Theme and Background
This section discusses the persistent challenges and historic opportunities facing value investing strategies in the third quarter of 2019. The author notes that while the fund has achieved positive returns since its inception at the end of 2015, it has failed to outperform the market, with the international and Iberian portfolios declining 12% and 18%, respectively, from their mid-2018 highs. However, management firmly believes that the current market valuation dispersion has reached its widest level in 20 years, with cheap companies being overlooked, representing a historic opportunity.
Core Thesis
The author’s core investment argument is that the current period of value stocks underperforming growth stocks has set a historical record (the first 10-year underperformance in non-U.S. markets in 36 years), but the disconnect between company fundamentals and market valuations is unsustainable, and value investing will ultimately deliver excess returns. Counterintuitive judgments include: high-valuation companies are not low-risk but high-risk; passive investing and ESG trends have led to a market stratification into "castes," but this phenomenon will eventually reverse.
Key Arguments and Data
- Historical Comparison: Value indices have underperformed growth stocks for nearly nine years, the longest cycle since 1992 (the bursting of the 2000 dot-com bubble). After underperforming from 1992 to 2000, value indices delivered annualized returns 8% higher than growth stocks over the subsequent decade, with cumulative returns 2.1 times higher.
- Non-U.S. Markets: MSCI EAFE (Europe and Asia developed markets) data shows that since 2011, this is the first time in 36 years that value stocks have underperformed growth stocks over a 10-year period, with the gap continuing to widen.
- Valuation Dispersion: The valuation gap between the most expensive and cheapest companies is the widest in 20 years. Reasons include the surge in passive investing, ESG trends, and insufficient returns from fixed income.
- Historical Return Decomposition: Since 1870, nominal returns of large U.S. companies have been almost entirely explained by dividends, real earnings growth, and inflation, with the price-to-earnings multiple remaining largely unchanged over the long term.
- Risks of High-Valuation Companies: The report lists several companies that experienced single-day plunges due to events such as earnings warnings, including GrubHub and Beyond Meat, with the common characteristic being "absurdly high" valuations. Additionally, numerous companies (e.g., Kraft Heinz, Netflix, Altria) have fallen 20%-50% from recent highs.
- Market Cap Ranking Changes: The ranking of the world’s most valuable companies changes significantly every decade. Between 1982 and 2017, the top 10 companies delivered an annualized return of approximately -4%.
| Indicator |
Data |
| Duration of value underperformance vs. growth |
Nearly 9 years (longest since 1992) |
| Annualized excess return of value over the 10 years after 1992-2000 underperformance |
+8% |
| First 10-year value underperformance in non-U.S. markets |
In 36 years |
| Degree of valuation dispersion |
Widest in 20 years |
| Examples of single-day declines in high-valuation companies |
GrubHub, Beyond Meat, etc. |
| Annualized return of top 10 global companies by market cap (1982-2017) |
Approximately -4% |
Companies/Assets Involved
- Azvalor Fund: The international and Iberian portfolios have declined 12% and 18%, respectively, from mid-2018 highs, but the author believes they have strong upside potential.
- High-Valuation Companies (Bearish): The report lists Kraft Heinz, L’Brands, Tapestry, Arista Networks, Under Armour, Twitter, Walgreens Boots, Capri Holdings, Altria, Hasbro, Netflix, Conagra, 3M, Molson Coors, Public Storage, Ball, Glanbia, Bunzl, Interpump, Evotec, Colruyt, Ubisoft, CHR Hansen, Anheuser Busch, Schibsted, Demant, Thales, Lagardere, all of which have fallen 20%-50% from recent highs.
- FANGMAN (Facebook, Amazon, Netflix, Google, Microsoft, Apple, Nvidia): The author warns that these companies are being pushed to dangerous valuation levels by passive investing and feedback loops, with historical probabilities suggesting that the highest-market-cap companies tend to underperform over the next 5-10 years.
- National Oilwell Varco (Bullish): One of the author’s investments, which rose 14% on the same day GrubHub and Beyond Meat plunged.
- Historical Case: The "Nifty Fifty" stocks of the 1970s, including Digital Equipment, Eastman Kodak, and Polaroid, most of which performed poorly over the subsequent decade, with nearly half going bankrupt or disappearing.
Investment Implications
- Avoid High-Valuation "Safe" Companies: The author argues that seemingly stable, low-volatility, high-dividend companies (such as FANGMAN) are "dangerous mirages" at extreme valuations, and once earnings fall short of expectations, they may face violent corrections.
- Contrarian Positioning in Cheap Companies: Currently overlooked cheap companies (such as National Oilwell Varco) have significant upside potential, and the disconnect between fundamentals and valuations is unsustainable.
- Beware of the Passive Investing Trap: Passive management has led to massive capital inflows into a few high-valuation companies, creating a feedback loop, but history shows that top-ranked companies by market cap deliver negative long-term returns.
- Adhere to Value Investing: Despite current underperformance, historical data (e.g., the 8% annualized excess return over the 10 years following the 1992-2000 underperformance) suggests that value investing will ultimately deliver excess returns.
Theme and Background
This chapter focuses on the persistent disconnect between the improving fundamentals of companies in the Azvalor portfolio and their severely lagging stock performance. The report notes that while overall market valuations are at historical highs, the assets held by the institution remain cheaply valued, and this divergence has further intensified over the past few quarters.
Core Thesis
The author's core investment thesis is that the market is currently turning a blind eye to the improvement in fundamentals for most companies in the portfolio. This massive gap between valuation and fundamentals is unsustainable and represents a clear investment opportunity. The counterintuitive judgment lies in the fact that the recession or trade war risks widely feared by the market are, in the author's view, largely priced in by the current extremely pessimistic valuations. What truly determines long-term returns is the structural contraction in supply, not short-term demand fluctuations.
Key Arguments and Data
The report uses specific data from multiple industries to demonstrate the divergence between improving fundamentals and falling stock prices:
- Uranium: The number of long-term contract negotiations has recovered to the highest level since the Fukushima nuclear accident in 2011. Cameco is negotiating with Chinese utility companies for the first time (which traditionally only purchased from the spot market or their own domestic mines). Prices for services and intermediate products in the uranium fuel value chain are steadily recovering, typically foreshadowing a subsequent rise in metal prices.
- Oil & Gas: Investment in U.S. shale oil has notably slowed, but the market appears to be ignoring this. In recent years, shale oil has met 100% of global demand growth and compensated for sharp production declines in countries like Iran, Venezuela, and Mexico. However, hundreds of billions of dollars in U.S. investment have led to five consecutive years of significant investment cuts in other oil-producing regions.
- Oil Drilling Rigs: The industry is seeing, for the first time, improvements in contract prices, contract durations, and overall fleet utilization. Customer demand has also grown to levels not seen in years. Yet, the sector fell by an average of 50% in 2019.
- Coal: International coal prices have rebounded 22% from their lows in the second quarter of 2019. Global supply is reacting to low prices, with production cuts and losses occurring even in low-cost regions like Colombia and Indonesia. U.S. supply adjustments continue, with production cuts, investment reductions, and bankruptcies. Despite strong growth in natural gas (coal's main competitor) production, depressed natural gas prices are causing financial difficulties for companies and triggering significant investment cuts. Nevertheless, Consol's stock price has fallen to historic lows.
- Shipping: The tanker sector has experienced an explosion after years of low freight rates, with rates reaching all-time highs on certain days. Although some investment targets have seen significant stock price increases, the author believes there is still upside potential. Stock prices of other shipping companies (LPG, chemicals, bulkers) have barely rebounded, and their potential remains largely intact.
Comparative Data Summary:
| Industry |
Signal of Fundamental Improvement |
Stock Performance |
| Uranium |
Long-term contract negotiations recover to 2011 levels; Cameco negotiates with Chinese clients |
Specific gains not mentioned, but implies underperformance |
| Oil Drilling Rigs |
Contract prices, durations, and utilization improve; customer demand grows |
Averaged a 50% decline in 2019 |
| Coal |
International prices rebound 22%; global supply contracts |
Consol's stock price falls to historic lows |
| Shipping (Tankers) |
Freight rates hit all-time highs |
Some targets rise sharply, but other sub-sectors do not rebound |
Companies/Assets Involved
- Cameco: A global leader in uranium. The report mentions the company's historic negotiations with Chinese utility companies as key evidence of improving uranium fundamentals. Bullish.
- Consol Energy: A U.S. coal company. Despite the rebound in international coal prices and industry supply contraction, its stock price has fallen to historic lows. Bullish (believes the market is overly pessimistic).
- Donald Smith & Co: Legendary value investor Donald Smith recently passed away. The report mentions Richard Greenberg taking over as Chief Investment Officer and emphasizes the continuity of the institution's management quality. Azvalor has investments in funds managed by this institution (the fund has 321 co-investors and assets over €20 million). Bullish.
Investment Implications
- Hold Firmly and Add to Positions: The report implies that the market's current disregard for improving fundamentals is a signal to strengthen investment conviction. Investors should use market pessimism to increase allocations to cyclical sectors like uranium, oil & gas, coal, and shipping when valuations are extremely cheap.
- Focus on the Supply Side: Investment analysis should prioritize long-term structural supply contraction (e.g., slowing shale oil investment, global coal production cuts) over short-term demand fluctuations. Supply constraints will ultimately drive price and profitability recoveries.
- Beware of Market Consensus: The widely feared recession risk may already be fully priced in. The real risk is long-term supply shortages, not short-term demand declines. Investors should act against market consensus.