The engineer's question - 2nd quarter, 2012
I recently found myself talking to an electrical engineer while waiting for a flight home from New York. Eventually, the conversation turned to what I did for a living. When I told him, he replied with a thoughtful question. This engineer wanted to know why being right doesn’t always make you money in the stock market. Intrigued, I urged him to elaborate. He said that he’s accurately predicted the outcome of certain situations and yet even as those predictions played out, he nevertheless lost money on his investments. Our ensuing conversation was the catalyst for this quarter’s commentary.
No doubt people believe that if they can accurately predict the future, then it should follow that they’ll be rewarded financially. Unfortunately, history demonstrates time and again that this is often not the case. The missing element is price. When everyone sees the same thing about an investment, this becomes reflected in its stock price. For example, excitement about a business’s future prospects can result in it being priced for more than it’s worth. Overpaying for something is one of the fastest ways to lose money.
Let’s look at a few examples where investors accurately predicted the future but ultimately lost money because of the high entry price they paid to invest in those predictions.
In the late 1990s, the internet was still considered new and held immense growth potential. Many people saw the possibilities and invested their hard-earned savings in internet-related ideas. The internet did grow and many businesses saw their profits flourish; however, investing in these prosperous businesses mostly turned out to be a big mistake. Why? Because investors simply didn’t pay enough attention to the price at which they bought these companies.
From the peak of the internet craze (in March 2000) to today, the NASDAQ Composite Index is down approximately 37%. Investors were right about the internet and the result was that they lost money.
In the early 1980s, investors started to fret about how long oil reserves would last. If you invested in oil then, you have yet to make your money back after accounting for inflation. Investors were right that the world was consuming oil faster than it was being produced but still lost lots of money. Their entry price (high) dictated their return (low to negative).
More recently, the world started to worry about oil supply again, this time because of emerging markets’ consumption. The all-too-familiar argument went, “If everyone in China buys a car, then the world will soon run out of oil.” Since that argument was popularized several years ago and oil prices peaked in 2008 (on July 3), consumption in China has increased by 22%1 (as measured by consumption of tons of oil), yet the price of oil is down about 45%. People were right about the world running out of oil and the result was that they lost money.
Investors know that emerging markets grow faster than developed markets. As global trade opens up to countries like Brazil, India, Russia and China, these economies enjoy a big boost in growth. They then channel the benefit of this trade-driven growth into expanding domestic consumption. The net result is greater economic growth than in such markets as the U.S. or Canada. Since the market bottom of the financial crisis (on March 9, 2009), China’s economy has grown approximately 30%, while the U.S. economy has grown around 4%. As a Canadian investor, you wouldn’t have done as well. Since March 9, 2009, the Shanghai Composite Index is down approximately 5% and the S&P 500 Index is up 67% (in C$). Investors were right that China would outgrow the U.S. and the result was that they lost money.
The conclusion to be drawn is that being right doesn’t make you money. Being right isn’t enough if everyone else is also right. To make money, we believe you need an idea about a business that isn’t widely shared or reflected in its stock price. Only when we find these ideas, which we call proprietary insights, do we invest. The hope is that as our idea about a business comes to fruition, this will become reflected in its stock price and thus prove a good investment.
Looking to the future, where do our views at EdgePoint tend to align with consensus? We’re inclined to agree with the popular view that the global economy will be slower for longer. There’s a lot of debt in the world that households and governments need to pay down, and doing so will create headwinds to growth for a long time to come. This is the consensus view and we share it. However, we act very differently than the crowd in the face of this belief. Confronted with a world that will likely be slower for longer, most investors have opted to park their money in cash and fixed-income securities, such as 10-year Government of Canada bonds. The current consensus is that global equity markets don’t offer as attractive an investment opportunity as bonds. Given this consensus thinking, we believe that many investors will look back on this period a decade from now and again say that they were right – this time about global growth being slower for longer – and unfortunately managed to lose money while being right. Since everyone expects to be “paid to wait” in government bonds until the global economic situation improves, they will likely prove poor investments. After accounting for inflation and taxes, there’s a good chance investors will lose money on their bond holdings. The idea’s widespread acceptance practically guarantees its failure. In order to make outsized returns, you must see something about a particular investment opportunity that others don’t. Today, that opportunity may lie beyond current economic woes and concerns about a continued slowdown to companies able to grow regardless of a sluggish economy. We’re looking to capitalize on the negative long-term outlook that exists around the world today.
More specifically, we’re trying to do two things. First, we want to own businesses that can be much bigger in the future even in the face of a tough economy. Second, when we find these businesses, we want to buy them when their growth potential has gone unnoticed by the market. To be clear, there aren’t a lot of these businesses out there but it’s our job to find them. The good news is that as pessimism intensifies, so does our chance of finding such growth and not paying for it. Think back to the year 2000 and how optimistic investors felt about technology companies. With that much optimism, it usually becomes next to impossible to find value because businesses are already priced for greatness. The opposite exists today. The world seems as pessimistic about the future as this generation has ever seen. We believe the pessimism is warranted. We also believe that we’ve assembled a small collection of companies in your EdgePoint portfolio that can grow despite a crummy economy and that we aren’t being asked to pay for their growth today.
Global equity comments
Delphi Automotive PLC
Let’s look at an example. Investors today are pessimistic that the auto industry can experience growth in a no-growth world. It seems like a tall order to find any thriving companies in this sector; however, we believe we’ve found one and that the pessimistic market isn’t asking us to pay for its growth. Delphi Automotive PLC is an auto-parts company focused on powertrain, safety, thermal and electronic systems. Each of these four divisions should see its content per vehicle increase irrespective of the global economy. The powertrain and thermal systems divisions should experience a content upsurge as manufacturers struggle to meet increasingly stringent fuel efficiency and emissions regulations. Safety content is also expected to increase as options such as adaptive cruise control and lane departure technology see greater adoption. Finally, electronic content is similarly poised to spread as cars become more electrified and less mechanical.
With content per vehicle increasing, Delphi can grow even if the number of cars sold in the world doesn’t. Over the last three years, Delphi’s revenue has increased at a 20% annual rate while global auto production has increased 13.5% yearly2. The difference between the two can be attributed to content per vehicle increases. We believe Delphi will continue to outpace the industry vehicle growth rate. Furthermore, 99% of Delphi’s manufacturing workforce is located in low-cost countries, which provides the company with a wage cost of approximately $7 per hour versus the industry average of $15. This cost advantage helps it achieve healthy profit margins. Lastly, Delphi’s balance sheet is in great shape – it should be in a net cash position in less than 18 months. Bottom line, Delphi is growing faster than its average competitor, is more profitable, has a better balance sheet and a demonstrated ability to sell more of its products in each new vehicle. We believe all of these trends will continue into the future.
What are we being asked to pay for Delphi? It’s trading at a free cash flow yield of approximately 15%. That means if we owned 100% of this business, our first-year return would be 15% before growth. If future vehicle production stalls at the current rate of around 80 million units per year, we believe Delphi’s profitability should increase by at least 3% annually due to its continued growth in content per vehicle. Between Delphi’s free cash flow yield and growth results, this could prove a very attractive investment even if macro headlines continue to cause market volatility. Said differently, we believe it’s possible that the value of our Delphi investment will double over the next five years. If we’re right, five years from now we’ll be able to look back and say that although we shared the common view that things would be slower for longer, we didn’t behave in the same way as the crowd. Coming up with proprietary insights is the key to being right about the future and making money from it. Without them, most investors will be right about the future and still see their wealth decline. We don’t believe that Delphi’s return will happen smoothly. Short-term volatility will move the share price around a lot. However, longer term Delphi should deliver the solid returns they have in the past.
Canadian equity comments
EXFO Inc. is another example of a company that sits firmly in the category of what the average investor doesn’t want to own right now. It’s not cash, it’s not a bond and it doesn’t pay a big dividend. Our thesis on EXFO revolves around the fact that it sells equipment to companies that deploy fibre optic networks worldwide and we believe fibre optic networks are the future backbone of the internet.
Global internet traffic is expected to grow at a 40% compound annual rate for the next five years3. In other words, traffic flowing through the internet may be five times larger five years from now. To move all of this information, bigger digital highways have to be built, and we believe the most efficient and economical digital highways are fibre optic. Although they’re the best type of highways to have their deployment is still in the very early stages. Only six countries (including Japan and South Korea have more than 15% of their households hooked up to the internet through fibre4. This low penetration has resulted in global growth rates in fibre optics deployment in excess of 25% per year5. EXFO sells equipment into this fast-growing market. It’s a leading provider of test and service assurance solutions for network operators and equipment manufacturers in wireless and wireline markets worldwide.
In recent quarters, EXFO’s customers, including service providers such as Bell Canada and Verizon, have slowed their purchases of EXFO equipment due to the state of the global economy. Service providers are reading the same headlines as you and are nervous about the future. However, with demand on their networks growing 40% a year, service providers can delay purchases for only so long. If they don’t continue to build out their networks, your internet connection at home, in your office, and over your mobile device will slow to a frustrating speed and cause you to switch providers. Therefore, companies like Bell Canada can postpone growing their network for a few quarters but can’t postpone deployment for years.
Due to the short-term concern surrounding fibre deployments, EXFO is trading for approximately $5 per share. The company has about $1 per share in net cash, which essentially means we’re buying the company for $4 a share. We estimate EXFO’s normalized earnings could be in excess of $0.50 per share. Therefore, stripping out the cash, we’re receiving a 12.5% earnings yield on a normalized basis for our ownership stake in EXFO (the equivalent of 8X earnings). In our judgment, this is an attractive price to pay for a company with a leadership position in a market growing over 40% annually. Historically, when we’ve been able to come up with proprietary insights around such unloved businesses, the long-term returns have been very satisfying and we look forward to EXFO delivering similar results.
In conclusion, we’re pleased with the collection of businesses in your portfolio and excited about their long-term prospects. We continue to approach investing in these markets with a sense of measured confidence, thank you for your trust in us and look forward to building wealth for you over the long term.
2 International Organization of Motor Vehicle Manufacturers. “How many cars are produced in the world every year?”
3 Cisco Systems Inc. “Global Internet Traffic Projected to Quadruple by 2015,” June 1, 2011 press release.
4 Fiber to the Home Council. December 2011 ranking for economies with at least 200,000 households.