Can a business’ long-term prospects be strongest when the economy is at its weakest?
Matthew Tillett and Mike Shrives, from the Premier Miton UK Value Opportunities Fund team, explain how certain cyclical business models can thrive during difficult economic periods, improving their earnings power whilst competitors may struggle.
For information purposes only. The views and opinions expressed here are those of the author at the time of writing and can change; they may not represent the views of Premier Miton and should not be taken as statements of fact, nor should they be relied upon for making investment decisions.
A cheery consensus?
Ben Graham, the father of value investing often made the point that businesses with the most appealing prospects don’t often make the best investments. His long-time disciple Warren Buffett puts it eloquently when he states:
“The future is never clear; you pay a very high price in the stock market for a cheery consensus. Uncertainty actually is the friend of the buyer of long-term values.”
The mission, should you choose to accept it…
Our task or mission as investors is to find materially mis-priced investments, and in our experience they often show up when there is significant uncertainty around the economic outlook. We know for example that often markets reach low points when the newspaper headlines are the worst. For example, during the 2nd world war, the UK equity market troughed during the Blitz despite the war continuing for a further 5 years.
To avoid the trap of overpaying for an investment during the economic good times and ignoring businesses during the tougher times, we try to look across market cycles and focus on the average earnings power of a company rather than any one year’s profitability. A best laid plan certainly, but even this can be hard to implement when the proverbial economic ceiling is caving in.
How do we get comfortable investing in a business despite a mixed economic outlook?
We like to turn to the concept of ‘Anti-fragility’. Nasim Taleb defined the term in his book Antifragile. It is a key component of what we look for in our investments.
“Some things benefit from shocks; they thrive and grow when exposed to volatility, randomness, disorder, and stressors and love adventure, risk, and uncertainty. Yet, despite the ubiquity of the phenomenon, there is no word for the exact opposite of fragile. Let us call it antifragile. Antifragility is beyond resilience or robustness. The resilient resists shocks and stays the same; the antifragile gets better.”
Whilst the external economic environment can produce lower company revenues and earnings, Anti-Fragile qualities give us the confidence to buy certain businesses when they appear most out of favour. Cyclical pain points and bumps in the road may give these businesses the opportunity to enhance their earnings power, whilst the market at large is busy fretting about their near-term outlook. Near term revenues and earnings may be on the decline but the average earnings power can trend higher.
Forms, guises, and combinations
These anti-fragile qualities come in various forms, guises and combinations. As an example, one of our newest additions to the Premier Miton UK Value Opportunities portfolio is Berkeley Group, a British property developer and housebuilder. Berkeley Group illustrates the power of combining several anti-fragile qualities in a cyclical sector such as housebuilding.
On multiple occasions Berkeley has illustrated its unique ability to effectively allocate capital. A good example of this was ahead of the 2007 housing recession. The business returned cash to shareholders, curtailed land investment ahead of its subsequent 50% drop in value and managed to remain significantly profitable. The carnage in the housing market allowed the business a clear run in the land market and it invested £700m between the H2 of 2009 and H1 2012, doubling its market share and sowing the seeds of exceptional growth in years to come. Whilst the wider housing industry had overextended itself and was forced to raise capital, Berkeley does things differently.
Today, Berkeley’s proven ability to allocate capital is supported by its anti-fragile quality – its unique bank of land holdings: 58,000 owned plots plus a pipeline of 14,000 plots suggests at least 15 years of supply at recent volumes. This compares to the typical 4-to-5-year average at the other major listed housebuilders.
This provides the business the ability to take a truly long-term view on capital allocation, akin to a skilled investor with a permanent source of capital. The group’s land bank is also considerably more concentrated, controlling only around 73 sites vs. national homebuilders with 600 plus sites. Berkeley is a mainstay in London producing 10% of the capital’s new build homes and operating many difficult and complex regeneration sites. Berkeley plays a key role in supporting London’s appeal, regenerating sites like Oval Village, an 8-acre derelict gasholder site with seven years of ongoing investment. A significant contribution to UK society.
London itself could be argued to be classed as ‘Anti-Fragile’ adding a further layer of long-term resilience and optionality. Overseas buyers take a view of the city itself just as much as the individual asset. When political upheaval and a macro economic shock strike, London may be insulated as it is the economic heartland of the UK. It has shown remarkable strength shrugging off the impacts of both Brexit and Covid. According to a recent FT article, London’s economy is 4% larger today than it was in 2019, unlike most of the rest of the country.
Many point to residential property affordability metrics being stretched in London, but a weak pound relative to the US dollar means house prices in $ terms are down approximately 30% since their 2014 peaks in prime Central London, whilst rents are moving ever higher. Buyers from overseas are just under 50% of Berkeley’s private sales.
With a difficult planning backdrop and significant uncertainty in the domestic market, Berkeley today is suggesting it has no intention of investing in land for the next two years but is instead returning capital to shareholders.
The final word
It is at uncertain moments like these that Anti-Fragile qualities should be most highly valued. Whilst it would be great to be able to categorise such Anti-Fragile qualities into neat buckets and scan the market for them with an AI based tool, they are invariably industry and company specific, hard to quantify and value.
Businesses with such qualities may thrive when external economic fluctuations provide the opportunity for management teams to deploy capital in a countercyclical manner. The financial result can be exceptional growth. In Berkeley’s case, earnings per share is 4x what it was 10 years ago. The economic cycle may ultimately provide the business with the opportunity to grow their intrinsic value – arguably making their prospects strongest, when the economic outlook is at is flimsiest.