The managers of Dodge & Cox International Stock, some of whom also run funds available for sale in the U.K. such as Worldwide Global Stock, discuss how they avoid value traps, their stance on emerging-markets valuations, where to seek value in the current market and some of their favourite sector plays, and what they have learned over the past decade. This is an abridged version of an article that first appeared on Morningstar.com on July 15, 2011. Read the full version here.
1. In your search for companies with low valuations "that more than compensate for the perception of weak fundamentals", how do you differentiate between the "perception" of weak fundamentals versus a company that may present a value trap?
Investing is a high-error-rate business. There are going to be times when we are right and when we are wrong in our view of the future prospects of a particular investment. That said, our task is to thoroughly understand a company's long-term fundamentals (for example, its earnings and cash flow prospects) in relation to its valuation so that we can weigh the extent to which the risks are priced in relative to the opportunities.
Lanxess AG (LXS) is a good example of how we weighed valuation against fundamentals as we assessed what could go wrong and right during our three- to five-year investment horizon. In January 2005, Bayer, a German conglomerate held in the fund, spun off its chemical business known as Lanxess in an effort to focus on its pharmaceutical and agricultural chemicals businesses. At the time of the spin-off, Lanxess was one of the cheapest publicly traded chemical companies in the world because of the many challenges facing the company. These challenges included low end-market growth, very low levels of profitability, the continued shift of its business to Asia from Europe, high levels of debt, and the difficulty of restructuring a company in Germany.
Although Lanxess was perceived as having weak fundamentals, our research revealed that there was more to like about the company than just its low valuation. In more than 40% of its sales, Lanxess was either the market leader or the second-largest competitor in its markets. For example, it is the world's largest producer of synthetic rubber, which is largely used in tyres. This leading position particularly appealed to us, as the market is an oligopoly, and high-performance tyres help fuel efficiency and driving performance.
Because Lanxess' profit margins trailed those of the industry by a wide gap as a result of the company's high cost structure, management's ability to execute its restructuring plan would be a critical factor in the success of our investment. Management impressed us with their drive, focus on the business, and ambition to improve profitability. They would be rewarded handsomely for increasing the long-term value of the company, which we thought aligned their interests with shareholders'. We decided to hold Lanxess based on its strong market positions, secular growth opportunities, and low valuation.
Since the spin-off, the company's restructuring and cost-cutting efforts have been very successful. Profitability has improved dramatically, and the share price has increased 388% compared with the MSCI EAFE's 39% return, through May 31, 2011.
2. Are you finding it harder to find attractively valued emerging-markets names these days? Has the recent weakness created any opportunities?
The companies domiciled in emerging markets comprise a very wide range of geographies, industries, and valuations. For this reason, we really don't think of emerging markets as a monolithic entity. Rather, we concentrate our research efforts on identifying individual companies that have strong business franchises, attractive growth prospects, and management teams working for the interests of shareholders. We weigh these fundamentals in relation to valuation, with the goal of investing when the valuation does not reflect our assessment of the company's long-term fundamentals.
We have long held the belief that growth in the emerging markets should lead global gross domestic product growth. When we assess a company's growth prospects, we factor in its current exposure to emerging markets and management's strategy for strengthening its position relative to competitors'. Importantly, we do not think that where a company is headquartered is the most important indicator of its exposure to growth in the emerging markets. As of March 31, 2011, the fund invested in several developed-market-domiciled companies with significant operations in the emerging markets. Examples include Millicom (MIICF) (domiciled in Luxembourg with wireless services throughout Africa and Latin America) and Yamaha Motor (domiciled in Japan with leading motorcycle market share in Indonesia and other Southeast Asian countries). We believe these holdings will benefit tremendously from their positions in emerging markets, even though they are not generally classified under the emerging-markets category. Although we continuously evaluate new investments for potential inclusion in our portfolio, we are optimistic about the management teams, business franchises, and growth prospects of our current emerging-markets-related holdings.
3. Pharmaceuticals that you hold have performed quite well of late. Are these stocks getting close to your sell targets or do you think there's still upside potential in these names?
We believe that these holdings are attractive investments, even after some recent outperformance. Although we evaluated each company individually, a number of common threads emerged: low valuations, continued scientific innovation, growth in emerging markets, and the central role of large drug companies in drug development and commercialisation. We recognise the challenges facing the sector, among them weak research and development productivity and pressure on reimbursement, but we believe these issues are well-appreciated by the market and reflected in current stock prices.
As with all of the fund's investments, we focus intensely on the downside scenario and ask ourselves, "If the future turns out poorly for the company, what might happen to our investment?"
For the fund's pharmaceutical holdings, we believe the downside is mitigated by multiple factors. First, the companies have strong balance sheets and high levels of free cash flow that enable them to weather disruptions to their businesses. Second, diverse revenue streams limit the risk from any single product or geography. Third, management teams are actively cutting costs and returning cash to shareholders. Fourth, we have modelled different scenarios of price cuts, R&D failures, and market disruptions to stress-test the durability of the franchise. We believe that today's low valuations embed significant pessimism.
After considering the downside, we turn our attention to the two key areas of upside potential. First, underlying the pharmaceutical industry is accelerating improvement in the scientific understanding of disease biology, which could lead to new treatments, earnings growth, and improved valuation. Second, the fund's pharmaceutical holdings generate about 25% of their revenues in emerging markets today, with solid profit margins and attractive returns on capital. As incomes rise, emerging-markets consumers can afford more and better medications driving attractive growth.
Roche (ROG), a Switzerland-domiciled pharmaceutical company focused on biologics and diagnostics, is representative of the fund's pharmaceutical holdings. Roche is a leader in the oncology market, and its R&D effort has been enhanced by Genentech's biotech expertise. As a result, the possibility of growth through innovation remains strong. Management has embarked on a significant cost-cutting programme that can drive meaningful earnings growth. Roche's current valuation is attractive at 10 times forward earnings and a dividend yield just under 5%.
4. Valuations moved down rapidly in response to the tragic events in Japan in March. What changes did you make to the fund's holdings in Japan and how are you able to react in volatile markets?
The tragic disaster in Japan highlighted that we can be nimble despite our long-term approach. Immediately after the disaster, we assembled a team consisting of our Japan specialists (native Japanese speakers who serve as a resource for our global industry analysts in addition to their specific industry responsibilities) and analysts with relevant expertise, such as our global utilities analyst. We wanted to evaluate the implications of the supply chain and electricity disruptions. We contacted managements, nuclear experts, and other specialists to assess the impact of facility damage, supply chain disruptions, power shortages, radiation, and other factors.
The fund's Japanese investments are mostly global companies with diverse manufacturing and sales footprints. We concluded that supply chain and power disruptions were short- to midterm issues. The fund's Japanese investments are characterised by strong cash flows and balance sheets that could withstand these disruptions. As a result, we incrementally added to seven of the fund's existing Japanese holdings as valuations plunged. We also added to our position in Royal Dutch Shell (RDSB), a global leader in liquefied natural gas production, which should benefit from the increasing demand for gas as a power source in Japan.
Additionally, we started a new position in Nidec, a leading industrial motor manufacturer with more than 70% global market share of hard disk drive spindle motors. Nidec had long been on our investment radar screen. We have been following the company for several years, and liked its management and business franchise, but it traded at a rich valuation. As a result of the earthquake, Nidec's valuation declined to a point where we believed it represented an attractive long-term investment opportunity, and we initiated a position.
5. As you look back on the past decade, what have been your lessons learned, successes, and failures?
Looking back over the past decade, our key takeaways are as follows.
One, bottom-up individual security selection was the biggest driver of long-term returns--more important than macro calls, country choice, or sector allocation.
Two, persistence and the ability to stay the course matter. Share prices can fluctuate much more wildly than underlying business fundamentals. As share prices and fundamentals change, we ask ourselves: "Would we invest in this company today?" When we answer this question affirmatively, price declines provide the opportunity to increase fund holdings in companies where we see an attractive future. There were examples where holding a company as it became less and less expensive was a bad idea-- Royal Bank of Scotland (RBS) comes to mind as an example. However, there are far more examples where staying the course or even adding to holdings as they became less expensive added significant value over the long term. For instance, Infineon Technologies (IFX), a German semiconductor company with a strong technology base, saw its share price plummet 90% during the financial crisis between Sept. 30, 2008 and March 9, 2009, (the market trough). Then, from March 9, 2009 to May 31, 2011, Infineon's stock price increased 2,188%. Persistence matters greatly to long-term results.
Three, country of domicile doesn't tell you where to sleep well at night. In a globalising world, it also doesn't determine investment opportunity or risk. One of our most successful investments during the past 10 years is Ultrapar, a diversified industrial conglomerate with operations in fuel retailing, chemical production, and propane distribution. Ultrapar is based in Brazil, a country considered risky when we started the fund in 2001. The entrepreneurial management team has been a key driver of the company's financial and investment returns; they act like owner/operators and have aligned their interests with ours in a variety of ways, such as tag-along rights and returning capital to shareholders. In contrast, some of the fund's biggest detractors to its results have been in Europe, where management served other stakeholders at the expense of shareowners. An example is Alstom (ALO), the French industrial conglomerate. Facing financial pressure during the 2002 economic downturn, the company acted to preserve relationships with its bankers and employees by massively diluting its equityholders.
Ultimately we have learned that a long-term, bottom-up stock selection, fundamental analysis-driven investment approach can add value over time, as our long-term returns attest.
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Esther Pak is an assistant site editor of Morningstar.com, a sister site of Morningstar.co.uk.
