The iMGP Oldfield International Value Fund lost 2.11% during the third quarter of 2021, lagging its benchmark MSCI EAFE Value NR (down 0.97%), and MSCI EAFE NR (down 0.45%). The fund was almost in line with Morningstar’s Foreign Large Value Fund peer group, which lost 1.97%. Year to date the fund is up 13.87%, ahead of EAFE Value by 426 basis points and its peer group by 448 basis points.
Since its inception November 30, 2020, the fund has risen 20.7%, beating its value benchmark and peers which were up 14.46% and 15.06%, respectively.
Performance quoted represents past performance and does not guarantee future results. The investment return and principal value of an investment will fluctuate so that an investor’s shares, when redeemed, may be worth more or less than their original cost. Current performance of the funds may be lower or higher than the performance quoted. To obtain standardized performance of the funds, and performance as of the most recently completed calendar month, please visit www.imgpfunds.com.
Commentary from Oldfield Partners
Market Comments
While the third quarter was dominated by continued momentum in growth shares, a combination of concerns over the potential default from Evergrande, the heavily indebted Chinese property behemoth and the rise in the U.S. 10-Year Treasury yield prompted a change in tone in global equity markets in September. The U.S. 10-Year Treasury yield has been on the rise since early August as evidence has grown of inflation throughout the global supply chain which in turn has caused the equity market to question the consensus view that inflation will be temporary. With a jump in the yield to over 1.5% late on in the month we saw signs of a rotation back to Value. The portfolio continues to trade on quite modest valuation levels: the price to sales ratio on the EAFE portfolio is at just 0.8 times and the forward price to earnings ratio on the portfolio is 10.7x compared 15.3x for the MSCI EAFE index and 11.1x for MSCI EAFE Value.
On the topic of inflation, while we are not macroeconomists we do see a plethora of micro economic news that suggests the inflationary pressure is being sustained. Seemingly every call with our companies includes references to challenges with supply chains and input costs. It seems very possible that this recovery-led cost inflation will feed through into inflationary expectations and more general pressure on wages. This has obvious implications for interest rates. Policy rates may be slow to move but bond markets do appear to be reacting.
Notable Purchases and Sales
In September we completed the sale of the position in Korea Electric Power at a significant loss. We had bought the shares in 2017 at a historically low valuation of 30% of book value. We had expected that the Government would allow the company to raise the electricity tariff to cover for rising input costs or finally agree to a new regulatory cost-pass through arrangement. Either of these would have allowed the firm to earn its allowed regulatory returns on capital. Unfortunately, the Government chose to abuse minority shareholders and allow operating losses to build much further. Finally, late last year, they enacted a cost-pass through tariff system but they included some tight caps and collars in the price adjustment formula. Within six months the Government then intervened (they claimed temporarily, citing COVID) to stop the cost-driven rise in tariffs being actioned. With energy prices soaring this year and a Presidential election now looming in 2022 we concluded that a meaningful tariff rise was still a long way off and we therefore decided to sell the position to fund the purchase of Alibaba.
Alibaba is the newest holding in the portfolio, bought in August. Alibaba is a far-reaching Chinese internet giant and arguably the world’s largest retailer, with a huge presence in several key markets including e-commerce, cloud, video, logistics and fintech. Long-time followers will remember our purchases of Microsoft in 2004, eBay and Cisco Systems in 2008 and Nintendo in 2013 at times when negative sentiment had brought down the headline valuations of high growth companies to valuations we felt offered a significant opportunity for classic, contrarian value managers like us.
The core e-commerce business competitive strengths are manifold; they have a high market share of over 70% in a business with high switching costs and substantial barriers to entry. E-commerce marketplaces benefit from strong network effects that lock in both merchants and consumers. The Chinese regulator has estimated the user retention rate at 98% from year to year on Alibaba’s platforms. Merchants have high switching costs because they build up large user bases and customer reviews that would be very hard to replicate on new platforms. Alibaba has continued to build the moat around the core e-commerce business by investing in adjacent products and services such as payments through Alipay and cloud-based IT infrastructure through Alicloud.
The main driver of growth beyond the core commerce business is likely to come from the cloud business. Alicloud is the No.1 player in Chinese cloud and third largest globally. Currently, it has revenue of RMB60bn ($9bn) and growing at 50% per annum. Today, Alicloud revenue is similar in size to Amazon Web Services (AWS), Amazon’s cloud business, in 2016. It will turn breakeven this year. There is a 5.5x opportunity for the business simply if they maintain share and IT spending in China rises to the same share of GDP as the U.S. and the share of IT spent on the cloud in China rises to the same as the U.S.. At this point revenue for Alicloud would be about $50 billion – similar to the current size of AWS. It is worth noting that the U.S. cloud is still growing at rapid rates.
Alibaba has a variety of other businesses and investments. These include a 33% stake in Ant Financial, Lazada (an e-commerce platform in south-east Asia with 80 million customers), ele.me the number two platform in delivery with 290 million active consumers, Didi (the ‘uber’ of China), and bilibili (the ‘youtube’ of China). The market value of the strategic investments is roughly .$45 billion.
The main reason for Alibaba’s attractive valuation is the threat of severe regulatory action. We do not believe that anything the Chinese government has done so far, to their technology businesses, to be beyond reasonable but this led to a collapse in the share price by some 45%.
The Chinese regulator’s review of Alibaba’s business very succinctly highlighted the competitive advantages that Alibaba had and was likely to retain for the foreseeable future. The regulator then proceeded to make sure that Alibaba did not continue to abuse its advantages. Looking forward, Alibaba may not be able to abuse its dominant position, but it still retains one. The other major part of Alibaba’s business to come under regulatory scrutiny is Ant Financial. Ant Financial had built the largest payment system, Alipay, and the largest lending system in China without any regulatory oversight; something no Western government would stand for. The Chinese regulator’s rulings to properly capitalise and structure this bit of the business is entirely reasonable.
We think there are several reasons why the Chinese regulator is unlikely to go further. Firstly, it has completed its review of Alibaba. Secondly, merchants on the platform employ about 70 million people directly and indirectly; China wants to support these people not harm them. Finally, the tech ecosystem has played a very important role in the economic success of China in recent years, and it makes little sense for a benevolent dictator to destroy this system.
We have seen several technology companies in America face similar pressures in recent years and continue to perform well following the regulatory interventions – Facebook with the Cambridge Analytica scandal in 2018 and the Durbin amendment with Mastercard and Visa in 2010 are a couple of examples. We consider everything we have seen in China so far to be of a similar order of magnitude.
The one topic that promotes much debate is the Chinese desire for foreign capital. It is possible, given internal savings, that the Chinese no longer want foreign capital invested in their technology companies. It is notable that as the perceptions of risk increased, Chinese regulators sought to calm nerves of international investors. However, given this risk we will be limiting the overall exposure in China. We have mitigated the risk around the status of the U.S. listing by buying the Hong Kong line.
The regulatory concerns make the valuation of Alibaba compelling. There are several ways of assessing the valuation, but the number of different businesses point to a sum of the parts approach. The market capitalisation at purchase at around $450 billion. With around $65 billion of net cash and approximately $45 billion of further listed investments, the enterprise value was $340 billion.
The 33% stake in Ant Financial is valued at around $50 billion (down from a peak of over $100 billion last year prior to the intervention from the government). The most important wholly owned asset other than the core commerce business is Alicloud; using a price-to-sales multiple of 10x (less than peers for a business that grew 50% last year) gives a value of about $100 billion today.
This leaves $190 billion of remaining value for: a) Chinese core e-commerce, b) Lazada, c) Cainiao logistics d) Last mile delivery network ele.me and e) Digital Media business Youku, along with a whole host of businesses we have not discussed. The Chinese core commerce business alone made over $23 billion of operating profit last year; if the entire residual value was assigned just to this business (unlikely given the other assets), it would imply 8x historical operating profit for a business that grew revenues and profits around 20% last year.
Using 15x operating profit for the core commerce business, the same as eBay, implies a value of $400 billion today. The current valuation stands at 12x enterprise value to historic EBITDA and just over 20x historic earnings. Our target price of HKD $350 a share could offer around 120% upside on a base case along with attractive risk-adjusted returns.
Discussion of Performance Drivers
Portfolio managers Nigel Waller and Andrew Goodwin build the iMGP Oldfield International Value portfolio stock by stock, focusing on only their highest-conviction ideas and ensuring proper diversification across regions, sectors, and other investment drivers that companies in their portfolio may have in common. As such, sector and country allocations are largely a byproduct of their stock picking.
| Sector Weights | Fund | iShares MSCI EAFE Value ETF as of 9/30/2021 |
|---|---|---|
| Communication Services | 5.8% | 6.5% |
| Consumer Discretionary | 10.3% | 9.0% |
| Consumer Staples | 4.8% | 6.6% |
| Energy | 4.0% | 6.5% |
| Finance | 23.2% | 27.6% |
| Health Care & Pharmaceuticals | 12.6% | 8.4% |
| Industrials | 21.2% | 11.9% |
| Information Technology | 5.8% | 3.1% |
| Materials | 0.0% | 8.5% |
| Real Estate | 0.0% | 4.9% |
| Utilities | 6.5% | 6.0% |
| Cash | 5.9% | 0.7% |
| 100.00% | 100.00% |
| Regional Allocation | Fund | iShares MSCI EAFE Value ETF as of 9/30/2021 |
|---|---|---|
| Africa | 0.0% | 0.0% |
| Australia/New Zealand | 0.0% | 7.3% |
| Asia ex | 6.9% | 3.5% |
| Japan | 21.5% | 24.9% |
| Western Europe and UK | 61.0% | 61.8% |
| Latin Am | 4.7% | 0.3% |
| North America | 0.0% | 0.9% |
| Middle East | 0.0% | 0.6% |
| Cash | 5.9% | 0.7% |
| 100.00% | 100.00% |
Our attribution analysis shows:
- Stock selection was the primary driver behind the fund’s underperformance during the quarter. Sector and regional weightings, a residual of bottom-up stock selection, had a negligible impact on relative performance.
- Stock selection was positive in the consumer staples sector, driven by Tesco (discussed below).
- Utilities, where the fund is slightly overweight, saw positive contribution from stock selection with E.ON and Kansai Electric performing well.
- Within industrials, stock selection was mixed. Embraer, discussed below, contributed positively. However, easyJet more than offset as it undertook a dilutive issuance to cushion its balance sheet. The stock remains cheap and has significant competitive advantages in the short-haul flight market in Europe.
- Stock selection within communication services was negative, with British Telecom declining nearly 20%. Last quarter it was among the top contributors to performance.
- The fund had zero weighting to materials, which was the worst-performing sector during the quarter. This contributed positively to fund performance.
Top 10 Contributors as of the Quarter Ended September 30, 2021
| Company Name | Fund Weight (%) | Benchmark Weight (%) | 3-Month Return (%) | Contribution to Return (%) | Country | Economic Sector |
|---|---|---|---|---|---|---|
| Embraer SA | 4.87 | 0 | 12.29 | 0.64 | Brazil | Industrials |
| Mitsubishi UFJ Financial Group Inc | 5.05 | 0.8 | 10.8 | 0.54 | Japan | Financials |
| Tesco PLC | 5.24 | 0.31 | 10.89 | 0.53 | United Kingdom | Consumer Staples |
| Eni SpA | 3.94 | 0.37 | 13.23 | 0.5 | Italy | Energy |
| E.ON SE | 5.29 | 0.22 | 5.88 | 0.35 | Germany | Utilities |
| Exor NV | 5.8 | 0.11 | 5.48 | 0.31 | Netherlands | Financials |
| Siemens AG | 5.59 | 1.49 | 3.8 | 0.21 | Germany | Industrials |
| Sanofi India Ltd | 4.79 | 0 | 1.8 | 0.16 | France | Health Care |
| Toyota Motor Corp | 5.04 | 2.24 | 2.45 | 0.12 | Japan | Consumer Discretionary |
| Kansai Electric Power Co Inc | 2.38 | 0.08 | 3.75 | 0.09 | Japan | Utilities |
Edited Oldfield Commentary on Selected Contributors
ENI
Eni, Italy’s national energy company, saw its shares benefit from the rise in oil and gas prices globally. The extreme tightness of the global natural gas market is being exacerbated in Western Europe by Russia’s Gazprom that is restricting supplies of natural gas to Europe, in an effort to pressure the European Union to allow Gazprom to use more of the Nord Stream 2 subsea pipeline (that runs across the Baltic Sea to Germany) than they had originally agreed. The high gas prices in Asia have fed through to a change in demand mix from power producers and begun to push up the price of oil globally. With historically low capital expenditure on oil over the last few years, that begun with the collapse in oil prices in 2014, the world may be facing a period of higher oil prices helping to bolster the global outlook for inflation.
Tesco
Tesco, the U.K.’s largest supermarket operator, responded to the latest set of Kantar industry data showing Tesco remains the strongest performer of the big four U.K. supermarkets, this time for the four weeks to early September. Tesco is winning customers from the other three large players. Although the hard discounters continue to gain share in aggregate, it is Lidl that continues to win share while Aldi is slipping backwards. With the private equity take-overs of Asda and now Morrisons, we would not be surprised to see these businesses become a little less promotional and this should allow Tesco to concentrate its focus on the hard discounters. This data bolstered our view that the interim results for Tesco’s first half of its fiscal year due in early October would prove robust. We view fair value at Tesco at 300p a share. The shares offer a 4% dividend yield while we wait.
Top 10 Detractors as of the Quarter Ending September 30, 2021
| Company Name | Fund Weight (%) | Benchmark Weight (%) | 3-Month Return (%) | Contribution to Return (%) | Country | Economic Sector |
|---|---|---|---|---|---|---|
| BT Group PLC | 7.02 | 0.25 | -19.6 | -1.55 | United Kingdom | Communication Services |
| EasyJet PLC | 3.88 | 0 | -27.92 | -1.32 | United Kingdom | Industrials |
| Bayer AG | 4.76 | 0.67 | -10.3 | -0.52 | Germany | Health Care |
| Alibaba Group | 1.37 | 0 | -12.31 | -0.44 | Hong Kong | Consumer Discretionary |
| Fresenius SE & Co | 4.92 | 0.26 | -7.74 | -0.38 | Germany | Health Care |
| Mitsubishi Heavy Industries Ltd | 3.86 | 0.11 | -6.9 | -0.28 | Japan | Industrials |
| Samsung Electro-Mechanics Co Ltd | 4 | 0 | -4.62 | -0.15 | Korea | Information Technology |
| Korea Electric Power Corp | 1.6 | 0 | -5.65 | -0.14 | Korea | Utilities |
| Lloyds Banking Group | 5.97 | 0.53 | -1.23 | -0.09 | United Kingdom | Financials |
| East Japan Railway Co | 2.94 | 0.16 | -1.07 | -0.05 | Japan | Industrials |
Edited Oldfield Commentary on Selected Detractors
Alibaba
Alibaba’s shares fell on concerns over the potential for further regulatory moves. During September, concerns over regulation were superseded by a more general concern for China’s economy from the potential collapse of Evergrande, the property company with balance-sheet liabilities of $304 billion and net debt of $75 billion as of 30th June 2021 but free cash flow that has collapsed from about $12 billion last year to less than a billion dollars this year explaining its problems meeting the interest payments on its local and international bonds. Evergrande alone, while very large, remains a small piece of the Chinese banking sector’s loan book but there are certainly paths that this Evergrande problem may take that could ensnare other property companies, construction and raw material providers more broadly. The real estate sector accounts for an estimated 29% of Chinese GDP and 20% of global steel and copper consumption and 9% of aluminium demand.
Bayer
Bayer, the German agrichemical and pharmaceutical conglomerate, fell another 8% during the quarter as investor confidence ebbed on the shape of the final legal settlement for the U.S. glyphosate (Round-up) litigation. The company has appealed to the U.S. Supreme Court to hear the case and we expect to hear the court’s decision sometime in the next five months. The company recognised an additional $4.5 billion in liability accruals in the second quarter suggesting they doubt their appeal to the Supreme Court will be heard. We value Bayer using a sum-of-the-parts approach that gives us fair value of €71 per share, 50% above the closing price for the quarter.