As a specialist investor in global equities we focus on evaluating public corporations and appraising their traded securities. Yet so much relevant corporate activity is hidden from immediate view. How do we
Ultimately, we accept there is much we don’t and probably cannot know. But we don’t fall into the trap of thinking that the information we do have is more relevant than the information we lack.
That trap can be described as a simple sampling bias and is a defining feature of today’s highly liquid public securities markets. It is something that delineates short-termism from long-term investment principles. And it is something to be harnessed by genuine long-term investors seeking to understand when and how the market creates bargains.
One of the main reasons people trade securities so frequently is that buyers and sellers react to new information. This new information arrives on a daily basis in the form of central bank musings, economic data points, company announcements, sell-side recommendations, televised punditry and all manner of news flow.
Humans have a strong tendency to give greater weight to new information over old information, perhaps for some simple belief that the sooner you act on the new information, the sooner you might beat others to it; or for a more primal instinct: new = fresh = good, old = stale = bad.
However, equities are a long-term asset class and, in most cases, immediate news has little bearing on the long-term prospects for a business. Information that is more relevant to the long term is likely quite old, like the way a business fared in a prior cycle, a fundamental competitive advantage or some valuable insight management shared several quarters ago.
Shareholder capital is permanent funding. When you really think about it, secondary trading of securities and the information that drives it has very little direct effect on a well-financed, well-managed corporation. It has no effect on actual operations, financial performance and control, and strategy, which are all far more important. For example, a manufacturer’s plans to expand operations in a foreign country, contract negotiations with a key customer, and whether or not to implement a costly ERP system all rightly take up far more of management’s attention than whether to recommend increasing the quarterly dividend.
Try to visualise FMC’s ±1000 scientists, global R&D facilities and discovery phase active ingredient programme in its crop protection business. Only cursory knowledge of these is actually available to those outside the company itself. Perhaps the only direct evidence we have is a single line item representing R&D expenditure in the quarterly P&L. This important part of FMC is likely to be overlooked or downweighted in favour of something more malleable in a valuation model, like free cash flow. Meanwhile, FMC’s future depends on its ability to innovate and bring new products to market, have them licensed in multiple countries and so enjoy superior margins for many years.
“FMC surprises with annual margin guidance” is a far more likely news headline than “FMC Laboratory Team from R&D: Pre-emergent Herbicides honoured for contribution to successful Stage 3 trial of F9600”.
In fact, there will never be a headline like the second, because so much of what really happens in corporate life is either unavailable to the public or deemed not useful by the information selling industry. It can be calming to remain aware that the array of new information presented to us each day is inherently affected by the information industry’s commercial interests. These typically prioritise the type of news that stimulate emotions such as greed, fear, envy and euphoria – driving humans to act.
As for the vast realm of corporate life that remains hidden but highly relevant, by actively acknowledging its existence we can gain an edge over those who commit a sampling error by relying on the news of the day to shape their decisions.
Exhibit 1 shows the headline of two sell-side analysts’ research note on core UMAPAN holding Mosaic. While only an isolated example, its contents are a good example of the way in which sell-side views are framed and disseminated. And since institutional investors are generally major consumers of sell-side research, we can infer that like it or not a great deal of money is transacted on the basis of such material. And from which we can again infer that sell-side research must have a not insignificant influence on share prices.
The report is dated one year ago, shortly after we actively increased our position in Mosaic shares. In the subsequent twelve months the share price has risen 60%. Yet over this time the analysts continued to advise clients to HOLD, meaning “don’t buy”.
Usefully, the report provides a link to an up-to-date history of recommendations which are outlined in Chart 1.
Coverage began with a forecast share price of $48. This target was reduced along with Mosaic’s worsening financial results and, after a brief period in which it was withdrawn altogether, was reinstated in line with the prevailing share price, which it has dutifully tracked ever since.
The Mosaic share price has clearly influenced the sell-side’s target price – the inverse of what we inferred earlier! This seems a little circular, but it reveals one mechanism behind why listed companies become and stay cheap.
After initially encouraging clients to BUY at a higher price, recommendations turned to HOLD when the share price declined. Developments at the company have evidently not yet convinced the analysts to again recommend buying the stock. But that will eventually happen, and it will coincide with widespread warming to the stock by the sell-side.
It seems to us that sell-side valuation methodology appears to be somewhat limited by a company’s actual short-term operating performance, and incapable of forming a strong view – rooted in the past – of true through-the-cycle earnings power. For Mosaic we have done just that and furthermore incorporated our deep knowledge of valuable, latent improvements that have occurred at the company in the past few years.
Chart 2 again shows the Mosaic share price, along with our own estimated fair value of the company and our actual real-money trading history in Mosaic shares. Clearly, we are doing something very different to what the sell-side analysts have recommended.
Firstly, our “target price” doesn’t change with the weather. Our fair value range for Mosaic has been practically unchanged since we first assessed the company in 2015 – a product of our long-term view and high conviction in our work. Secondly, we have persistently bought more shares, lowered our average cost, and are prepared to reap a potentially outstanding reward from an eventual share price rerating.
Whereas sell-side research is inherently focussed on the short term, we are true long-term investors. Sell-side analysis never fails to pick over the minutia of a company’s quarterly results, but usually misses out on key points which illuminate its long-term prospects. Too often we see management reveal crucial business and industry insights which are of little use to the sell-side as they cannot be easily quantified and distilled in a valuation model.
Sell-side analysis is fundamentally limited in its ability to identify sound investments, let alone provide the necessary confidence with which to act. In Mosaic we have identified a great company trading below what the whole business would sell for in a negotiated transaction, and we have bought shares in that company with our clients’ money.
It is clear to us that anybody reliant on sell-side research must lack a real understanding of Mosaic as a corporation. Our ongoing research and uninterrupted interest in the company has left us in an unrivalled position now to HOLD our Mosaic shares, and that will make all the difference.
We look forward to writing to you again.