Bottom-up stock selectionour approach and experience

Giovanni Govi, CFA 4th July, 2013

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Myself

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Economics Degree, Turin Univ. 7/1988;

MBA Columbia Business School, NYC, 5/1994;

CFA 9/1997

1994-2000 Goldman Sachs, equity analyst

2000 Gabelli & Co, portfolio manager,

2001-2013 co-founded Theorema Asset Management Limited, (currently CIO)

Lived in Italy, Paris, New York and London

Theorema AM

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Long/Short European Equity Manager

Philosophy: focus on bottom-up company valuation and/or catalyst that alter that valuation;

Identify Opportunities: based on stocks selling at a discount to historic valuation, intrinsic value orfranchise value;

Initiate Positions: from toe-hold to maximum position size based on timing, risk/return analysis,relative attractiveness and diversification; add technical factors to optimize entrypoint.

Position Management: change position size based on value reassessment and technical factors;

Sell Discipline: use fundamentals to set expectations for future exit, add technical factors tooptimize exit point.

How do we want to invest

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1. Bottom-up value plus catalyst;

2. Look back at history but be sceptical looking forward;

3. Know where you are in the cycle (don’t forget some top-down);

4. Be Contrarian/Innovative, Patient/Disciplined and Unconstrained in Risk Taking.

1./a Bottom-up value plus catalyst

Central assumption: the price we pay for an investment determines likely return (an asset can be agood investment at one price but not at another);

We try to assess what is fair value (FV) of an asset and buy only if P<FV with a good margin of safety;

Value for us not low P/E, low P/B (does it work?);

Asset can have many values: look at many of them and try to exploit inefficiencies

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1./b Bottom-up value plus catalyst

Relative subsequent EPS growth in highest, high, low and lowest quintiles of E/P ratio

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1./b Bottom-up value plus catalyst

Fair Market Value: “cash price at which the assets would change hands between a willing buyer anda willing seller if the assets were offered for sale on the open market for reasonable period of timewith both buyer and seller being apprised of the relevant facts and neither being under anycompulsion to act”;

Investment Value (or Franchise Value): value of that asset to a specific buyer

Value & Catalyst for us: “you have to be able to see an important factor that (most) other peopledon’t see but…it’s not enough if it does not make a difference in the way the company is valued…You have to see a moment where these mechanics begin to impact (+ or -) the P/L & B/S…”(catalyst);

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1./c Bottom-up value plus catalyst

Finance (Market Value) Balance sheet

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DCF/ Earnings-based Valuation

plus

B/S Value Adjustment

Current Non-Interest Bearing

Assets Current Liabilities

Debt

PPE

Firm Value

Intangible Assets

Equity

Going-Concern Value

1./d Valuation Methods

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1./e Accounting & Other Issues

Some accounting items to look at indetail:

1. Accrual rate

2. One-time items

3. Depreciation rate

4. Pension Plan gains

5. Bad debt allowances & expenses

6. Inventory adjustments

7. Earnings vs cash flow

8. Tax rate

9. Intangibles and their amortization

10. Mark-to-market of Property &Securities

Board composition & compensationcommittee

Management incentive system

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Common problems:

1. Overstatement of Revenues

2. Understatement of Expenses

3. Reported EPS flattered

More/less likelihood of fraud

Examples 1: Asset-rich companies (overemphasis on P&L)

Industrial companies vs mixed asset owners

The US-style wave of 2005-07 in the UK : Selfridges, De Vere Hotels, Intercontinental Hotels,Somerfield, Mitchells & Butlers;

Some Italian cases (patience required): INA, Impregilo;

Earnings downgrades vs B/S value: Statoil Fuel & Retail

Replacement value: AKER drilling

France, mixed so far: Accor, Carrefour, Club Med

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Examples 1a: Impregilo, the value of a catalyst

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Examples 1b: AKER Drilling, asset replacement story

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Examples 1c: Statoil FR, EPS downgrades & B/S value

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Examples 2: Asset-poor companies (overemphasis on P&L)

The UK disasters of 2007-09: Royal Bank of Scotland, Lloyds/HBOS;

Some Italian cases: the smaller banks (are they cheap?)

Problematic businesses and B/S : Imtech

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Examples 2a: RBS Numbers in 2007

“RBS chief attraction is its valuation, its earning multiple is the lowest of any large bank. We retainour BUY rating”. Sell-side Analyst X

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ASSETS LIABILITIES AND SE

Loans 1,148 Interbank 313

Other assets 705 Customer Deposits 682

Intangibles 48 Debt 274

Other 541

Total Liabilities 1,810

Minorities 38

Shareholders Equity 53

Total Assets 1,901 Total Liabilities and SE 1,901

PROFIT & LOSS STATEMENT MKT CAP 45.3

NII 12.7 P/BOOK 0.9

Non II 18.4 P/TE 9.1

Expenses -14.1 P/E 6.2

Ins. Claims -4.8

Impairment -2.1

PBT 9.9

Net Income 7.3

ROA 0.38%

ROE 13.8%

Examples 2b: IMTECH

2010-11 Cash flow generation not matching growth in IC. Payablesdecrease, growth in unbillable receivables

2011 Total receivables continued increasing, margins fall;

10/7/12 “Who’s afraid of working capital? BUY”; Broker Y

29/10/12 IM takes EUR50m restructuring charge;

30/10/12 “IM is tackling weaker markets more radically”; Broker x

4/02/2013 IM takes EUR100m write down and E200m adjustment in thecash position. Investigation into accounting improprieties;

5/02/2013 “We downgrade to hold, pending more clarity”; Broker x

23/04/2013 IM has had a difficult Q1 and announces further charges,delays publication of accounts.

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Examples 2b: IMTECH

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2. Look back at history but be sceptical looking forward/ 1

JK Galbraith: “ The markets are characterized by extreme brevity of financial memory. Financialdisaster is quickly forgotten. In further consequence, when the same or closely similarcircumstances occur again, sometimes in a few years, they are hailed by a new often youthful andalways supremely self-confident generation as a brilliantly innovative discovery in the financialworld. There can be few fields of human endeavor in which history counts for so little as in theworld of finance”

Do you think we will learn anything from this turmoil? Jeremy Grantham: “We will learn anenormous amount in the very short term, quite a bit in the medium term and absolutely nothing inthe long term”.

Exemple: the Kindleberger/Minsky framework for analyzing bubbles: Desplacement->CreditCreation->Euphoria->Critical Stage/Financial Distress-> Revulsion

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2. Look back at history but be sceptical looking forward/ 2

Looking forward, 2 points:

1. In terms of predictive power, past tells uslittle about the future

2. However, it is not easy to be moreaccurate than consensus (“the wisdom ofcrowds”)

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2. Look back at history but be sceptical looking forward/ 3

The collective is smarter than the average person within the collective

Collective error is determined in part by ability and in part by diversity

The collective is usually better than even the best of individuals

Conditions for working: diversity of agents, good aggregation mechanism, presence of incentives,sufficient time

If one condition violated breakdown in market efficiency

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2. Examples of break down: extrapolation in earnings

Miners

TF1

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3. Know where you are in the cycle

For bottom-up investors, ignoring top-down can be extraordinarily expensive

Financial stocks in 2008

“Value investors place great faith in the principle of assessing value and then buying at a discount. Ifvalue is subject to considerable erosion, then how large a discount is sufficient?” (Seth Klarman);

“Values aren’t fixed they move to response in changes in the economic environment. Thus cyclicalconsiderations influence an asset’s current value. …. We want to buy when prices seem attractive. But ifinvestors are giddy and optimism rampant, we have to consider whether a better buying opportunitymightn’t come along later” (H.Mark).

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4. Contrarian/Innovative, Patient/Disciplined, Unconstrained in RiskTaking

Be Contrarian/Innovative: ”It is impossible to produce superior performance unless you dosomething different from the majority”; (sir Templeton)

Be Patient (be able to wait for the right opportunity but also but also for give it some time to work);

Maintain a disciplined process

Keep the personal fortitude to endure periods of underperformance; be supportive of that within theorganization (or contribute to);

Constantly reassess quality of the decisions;

Avoid Bayesian Rigidity: re-evaluate with new information;

Avoid Price-target revisionism and seek contrarian views;

Respect Mr.Market with some basic technical analysis ;

Be unconstrained in risk taking: no bias to action, no need to be fully invested all the time. Go forexceptional exposures and concentration

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4. Example of Technicals: ENRON

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Conclusion

Individual decisions can be badly thought through, and yet be successful, or exceedingly well thoughtthrough, but be unsuccessful, because the recognized possibility of failure in fact occurs. But overtime, more thoughtful decision making will lead to better results, and more thoughtful decisionmaking can be encouraged by evaluating decisions on how well they were made rather than onoutcome.(Robert Rubin, Harvard Commencement Address, 2001)

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References

S4: James Montier, “Value Investing, tools and techniques for intelligent investment”, Wiley 2009;

S6: R. Haugen, “The New Finance, the case against efficient markets”, Prentice-Hall 1995; Chart is from Fuller, Huberts and Lennnson, “Return to E/PStrategies,Higgledy Piggledy Growth, Analyst’ Forcast Errors, and Omitted Risk Factors”, Journal of Portfolio Management, Winter 1993, Exhibit 6;

S7: R.Porrino, “Choosing the right valuation approach”, CFA Institute 2005;

S10: R. Gulliver, “An Analyst’s Perspective on Financial Reporting”, CFA Institute 2005

S16: UBS Research 2006;

S17: E. Klerk, A. Grobler, D. Rigby, I. Tsiokos, S. Tonnesen, “Imtech NV Equity Research”, April 2012;

S19: James Montier, “Value Investing, tools and techniques for intelligent investment”, Wiley 2009;

S20: R.Haugen, “The New Finance, the case against efficient markets”, Prentice-Hall 1995; Chart is from Lintner, J. and R. Glauber, “Higgledy Piggledy Growth inAmerica,” (Unpublished paper presented to the Seminar on the Analysis of Security Prices, May 1967), University of Chicago, Table 3, Part (e);

S20/21: M.J.Mauboussin, “The Wisdom and Whims of the Collective”, CFA Institute 2007;

S22/23: James Montier, “Value Investing, tools and techniques for intelligent investment”, Wiley 2009;

S24: M.L.Leibowitz, “Alpha Hunters and Beta Grazers”, CFA Institute 2005;

S25: J.Bollinger, “Combining Technical and Fundamental Analysis”, CFA Institute 2005;

S26: M.J.Mauboussin, “More than you know”, Columbia University press 2006;

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