Jamie Ross, Portfolio Manager of the Pan European Equity Strategy, explains how the market can often misprice companies and discuss what they look for to find payoff potential in undervalued stocks.
- We believe that the best investors have a sense for situations where the payoff proposition is too favourable relative to the underlying fundamentals of a company.
- Telecommunication companies can often have sizeable infrastructure assets, such as towers or fibre access networks, but are often mispriced by the market upon tales of structural decline, onerous regulation and price wars.
- We aim to identify the important signals that contain pertinent information about the external environment that a company faces.
Ed Thorp, the author of Beat the Dealer, which was the first book to prove mathematically that blackjack could be beaten by card counting, and Beat the Market, which showed how warrant option markets could be priced and beaten explains:
The overlap of interest between gambling and the stock market is very high. Gambling provides an analytically simpler world. The blackjack tables are an amazingly good training ground for learning how to think about investments and how to manage them. They teach you, on the one hand, to use probability and statistics to evaluate things. And on the other, discipline. When you find something, you stick to it.
…When I had the edge, I bet big, but not so big as to risk going broke. The same approach worked on Wall Street: the bigger my edge, the more I bet and the greater the risk the more cautious I was”
One of the most important aspects of skill in gambling consists of figuring out which possible outcome to bet on, when to bet heavily and when not to. This is where all facets of the decision come together. How likely is one participant to win and conversely, how likely is one of their opponents to win? Whether in card games or sports betting, there are a number of factors to consider. The job here is to ‘handicap’ the outcome.
Many people believe that figuring out who is most likely to win is as simple as successfully betting on card games or sports i.e. picking the favourite. However, there is usually not much mystery involved in identifying the favourite; in most cases there is a solid consensus around which horse or team is most likely to win. It is therefore possible to have a sense for how good one’s hand is in absolute terms. However, we believe that one of the most important things to know about gambling is that information that is available to everyone is not likely to produce winnings.
The goal is not to figure out who the favourite is and bet on it. Rather, the goal is to figure out who the favourite is and whether the odds are fair or not.
In his speech titled The Art of Stock Picking, Charlie Munger compares investing with the parimutuel betting system at the racetrack, where the payoff for each horse winning is determined by how many people bet on it:
If you stop to think about it, a parimutuel system is a market. Everybody goes there and bets and the odds change based on what’s bet. . . . Any damn fool can see the horse carrying a light weight with a wonderful win rate and a good post position. is way more likely to win than a horse with a terrible record and extra weight and so on and so on. But if you look at the odds, the bad horse pays 100 to 1, whereas the good horse pays 3 to 2. Then it’s not clear which is statistically the best bet”
The goal is to find situations where the odds are more generous to one side than the other, whether favourite or underdog. In other words, the goal is to find a mispricing. But let us not pretend that investing is identical to gambling. Investors are not offered explicit odds: the attractiveness of the proposition is established by the price of the asset, the ratio of the potential payoff to the amount risked and what we perceive to be the chance of winning versus losing. Superior investors may be superior because they can ascertain which companies are more likely to be ‘winners’. But we believe that the best investors have a sense for situations where the payoff proposition is too favourable relative to the underlying fundamentals. This might be a company whose securities are cheap enough to more than compensate for its poor prospects, or one where the future is exceptionally bright but its securities are not priced high enough to charge fully for that potential.
In A Scandal in Bohemia, Sherlock Holmes teaches Watson the difference between seeing and observing.
“When I hear you give your reasons,” I remarked, “the thing always appears to me to be so ridiculously simple that I could easily do it myself, though at each successive instance of your reasoning, I am baffled until you explain your process. And yet I believe that my eyes are as good as yours.”
“Quite so,” he answered, lighting a cigarette, and throwing himself down into an armchair. “You see, but you do not observe. The distinction is clear. For example, you have frequently seen the steps which lead up from the hall to this room.”
“Well, some hundreds of times.”
“Then how many are there?”
“How many? I don’t know.”
“Quite so! You have not observed. And yet you have seen. That is just my point. Now, I know that there are seventeen steps, because I have both seen and observed.”
We can easily extrapolate the above lesson to the investment case of a company such as Telecom Italia at this present moment. We are sure the public market participants can see what we see, but we are not quite sure they are really observing.
We agree that given onerous regulation, nimbler competitors, price wars, structural declines (e.g., voice/legacy data), rising capital expenditure (capex) and a general absence of revenue growth, EU telecommunication (telecom) stocks have rarely been in favour over the last decade, and rightly so in our opinion. The refrain has typically been that a theoretically appealing telecom dividend yield is unsustainable given bearish business trends, repeating liabilities or rising future capital expenditure. No one should want to ‘clip a dividend’ whilst ending up with a capital loss.
While this outcome may not seem attractive, telecom companies often have sizeable infrastructure assets, such as towers or fibre access networks, that may appeal to a different set of long term and due diligence-driven investors, namely infrastructure private equity funds.
These investors are not scared by the ‘Telecom’ label at the front of the shop. They may have spotted a financial arbitrage opportunity, are observing it carefully, and are often willing to pay much higher prices than the public equity market for these unique assets. Infrastructure assets can often be predictable because of agreements in place that define cost structure (inflation escalators for towers), a growth theme (rising demand for high speed data), market structure (a rural fibre monopoly), or even regulation (regulated returns on capital).
Over the last couple of years, mobile communication tower stocks have generally done very well in a low rate environment, with growing value coming from built-in inflation escalators, amendments, and high incremental returns from adding tenancies.
We invested in Spanish mobile communication tower company Cellnex in May 2019 with the thesis being mainly based on three secular points: 1) security – these are hard assets, 2) scarcity value – location, location, location; you simply cannot recreate or replicate these assets and 3) platform economics – a platform-based business model that facilitates a large amount of social and economic activity leading to healthy economics that are likely to trickle down to shareholders.
If you think about the US$160 billion of annual revenue at Google1 and the US$125 billion of revenue at Microsoft2, you are looking at platform economics. Now just wrap that up into a secure, tax advantaged, high dividend yielding real estate wrapper.
Moving back to telecoms, progress on fibre access (or broader network) separation has been much more patchy, with very few of the large EU telecoms deciding to follow such an approach. This is partly due to the complexity of separating access networks, with regulation proving tricky, but also with widespread management views that telecoms should continue to own their access networks. We believe, there is now perhaps a better case for finding external investors for fibre access networks than is generally perceived, as sharing increases Fibre To The Premise (FTTP) penetration, reduces overbuild and boosts return on capital.
It is very clear to us that data is a ‘secret sauce’ that can help to enable success in any modern business and the ability to utilise that data for action is a competitive advantage. This thinking has been a guiding force for a considerable part of our portfolio investments and given the power of data, it is likely to sustain for cycles into the future. We believe that any company that realises and materialises this trend can have a significant advantage.
In Europe, French telecommunications company Altice led the charge in fibre network monetisation, selling nearly 50% of both wholesale fibre operations SFR FTTH to infrastructure investors at premium valuations. 3 In December 2019, Altice Portugal sold its fixed line network to Morgan Stanley Infrastructure Partners.4 The deal carried with it substantial restrictions over Morgan Stanley’s ability to resell connections to non-Altice parties on the network. This substantially limited the upside of the assets for the buyer, yet the transaction still fetched a very full price of 20x EBITDA.4
Infrastructure investors buying into fibre access networks typically pay multiples of invested capital for these assets given a predictable growth outlook and the ability to deploy significant capital for which they expect to earn premium returns. In the case of joint ventures with insurance companies like SFR FTTH , these have turned what telecom investors see as rising liabilities (future FTTH capex) into an asset (cash paid for a stake in the joint venture).
Likewise, Telecom Italia (TIM) has already started the monetisation of its quasi-monopoly network assets by entering into exclusive negotiations with private equity firm KKR to sell c.40% of its fixed secondary network. In its recent Q1 2020 earnings presentation TIM announced that the deal implied an enterprise value of EUR 7.5bn of the asset and with EUR 3.3bn of net debt to be applied to the entity (i.e. EUR 4.2bn equity value), this would imply cash proceeds of c.EUR 1.8bn to Telecom Italia.5 TIM has said a deal will be finalised within the summer and Italian newspaper Milano Finanza has reported that KKR has created a special vehicle for the investment, and is looking for other funds to participate.
When stripping out TIM’s other publicly listed assets (TIM Brazil and Inwit), the market may calculate the TIM Italy domestic equity stub stock to be worth EUR 90m, as at 22 June 2020.
The below chart from JP Morgan shows the evolution of the TIM domestic Italy equity stub since July 2015.
Source: JP Morgan estimates, Bloomberg, as at 8 July 2020.
We believe that the odds are severely mispriced and the handicap is clear. The market is valuing the TIM domestic business at EUR 90m, at a time where the KKR deal values its secondary network alone at an equity value of EUR 4.2bn.5 The difference is huge even if we choose to ignore the value of all the other TIM assets.
This move by KKR is seen by many market participants as the first step towards the single network integration with the main competitor, Open Fiber. This has been very topical in Italy in the post COVID environment, where the Italian government has been pushing very actively for the creation of a single network. Italy’s Prime Minister Giuseppe Conte stated in a press conference on 21 June 2020 that the creation of single network for the country will be one of the main pillars of the plan to relaunch the Italian economy post the COVID pandemic. The government has urged the CEOs of multinational energy company Enel and Italian state-controlled investment vehicle Cassa Depositi e Prestiti (CDP) – who each own 50% of Open Fiber – to reach a solution on the single broadband project and merge with Telecom Italia’s network as soon as possible.
It has been reported that CDP is also in favour of a deal and is currently discussing plans to swap its 50% ownership in Open Fiber with a stake in the new entity created post the merger. Indeed, we believe that the formation of an FTTP joint venture with Open Fibre could unlock huge synergies and market repair.
In Italy there is a well-known expression which has its origins from medieval times: all the roads lead to Rome.
And it seems that, in this case, Rome has decided. The government and other political figures, both past and present, appear to be in favour of the formation of a single network.
The single network separation is not the only thing that Telecom Italia CEO Luigi Gubitosi has been working on in the Italian side of the business. In November 2019 he initiated a financial joint venture with Santander to offload equipment receivables from TIM’s balance sheet and has also inked a deal with Google to build the leading cloud services provider in Italy.6
Debt pay-down, the primary financial aspect Gubitosi is focused upon, can be an impactful driver to equity returns and given the de-leveraging actions made by TIM over the past few years we should theoretically see a shifting of enterprise value from debt to equity holders.
Yet, the public market seems to ignore these developments and has continued to price the TIM domestic Italy equity stub close to zero.
However, that is not to say that the market will never change their mind once they observe what we observe. In his book entitled Sapiens, author Yuval Noah Harari, talked about opinion change through an anthropological lens.
Under the right circumstances minds can change rapidly. In 1789 the French population switched almost overnight from believing in the myth of the divine right of kings to believing in the myth of the sovereignty of the people. Consequently, ever since the Cognitive Revolution Homo sapiens has been able to revise its behaviour rapidly in accordance with changing needs”
Given the enormous amount of ‘noise’ in the world, we aim to identify the important signals that contain pertinent information about the external environment that a company faces. The process of pulling signal from noise requires a vigilant presence – a mindfulness to determine what is and is not noise, what will change, and what will not change. Our focus is on events and facts with a near disregard for casual and ubiquitous commentary. Through this disciplined pursuit, we seek to connect non-obvious dots – and it is the connection of non-obvious dots that yields insight not yet valued by the market. We never know exactly how or when a key dot might present itself. Therefore, we must be vigilant and place ourselves in places where luck has a better chance of striking.
These situations are more likely to occur when investing in companies which embody resilience and optionality, where the market values the optionality deep out of the money, while questioning the company’s resilience. This is where the analyst can most fully express skill: where investment returns are at their most nonlinear. Resilience buys you ‘budget’ for optionality. Having discipline in decision making and paying attention buys you the ability to think creatively and recognise when good portfolio allocation decisions arise.
Resilient companies with out-of-the-money optionality, is the most powerful way to generate value for our clients through our framework. Because the business is resilient, it can immediately become a large position without adding much risk. If the optionality part of their business expresses itself, then the stock can potentially go up multiples of the original price and it can be allowed to ‘run’ in the portfolio. The reality is stocks like this are very rare, which is why they must be capitalised on when found.
A special subset of these stocks are resilient companies with out-of-the-money optionality perceived by the market to be ‘value traps’ – companies that appear to be cheap but languish because of lack of growth or structural problems. These special situations have the potential to move from value trap, to resilient, to resilient with optionality.
A foolish optimist is only less noxious [than] an utter pessimist ” - American Ideals, Theodore Roosevelt
As stewards of your capital, we aim to find the largest expectation gap between the foolish optimists and the utter pessimists. That is, we seek to find under-researched, unloved companies which are often misunderstood, and place them under a microscope to see where there might be value and then shine a light on it.
1 Statista, Google annual revenue, as at 31 December 2019
2 Microsoft annual report, annual revenue as at 30 June 2019
3 Atlice press release, 27 March 2019
4 Atlice press release, 13 December 2019, EBITDA = earnings before interest, tax, depreciation and amortisation.
5 Telecom Italia Q1 2020 results presentation, as at 31 March 2020
6 Telecom Italia Q4 2019 investor presentation, as at 31 December 2020