Finding patterns in the prosaic
William Lough, Portfolio Manager at River and Mercantile, considers how the team’s proven and repeatable process enables them to recognise recurring patterns to unearth opportunities that the market often overlooks.
“Over the course of a season, there's some predictability to baseball. When you play 162 games, you eliminate a lot of random outcomes. There's so much data that you can predict: individual players' performances and also the odds that certain strategies will pay off.”
Billy Beane (General manager of Oakland A’s baseball team)
Like Billy Beane, who made his name finding value in baseball players based on hard data, the features we look for in our investments are often more prosaic than the ‘glamour’ companies that grab headlines with eye-catching statements about the huge addressable markets they can disrupt. We value pattern recognition, i.e. there are certain scenarios that come up repeatedly within our four lifecycle categories (Growth, Quality, Recovery and Asset-backed) and these enhance our ability to execute the investment process systematically. Just as in baseball, our strong belief is that a robust process, focus on evidence and a longer-term time horizon iron out a lot of the uncertainties inherent in investing (but not all!) and can therefore increase the predictability of outcomes. We’ll use our investment in Japanese mobile crane manufacturer Tadano (equally prosaic) to demonstrate. Tadano is a global market leader in the cyclical crane market and the company’s management has issued medium-term guidance for sales and margins which are materially ahead of current analyst expectations.
In companies that are undergoing restructuring as part of a Recovery, one area where we routinely identify opportunities is cost modelling by sell-side analysts, or rather a lack of cost modelling. Analysts appear to pay less attention to these line items than they do trying to forecast revenues. We can speculate as to why this is, but the reality is that while analyst models will typically have multiple line items to build out revenue (volume, price / mix, M&A, currency etc) the operating profit number that drops out is often the result of hard-coded, typically linear or ‘drag to the right’, margin assumptions.
In Tadano’s case, it is restructuring its Demag subsidiary that it acquired in 2019, resulting in material cost savings. Figure 1 below shows three things: the company’s reporting numbers for FY2020 (ending March 2021), which broadly equates to near the low point of the economic cycle, its medium-term guidance for the FY2023 (ending March 2024), and the consensus numbers for FY2023.
Figure 1. Tadano financial
Source: Company reports and guidance documents, Bloomberg
As we can see, analysts are sceptical, after all, 10% does seem a long way from -2.3% and peak profits (FY14) were ¥29.5 billion, so the management targets are widely seen as “punchy” (read “unlikely to be achieved”). But are they?
“Just as in baseball, our strong belief is that a robust process, focus on evidence and a longer-term time horizon iron out a lot of the uncertainties inherent in investing (but not all!) and can therefore increase the predictability of outcomes.”
Breaking down the loss in FY20, some context is required:
- Pre-restructuring, we estimate Demag’s loss (based on public disclosure, but it requires a bit of piecing together) was ¥7.1 billion, so ‘legacy’ Tadano made ¥2.9bn operating profit.
- Tadano is taking out ¥5.5 billion of fixed costs that are considered duplicated, and which therefore will not impact revenue generating capacity. This figure thus drops to their bottom line.
- Adding ¥5.5 billion to our (¥4.2) billion leaves ¥26.2bn to hit management’s target, or ¥16.5bn to meet consensus.
Tadano is a manufacturing business with a high level of fixed costs associated with its plants. Typical operational gearing has been ~35% since 2010, which means that for every additional ¥100 revenue they receive, we can expect ¥35 profits to drop through. Therefore, taking the incremental Y89 bn of revenue the company expects to be generating in FY23 vs FY20 we can expect 35 per cent of this amount i.e. ¥31.2 bn, to be added to operating profit, all things being equal. Even if we assume that the analysts’ lower revenue number for FY23 is correct, that still adds ¥22.4bn to operating profit or 36% more than what’s required to hit analysts’ profit forecast. Put another way, we think there is broadly ¥5 billion to ¥6 billion of ‘cushion’ in forecasts, which is a lot of additional fixed cost to come back into the business post COVID and/or inflation that is far from ‘transitory’.
Figure 2. Considering where the costs fit into the equationSource: River and Mercantile Asset Management LLP, Bloomberg, company presentations
Another way to think about this is to break out Demag versus ‘legacy’ Tadano margin to assess the implied forecasts in the context of history. Assuming a 3% margin at Demag in FY23, to hit consensus operating profit would only require a 9.6% operating margin in the legacy business. This compares to historic mid-cycle margins of 12-15%.
So far, so exciting (for us, anyway!). Using Bloomberg’s calculation of the company enterprise value (EV) of ¥147.7 billion, the shares trade on 8.3x EV/EBIT. This is cheap. The company has, over the long term, traded on roughly 10x. However, as we’ve shown, the company believes it can earn ¥27.5bn and we believe them, in which case it trades on 5.4x EV/EBIT. This is very cheap. But there’s more: we need to knock ¥10 billion off the EV for debt forgiveness as part of the Demag restructuring, and added to this, the company also has investments of ¥7.7bn on its balance sheet and has indicated a willingness to begin to realise these, in line with the way the wind is blowing in corporate Japan. Tadano’s EV/EBIT could be as low as 4x (even before we consider whether any of the ¥26 billion of land, in the books at historic cost, is surplus to requirement).
We’d be the first to accept that, at face value, telling people about the mobile crane manufacturer you’ve invested in is unlikely to make you the most popular kid at the party. However, when faced with the numbers-backed evidence we think it is very exciting indeed! Repeatedly interrogating ideas like this that come out of our process puts the odds on our side to create value for clients over the long term.
 Beane was the feature of Michael Lewis’s book, Moneyball (2003), subsequently turned into a film (2011) starring Brad Pitt. Beane famously had a rigorous focus on data which he used to build a competitive team at the A’s with a limited budget.
 Using consensus revenue forecasts.
 We think this is a triple win – returns to shareholders, better capital efficiency and improved S-PVT / ESG.
 We have not included the pension deficit as, while there is a significant accounting liability this is not reflected in the cash flows of the business.