Gradually, then suddenly
“Large amounts of money aren’t made by buying what everybody likes. They’re made by buying what everybody underestimates.” Howard Marks
One of the key parts of our investment process is that as well as trying to work out how undervalued a company’s share price might be, we also seek to identify why this mispricing might be occurring. In other words, we ask “what is the market missing?”
Identifying what the market is missing allows us to see the path to how the value gap might close, and therefore be more efficient by focusing analysis on the issues that really matter. Further, by categorising our investment targets by their stage in the company lifecycle (Growth, Quality, Recovery or Asset-backed), we have a head start as the key reason for mispricing within each category will typically have a common thread. So, within Growth or Quality, the market is likely to be mispricing the sustainability of growth and/or return on capital, in Recovery it’s probably missing the extent to which profits can return to prior levels. The trick to build conviction is to keep ‘burrowing down a level’ to understand the company-specific thing or things relating to this on which we can take a differentiated view. I touched on a few of these things in a prior post.
One item we have in our analytical or ‘burrowing’ toolbox is our consideration of sustainability, or ESG. As my colleague James Sym recently discussed, “we have developed a robust framework where we assess each company’s activity and behavioural impact on wider society through three pillars which are People, Innovation and Environment. The process covers the business model, the corporate behaviour, ESG risks and controversies, governance and where appropriate, engagement. Some managers’ approach to ESG is to screen out companies early on based on their business activities, sector or 3rd party ESG rating. Instead of this, as part of our fundamental analysis of each potential investment, we assign it to one of our own four sustainability tiers shown below.
River and Mercantile Sustainable-PVT (S-PVT) internal,4 tier scoring system
Source: River and Mercantile Asset Management LLP
“When considering the benefits of integrating sustainability credentials as part of our fundamental analysis, something of particular interest is how noticeable it is that large gains can be made – sometimes rapidly – from stocks within the S3 tier.”
When considering the benefits of integrating sustainability credentials as part of our fundamental analysis, something of particular interest is how noticeable it is that large gains can be made – sometimes rapidly – from stocks within the S3 tier. This happens when we can identify companies where improvements to the sub-par element(s) of ESG, potentially accelerated by targeted engagement from ourselves and other investors, are not yet being recognised by 3rd party ESG rating providers. The rating providers can be slow to react to the positive change taking place, or place undue emphasis on a single issue, leading to a rating which reflects past ‘sins’ rather than the path that the company is on today. There are a couple of likely reasons why this creates opportunity via a mismatch between buyers and sellers. Some investors may have screened the company out as a matter of process due to their low ratings, so as the rating eventually increases to reflect improvement the shares become ‘investable’ again for a wider set of investors. Alongside this more practical reason, behavioural factors which are more aligned with the traditional rationale for why the value factor has delivered positive alpha over the long term can play a role. Investors may have overestimated the scale of the issues or might not want to be seen to hold a ‘difficult’ stock from an ESG perspective. In this sense, we can therefore consider ESG as one of our potential reasons why a mispricing might occur.
On top of this, we’ve observed that these gains can be turbo-charged if the underlying business is revealed to have attractive sustainability characteristics (beyond the issue identified by ratings providers). To use some examples from our global portfolios, Chinese technology company Baidu and Korean auto parts provider Hyundai Mobis have risen ~200% and ~50% since their ESG ratings were upgraded by MSCI, in May and October 2020 respectively, from the lowest-possible CCC (Baidu has risen ~140% since last September alone, when it was upgraded another notch). In both cases, we had identified improvements being made in key areas of corporate governance which were dragging down the external perception of the companies, while the businesses themselves scored well under our framework regarding most areas of People, Innovation and Environment – particularly the latter two. Tying back to the Howard Marks quotation at the start, a perception of ‘weak ESG’ relating to a single (albeit important) issue had effectively caused investors to underestimate (and therefore misprice) the other strengths.
Recent share price performance has been supported by the realisation that both companies are well positioned to benefit from the growth in electric vehicle (EV) usage and autonomous driving growth. Baidu has formed a joint venture with Chinese auto manufacturer Geely to monetise its leading technology IP in the space, alongside existing monetisation opportunities around their Apollo system for intelligent driving and smart transportation (autonomous / connected vehicles). Hyundai Mobis, meanwhile, has the potential to gain share outside their ‘captive’ market of the Korean auto manufacturers due to strong product positioning in power modules (inverters and traction motors), onboard charging units and the assembly of the battery system. Like Baidu, they also have strong IP in autonomous driving / connected vehicles, so should benefit from long-term structural growth here.
Other holdings, such as Japanese logistics and auto parts company Toyota Industries, continue to be overly penalised (in our view) for elements within the pillars of sustainability which are below best practice but improving. Its current B rating from MSCI (one level above the lowest) doesn’t account for improvements to board structure. We think this could be a reason investors are missing the opportunity to buy the market leader in electrified forklifts (including leading fuel-cell technology) and warehouse automation software for barely more than the value of the company’s net cash and investments.
In Ernest Hemingway’s novel ‘The Sun Also Rises’, a character called Mike is asked how he went bankrupt. “Two ways,” he answers. “Gradually, then suddenly.” We think we’re witnessing the reverse in companies with strong underlying ESG characteristics, where a rectifiable issue is currently clouding the market’s view, often through the lens of a poor ESG research provider rating. By doing our own research and forming our own judgements, allocating our S-PVT tier and identifying the areas for and path to improvement, we can build confidence that we’ve unearthed a genuine mispricing. If these clouds dissipate in the way we expect, we’ve seen from the Baidu and Hyundai Mobis examples that share prices can rise gradually, then suddenly.
 I will use the two terms interchangeably in this note.
 As with the bond rating agencies S&P and Moody’s, there are now ESG ratings agencies such as MSCI and Sustainalytics.
 An interesting note is that the level of innovation at Hyundai Mobis is marked down by MSCI but we believe they aren’t comparing “apples with apples” – they compare R&D as a % of group sales versus peers, however this unfairly penalises Mobis, which has some 25% of sales from high margin after-sale servicing. This is an attractive, niche feature (typically the car manufacturer takes the servicing revenues) which is not capital intensive in the form of requiring high upfront R&D.
 In addition, like Hyundai Mobis, growth in EVs will allow Toyota Industries to expand share beyond their current ‘captive’ customers (the Toyota Motor Corp parent company) due to market leadership in electric compressors which previously had the sole use of air conditioning, but are now required in a much greater scale to cool batteries.
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