to-book – by size 10 Nov Rank by market cap 17

  18. Pan-Euro market to book performance Quality filters don’t help when the market takes off 18

  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 (10yr) = ------------------------------------------------------ • 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. Finding Value II: UK Quest market-to-book: Time to rejoin the Q? 20

  21. Value Superscreen – using Quest screening - Criteria Cheap on Quest for 1st time in a long time Mkt to book below LRA Quality filters (optional) 21

  22. Value Superscreen – using Quest screening – Stocks Criteria >3 >1 >5 <0.8 11 Nov Ranked by mkt cap Quality filters.1) Lots of debt/quasi debt . 2) Negative EPS momentum. Signal of risk of a profit warning? 22

  23. 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 23

  24. Overextended valuations – the other side of the value trade >5 <5 >1 11 Nov Rank by market cap 24

  25. Margins bite, leverage hurts – Fears resurface in Q3 • March/June articles: GDP slowing, commodity prices rising. Peak margins screen combined full valuation • Output: Excel spreadsheet (searchable + Filters) + CITN articles + ‘Margins bite, leverage hurts’ note UK Screen as at 10 Nov 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). 25

  26. Margins plus other risk factors UK Screen as at 10 Nov 26

  27. Performance of the Q-discount screen from Nov 08- Pan-euro Source: Datastream Rel to WIEROP$ 27

  28. Appendices 28

  29. 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) 29

  30. 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 30

  31. 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 31

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