Taking Stock

FUNDAMENTAL VALUE EQUITIES

Q1 2018

Concentrating on long-term value

04 FINDING VALUEStock Highlight: Goldcorp Valuation and quality metrics rather than fluctuating gold prices are key in analysing miners.

06 RESEARCH BRIEFINGValue and Share BuybacksWe look at whether share buybacks are the best option for shareholders.

02 THE BIG PICTUREVolatility re-emerged in Q1 after a lengthy absence. But does that change how one should value stocks?

2

Fundamental Value Equities Q1 2018

Global equities, as measured by the MSCI World Index, fell 2.2% in the first quarter of 2018, and along the way triggered a cascade of headlines proclaiming the resurgence of volatility and risk.

As long-term value investors, we are familiar with sudden market shifts while recognising that these moves are for the most part a reaction to ‘noise’. But such moves also serve as a reminder about the importance of fundamentals in determining value. Pausing to take stock of the landscape is usually a worthwhile endeavour.

The index ended the quarter at a level of 2050, some 9% below its January peak. This move is actually quite modest in the context of where the market has come from — the index low in March 2009 was 649. Nevertheless, it’s not an insignificant drop and anxiety levels are elevated; and if we just look at price, the current set-up is less than encouraging. If the goal is to buy low and sell high, uncharted territory is required — we need new highs.

THE BIG PICTUREBarry Glavin, Chief Investment Officer

High Market ValuationsAs we’ve pointed out before, for the index to rise, either earnings must grow or the multiple the market is willing to ascribe to those earnings must expand. Earnings growth has been improving and now exceeds the peaks recorded prior to the onset of the global financial crisis in 2007. The Price-to-Earnings (P/E) multiple of 15.6x sits two percentage points above the 10-year average (Figure 1a). A high P/E can indicate investor optimism for future earnings growth.

The Price-to-Book (P/B) ratio produces similar observations. At 2.3x, the market P/B compares to a ten-year average level of 1.8x (Figure 1b). Unlike earnings, the market’s Return on Equity (ROE) has not recovered to pre-crisis levels and we do not expect it to. Leverage in the financial sector “flattered” the market’s ROE pre-crisis and, for now at least, that lesson seems to have been learned.

Historic data offers guidance. Having plotted the P/B ratio of the index for each month and the subsequent return over five years, Figure 2 illustrates a clear relationship between valuation and investment outcome — the lower the valuation (P/B), the better the return. We can see that P/B multiples have been well above today’s levels — but once above current multiples, the prospect of negative returns becomes more prevalent.

For an investment in the index at this level to be profitable, either earnings growth must accelerate, or multiples must expand from already elevated levels. This is possible, but requires unadulterated good news to overcome the odds. Anything less and the high multiples of record profitability leave the market ill-placed to withstand disappointments or adverse events. In other words, we don’t believe there is a ‘margin of safety’ in the global index at this point.

Figure 1a: Corporate Earnings (April 2008–April 2018)

— Average MSCI World P/E— MSCI World P/E MSCI World Earnings per Share (Local Currency) — LHS

2008 2010 2012 2014 2016 2018

4

8

12

16

00

50

100

150

200

20250

EPS (Rebased to 100) Price to Earnings (Multiple)

Figure 1b: Market Price-to-Book (April 2008–April 2018)

— Average P/B— MSCI World P/B MSCI World ROE — LHS

2008 2010 2012 2014 2016 2018 -0.5

0.5

1.5

2.5

3.5

0

5

10

15

20

Return on Equity (%) Price to Book (Multiple)

Source: FactSet, MSCI, SSGA as at 31/03/2018. Past performance is no guarantee of future results.

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Figure 2: MSCI World 5-Year Returns Versus Trailing P/B: 1980—2018

Starting P/B (Trailing)

5-year Return (%)

-20

0

20

40

60

80

100

0.0 0.5 1.0 1.5 2.0 2.5 3.0 3.5 4.0 4.5

Current Trailing P/B: 2.3x

Source: Factset, MSCI, SSGA as at 31/03/2018. Past performance is no guarantee of future results.

Figure 3: Many Regions Expensive at Market Level

Current Price to Book— 10 YR Range

Price to Book (Multiple)

0

1

2

3

4

Developed Emerging NorthAmerica

Europe Eurozone Asia Pacific ex Japan

Japan

Source: Fact, SSGA as at 31/03/2018. Past performance is no guarantee of future results.

Value in StocksHowever, we don’t invest in the index, we pick stocks. We look for companies where earnings or returns are below what we believe to be normal, and we seek to acquire stakes at depressed multiples of those through-cycle earnings. Identifying such opportunities requires effort, discipline, patience etc., but also a co-operative opportunity set. Despite overall market valuations, we believe that significant pockets of value remain in the market.

Today the US accounts for almost 70% of the MSCI World Index. The US portion of the index trades at three times book value — a significant premium to both history and other markets. Elsewhere, headline valuations look reasonable and, as one would expect, it is towards these regions that our capital is presently weighted.

This means our Global Value Spotlight Strategy has about 30% of its assets in US stocks. Does this significant underweight relative to the index represent a risk? To some it might, but to us it does not. Our mandate is to go where the value is, not to reason in terms of benchmark weights.

Risk Approach Our approach to risk is to conduct detailed due diligence on each investment to ensure that a) our assumptions around earnings power are robust, b) that the company has sufficient capital to support that earnings stream, and c) that it has the resources to cope with adversity. We then seek to establish that the price we pay is sufficiently attractive to provide a margin of safety. Despite our extensive analysis, we accept that we can be wrong. The future is uncertain, and we demand a price for each investment that compensates us to assume that uncertainty.

Rising geopolitical and trade tensions, higher inflation, and the ongoing withdrawal of monetary stimulus have re-introduced near-forgotten levels of market volatility. Longer term data suggests that volatility levels are now simply closer to historic averages and, as such, investors may have to get used to equity markets behaving like equity markets again.

The CompanyGoldcorp is the world’s third largest gold miner by market cap, producing 2.5 million ounces of gold from eight assets in the Americas (Canada, Mexico, Argentina and Dominican Republic).

For most of the 2000s, the company attracted investor interest as it invested heavily in growth as the gold price rose. At the share price peak in 2011, Goldcorp had an Invested Capital base of c. $24bn with plans to increase gold production from 2.5m to 4m ounces by 2015. It wasn’t alone in pursuing a hefty capital expenditure strategy (Figure 4a) but success needed a rising gold price. Instead, gold dropped from $1,900 in mid-2011 to about $1,200 in 2015. Goldcorp’s Return on Invested Capital (ROIC) of c.7% in 2011 collapsed to zero in 2015, and the company wrote down assets of $10.5bn.

By 2016, the shares had dropped 70% and went from trading at over two times Enterprise Value to Invested Capital (EV/IC)* to today’s level of 0.6x, with all of the invested capital in tangible assets and the majority of which is tier 1 gold mines (large, low cost, long life and relatively new). Organization change followed with an external CEO appointed alongside a more value and operationally focused management team.

Goldcorp is now on track to increase production by 20% where the vast majority of the capex has been spent and should lead to a 20% reduction in costs at a time when industry investment has collapsed and grades (i.e. % gold per tonne of ore) have significantly deteriorated (Figure 4b). It’s EV/IC of 0.6x compares favorably to 1.2x–1.8x EV/IC range of its gold and industrial mining peers.

GoldcorpAt a time when most asset markets are close to all-time highs, gold mining stocks are trading at 15-year lows and look intriguing to value investors. Within this sub-sector, Goldcorp stands out, trading at a low valuation, with a high-quality asset base, a strong balance sheet and a relatively new operationally-focused management team. The company trades at a substantial discount to our assessment of its intrinsic value.

FINDING VALUEOwen Dwyer, Research Analyst

Fundamental Value Equities Q1 2018

4

Figure 4a: Gold Industry Capex 2000–2016

FY 00 01 02 03 04 05 06 07 08 09 10 11 12 13 14 15 16

Long-term trend:

25% CAGR -78%

5000

0

10000

15000

20000

25000

30000USD (mn)

Figure 4b: Industry Head Grade (Gold per Tonne of Ore) — 2000–2016

FY 00 01 02 03 04 05 06 07 08 09 10 11 12 13 14 15 16

0.5

0.0

1.0

1.5

2.0

2.5

3.0(% gold per tonne of ore)

Long-term trend:

-5% CAGR Defying thetrend to makeends meet

Source: Citi Research as at October 2017.

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Cerro Negro: Helped by an improving political backdrop and company efforts to address labour unrest, production is on track to increase by 33% while costs should decline by close to $100/oz as productivity improves.

Eleonore: Production here is expected to increase by 50% while costs are expected to decline from $1,100/oz to $750/oz.

Elsewhere, the firm’s portfolio has been streamlined, costs have been taken out and operational delivery significantly tightened up. A focus on productivity appears on track to deliver $250m in sustainable efficiencies to help the company reduce its all-in cost to $700/oz versus $850/oz today. This should move Goldcorp costs firmly into the first quartile of gold miners globally and at the current gold price generate about $1bn of free cashflow.

Invested CapitalThe commodity super-cycle led to capital destruction on an epic scale across the mining industry. Goldcorp was among the largest culprits with a write-down of asset values amounting to $10.5bn and capital expenidture of $12.7bn since 2010; in the context of today’s market cap of $13bn that is a significant outlay.

Goldcorp has spent most of the money to ramp up its newest mines while sub-scale and high-cost operations have been sold and long-life but older assets have been restructured. In addition, with 53m ounces of reserves, we believe Goldcorp can sustain production above 3m ounces in the medium term.

SummaryTrading at 0.6x EV/IC, where all the Invested Capital is tangible assets, and a clear operating plan which can be tracked and monitored, Goldcorp looks to tick a lot of the boxes that are attractive to value managers such as ourselves.

Our approach to evaluating companies in the gold industry is to focus on what we can measure without getting overly involved in an emotive philosophical discussion around gold’s status as 1) a currency, 2) an insurance policy against turbulence, or 3) a lump of useless shiny metal. In the context of the broader mining/commodities sector, history tells us that over time, industry returns revert to cost of capital.

If the outcome is cost of capital type returns, then the objective is to find a potential investment which has at least industry average quality assets, trading at a substantial discount with a decent margin of safety. In Goldcorp, we believe this company has well above average asset quality, a decent balance sheet, shareholder-aligned management and a valuation which assumes that company returns remain below the cost of capital into perpetuity.

Revenue, Operating Profit and Cashflow OutlookGoldcorp revenue is largely a function of production volume by the gold price. Unlike most commodities, where prices are typically well above industry cost, gold is currently trading broadly in line with industry cost and well below the price that would be required to incentivize producers to develop new mines.

Goldcorp volumes are likely to increase from 2.5m ounces to 3m ounces by 2020 as its recent investments start to deliver, with three key mines driving performance — Penasquito in Mexico, Cerro Negro in Argentina and Eleonore in Canada. We believe all three mines have been largely operationally de-risked.

Penasquito: Productivity gains and operational improvements should see production double at low cost — we assume a mid-term cost of $350/oz.

* In our investment framework, the market rating of capital is measured as Enterprise Value divided by Invested Capital, or EV/IC. Enterprise Value is the market valuation of the firm’s capital, and includes the market value of equity, debt, pension liabilities, associate investments and minorities. Invested Capital is the measure of capital intensity of the firm, and represents the replacement value of all assets on the firm’s balance sheet, adjusted for working capital.

66

Fundamental Value Equities Q1 2018

Can Share Buybacks Create Value?Ascertaining a company’s value is at the heart of what we do. We analyse the sustainable earnings power or returns of the company and the capital required to generate those returns. We prefer companies with the potential to generate good returns, and have opportunities to grow their invested capital base by reinvesting in areas with returns above a required hurdle rate. We are interested when the market undervalues these returns.

We are surprised by the number of analysts and managements who concentrate instead on earnings per share (EPS) and earnings growth without thinking about the link between returns on invested capital (ROIC) and price earnings. Share buybacks might boost EPS, but is that best for shareholders?

Capital DeploymentWe look at capital deployment in terms of whether it adds value by earning a return above our required hurdle rate of return (the opportunity cost of capital). We calculate the net present value of the excess returns and add them to the opening invested capital to arrive at an intrinsic value.

As a rule of thumb, our hierarchy of priorities around capital deployment are as follows:

1. Organic investment, whether classified as capital expenditure or operating expenditure, is the charge required to deliver our assumptions about growth and profitability. As long as the investment generates a ROIC in present value terms above the hurdle rate, it is truly accretive to shareholders.

2. Most M&A fails to create value for the acquirer. In addition, many deals take place at the peak of the economic cycle when valuations are high. While the ROIC and growth of the target is often attractive, the price paid determines its real value.

3. Dividends allow shareholders to choose how to reinvest the cash (accepting some tax differentials between income and capital gains). If a company is overcapitalised, has little opportunity to invest to create value, and has a stock value which management believes is overvalued, then shareholders should prefer a special dividend.

4. We believe management should objectively value their companies, and only buy shares when it is trading below its intrinsic value and no better investment opportunities are available. In his 2000 shareholder letter, Warren Buffet criticised those prioritising buybacks — “I can’t help but feel that too often, today’s repurchases are dictated by management’s desire to ’show confidence’ or be in fashion rather than by a desire to enhance per-share value.” Berkshire Hathaway (Buffet’s investment vehicle) recently set an intrinsic value below which they would be prepared to buy back their shares.

We are skeptical that most management teams only consider buybacks when intrinsic value far exceeds book value. Management are often incentivised to do share buybacks because they have EPS targets rather than using returns based metrics. According to a Goldman Sachs study, some 30–35% of S&P 500 companies (ex financials) use EPS as a measurement of management performance in Long and Short-Term Incentive Plans.

RESEARCH BRIEFINGJeremy James, Head of Investment Research

1. Organic investment2. Value creative merger and acquisition (M&A)3. Dividends4. Buybacks

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Share BuybacksShare buybacks do not increase the value of a company, because they do not increase the total cash flow of the business. While share repurchases can increase EPS (when the earnings yield of the company is above the after-tax interest rate), they tend to reduce the P/E multiple as investors adjust their valuations to reflect the reduction in both cash and shares, as well as for the higher leverage of the business.

Low returns from excess cash should not be used as a benchmark for new investments and neither should the low cost of borrowing. Returns on investment should be benchmarked against the risk associated with that investment.

Even repurchasing shares when undervalued simply shifts value from shareholders who sell to those that do not.

However, assuming that management have conducted objective work that tells them that their stock is undervalued, then share buybacks can create value for continuing shareholders.

Historically, the timing of share buybacks has been value destructive. Figure 5 shows buybacks in the S&P 500 since 1999; buybacks were highest near the peak of the market and lowest at the bottom. And it was at the lows of the market that gross issuance of equity exceeded buybacks.

Buybacks vs InvestmentHow management measures returns on organic investment versus other forms of capital allocation such as share buybacks is important. In particular, where investment hits the P&L rather than being capitalised, a timing mismatch between investment and payback is created. To increase short-term returns at the expense of sustaining long-term returns, there is a temptation to underinvest or increase leverage through buybacks.

We look at the historic long-term returns of the firm’s industry, and any competitive dynamics that may fundamentally affect those. We compare them with company returns and the required rate of return. If materially different, we analyse why this might be (point in the cycle, competitive advantages/disadvantages etc.) and whether the differences are sustainable.

When we talk to management teams we discuss capital allocation and sustainability of returns at length. Capital allocation decisions are powerful drivers of value creation. We would expect companies to have management accounting systems which allow them to measure returns by division or returns on major investment projects. Similarly, management should be able to justify the value created by share buybacks.

Figure 5: Buybacks and Issuance Follow Market Cycles — March 2000 to December 2017

Buybacks Issuance

Mar2000

May2002

Aug2004

Nov2006

Feb2009

Apr2011

Jul2013

Oct2015

Dec2017

3,000 2,300

1,000

500

1,500

2,000

2,500

300

-200

-700

800

1,300

1,800

0 -1,200

— S&P 500 (lhs) — Net Buybacks

S&P 500 Index Level USD (bn)

Source: Bloomberg Finance L.P. Past performance is no guarantee of future performance.

© 2018 State Street Corporation. All Rights Reserved.ID12653-2093069.1.2.GBL.RTL

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