UK’s Deep Value Investing guru: Bank shares today like commodities in 2015.

Nick Kirrage, the value investing flagbearer at the UK’s biggest asset management company Schroders, is buying banking shares by the bucketload. Because for this shrewd contrarian, the opportunity they offer is just like the one he seized 18 months ago when buying bombed-out commodities shares before their exponential rebound. Kirrage, co-manager of the hugely successful Schroders Global Recovery Fund (31% return in past year), is one of the biggest money managing names in the City of London. This in-depth interview explores what makes him so different and why he is once again delighted to be scraping the bottom of the ratings barrel – and why his rivals rarely care to look there. – Alec Hogg

Nick Kirrage

Nick Kirrage is smart, articulate, and quick-witted but mostly he’s a contrarian being the deep value flagbearer at Schroders, the UK’s biggest asset management firm, he’s also a popular drawcard in the city of London. He co-manages the hugely successful Schroders Recovery Fund, a portfolio which specialises in digging around the bottom of the stock market’s fashion table. Its recent performance has been stellar, with a 31% growth over the past year boosted by his prescient call on the commodity sector in stocks like Anglo American, a five-bagger in just 18-months. In what follows we enjoy a rare insight into what makes this contrarian, investment manager tick? How he picks losers that become tomorrow’s winners, and why he is as besotted with banking stocks right now as he used to be with commodity shares. The interview kicks off with Kirrage’s unusual background. He qualified as an aeronautical engineer before doing a CFA and switching to finance.  

Having a background that is quite mathematical, quite engineering driven – I like things that I can prove. The fundamentals of engineering are everything is based on a sound understanding of building blocks, this works, then this works, then this will work and the plane will fly. I think when it comes to investment we like to, fund managers love to emphasise the art part of what we do. It’s serendipitous and idea generation comes to me and I do it on my morning jog or I have a set newspapers I read and how it all comes to me. But actually, we don’t focus enough on the science and for me that’s what first drew me to value investing is it’s something on which you can look back and say ‘this has worked over more than 100 years in equity markets and not only has this worked because as we know, back tests of various strategies have frequently come a cropper and caused some of the great blow-ups in investment markets over the last 50 years.

But why this works and it works for a very simple reason because deep value strategies, low valuation is based on exploiting human emotion. Exploiting fear and uncertainty and that uncertainty, that fear, is something that’s ever present. It doesn’t matter what the microenvironment is. It doesn’t really matter what the GDP is doing or FX rates are doing or whether in a bull-market or a bear-market. Humans will behave as humans. They’re the constant, the consistent bit about all markets. Being a value investor just says ‘I’m going to exploit that for my clients because that’s the one bit I can be reassured repeats over time.’ Having that aeronautical engineering background I like being able to base my entire philosophy on something where I understand why it works and believe it will work over the next 30-years.

Applying rationality and to take advantage.

Yes absolutely, there’s so much emotion in what we do and there are so many artificial constructs. Theories about the way markets should work. This should happen. We should appraise the utility of investments this way but the truth is that you throw humans into the mix and you get emotion. You lose that objectivity. You lose that rationality, over quite long periods of time actually, and that’s something that if you are rigorous enough and do it in a repeatable and structured way. I’m not an automaton. I’m emotional like everyone else. I’m just more aware of my emotions and what they’re doing to me, and my judgements and I give myself and the team I work in, we give ourselves every chance to try and get around, or see through those emotions to make more rational judgements. If we can just be a bit more rational than the market, it doesn’t have to be dramatic. We don’t all have to be Spock but if we can just be a bit more rational, it’s incredible the value you can generate for clients.

Not Spock but Charlie Munger.

Yes perhaps, I think one of these things is if you’ve been in the market long enough there’s that element of experience where you can kind of say ‘well I felt this way before.’ ‘I know myself slightly better but the stock market is always giving you something a bit different. It’s never quite the same. That old adage ‘history doesn’t repeat but it does rhyme.’ So, there’s an element here of the more you know yourself the more experience you have in the stock market, the better you can perhaps implement a value philosophy. I do believe that and I believe you get better at things like portfolio construction but in the end it does come down to a fundamental tenant about whether or not you’re going to stick with the approach. What I frequently find is with any approach, whether it’s value investing, growth investing, or whatever it might be, people are happy to stick with it when it’s doing well. When it goes wrong for a period of time, or is out of favour, you quite quickly find out whether or not people genuinely believe in what they do and have the ability to stick with it.

Lots of people say they’re value investors. We know that isn’t really the case. Your presentation that you gave a couple of weeks ago you suggested that 89% of people who manage money are more growth than value.

Yes, I think value investing has become a very broad church in the last 10 to 15 years. Even someone like a Warren Buffett, if you look at his approach. He’s moved away from his original teacher, Ben Graham, who’s a very different investor to the Warren Buffett of today and it’s not right or wrong, it’s just you see that evolution. We’re very clear about the kind of value investor we are. We are the Ben Graham, the cheapest 20% of the market, the people who are looking for that fear.

So you wouldn’t buy Apple for instance?

We look closely at that business and I think it’s not that we wouldn’t buy a certain type of business. In the time I’ve been doing this, the 15-years I’ve been doing it, we bought everything from banks to newspaper companies at the very acute end of structural change. To business I think they are great businesses, we have owned Staples and Tobaccos at different points in the last 15-years. Just not today because I would perceive them to be very expensive. So actually, the nature of human psychology is, is that even great companies fall into the cheapest bucket over time. You’ve just got to be a lot more patient than the average person today and if there was one thing I think is executive markets, all investment markets more than any other trend in the last 15-years, is peoples’ short-termism. The lack of tolerance of volatility of any sort and peoples’ time horizons for… Even if you’ve got a 20-year horizon people stare at one-year numbers intently and just don’t want to see the drawdown. That has made it very difficult to be a long-term value investor.

Getting back to Buffett. Apple was cheap but it wasn’t that cheap, so that’s now his second biggest stock. Would that have come onto your radar?

Warren Buffett

When it comes down to it the way that we think about cheapness is we use the screen because the screen, thinking about average profits, a cape or an average enterprise value to operate in profit. Whatever you construct it’s just looking to try and get at that bit I talked about, the human emotion, and where is the fear? Typically, it doesn’t matter what screen you use it highlights companies that you would have probably picked yourself as a contrarian and said, “Well I know banks are out of favour. I know commodities are out of favour,” and funnily enough they all crop up on the screen.

Apple was one that for a while did crop up on the screen but the question is we’re trying to look forward and not back. I’m heavily influenced by history as a guide to the future. I believe that whilst it always feels like it’s going to be different this time – 95% of the time it isn’t. The question is when I look back and I try and work out what to do, Apples’ historic profits guide me as to what they should make in the future? Then you are left with a very difficult choice, which is Apple makes demonstrably higher margins doing what it does than almost any other consumer electronics business in the entire world. Is that sustainable? Bulls would argue yes, because of the software sales, because of iTunes, because of lots of things because it’s a wonderful brand. It’s almost a luxury good. Bears might say well, Sony has got a wonderful brand. It’s one of the great consumer electronics companies in the world and has been struggling for decades to make the same profit margin. Wherein between those two shall I come out and which kind of view you take makes a difference whether you think it’s a big value stock or a growth darling that’s going to end in tears.

You’ve stuck with this policy, this bottom 20%, the bottom feeders as it were, and it has worked out. Did you fall into it? Did you do some back-testing to say that cyclically adjusted PE stocks that are right at the bottom-end are the ones that you should be investing in long-term?

Yes, there is an traversable weight or wave of evidence that suggests the fact that cheap companies, almost however you choose to describe that, outperform over time. So, whether you might use a high yield or a high dividend yield as a marker or a low price to book, a low PE. We prefer low cyclically adjusted profits, (capes), because we think that in any one year profits can swing around. If you think about the economic scenario over the last 10-years we’ve had fantastic bull environments for companies. We’ve had awful bear environments and trying to work out what to buy based on any one-year’s profits within that seems, to us, a bit of a hiding to nothing. So, we think that using a cyclically adjusted or average profits, over an economic cycle as a more sensible way to start.

But as I say, in the end, irrespective of what valuation metric you pick or how frequently the screen does, it just keeps you honest because with a blank piece of paper very few people or very few, even if they’re rational and objective, very few people come in the morning and go ‘do you want to really know what I want to do today, is I want to fish through 500 pages of Royal Bank of Scotland reporting accounts. I’d like to get up to my knees in what’s going on in Kumba Iron Ore, a subsidiary in Anglo American. Those are areas where there’s a lot of uncertainty, a lot of distrust, a lot of bad things are going on that needs to be sorted out. People tend to naturally move towards things that they’d prefer too, well it’s just less hard to go and look at a Staples company or a Tobacco company.

A worker walks past a board outside Anglo American offices in Johannesburg. REUTERS/Siphiwe Sibeko

So, the screen is about keeping us honest and making sure that we fish in a pond that statistically outperforms. Even if my stock picking turns out to be bad and hopefully that won’t be the case and the evidence suggests we have been able to add value over the screen. But even if I turned out to be a terrible stock picker, just by continually fishing in that pond I’m going to outperform for my clients and that is being able to underpin that in that way is a very important part of making sure we do our job.

Typically how long would you hold the stock for?

Well, I think averages are instructive but it is somewhat ‘your feet in the freezer and your head in the oven’ and your average temperature is great. On average, we hold stocks for around 5 years. Some of those will be a year, others will be 7, 8, or 9. If we’re holding them for 7, 8, or 9 it’s probably fair to say we’ve made a mistake at some point and been far too early. But we average out at about 5 years. That 20% turnover hasn’t changed in a very long period of time, and is that right or is that wrong? We ask ourselves that question the whole time and we’re trying to look back over history and say; should we be more brutal in cutting stock sooner and reducing our holding periods? Or in fact, be holding for longer periods? I think it’s not crazy that it averages out at about the length of an economic cycle. Companies have a cycle of recovery, of improving, of coming out of that doghouse, that fearful section and 5 years feels about right.

My point there is when you compare performance of various funds what would an ideal time be for you because if you were to buy early and ride through the full cycle, presumably that would give you a, and sometimes it would b, some would say 3 years is a good time but if you’re prepared to hold the stock for 8 or even 10 years, maybe that’s the cycle.

It’s hard to look back and say that value has a particular bias, a pro-cyclical bias or whatever it might be. Just when you think you’ve worked out the pattern of when this will outperform it comes and bites you. For a long time value was very defensive. It outperformed in falling markets because you had the cheapest part of the market and if you look back to 2009, that was completely reversed and value did the worst. So, it’s hard to second-guess it. What I would say is that the drivers behind why this is typically outperforming over rolling 5-year periods, it’s that human nature, that human psychology that companies grasp the nettle and improve over time. They’re not an inevitable path to destruction or disappointment. They change, managements change, businesses change, they invest, they cut costs and so forth, their dynamic.

I think the right time period to judge is probably rolling into about 5-year time periods. Having said that, the last 5-years for value as a whole have been pretty awful, barring the last 6 months. I think that’s what’s really spooked people is if you look over longer time periods, 5 to 10 year time periods, value has always been good and we have just gone through a period where the last 5 to 10 years globally, value has been about as bad as it’s been in many decades and that’s really scared people and you started to see that death of value headlines.

But the last 6 months have been better. Are you seeing a change in the trend and if so, how long might it last?

It would be nice to think that this was the beginning of something more long lived. You can’t ever say that. The market has a way of making you look very foolish when you predict these things but I’ll come back to something I said at the beginning of the interview, which is I believe very strongly in mean reversion and when you think about value and growth. To me, they’re two-sides of the same coin. They’re both strategies of perhaps growth, momentum is what I mean. If you think about those, they both have their days in the sun and over a long period of time, we’re talking 50-years, you can see that performance of value and how it does versus growth. If you look at where we are today in the context of the last 50-years, we’re at an enormous, despite the last 6-months, positive performance of value. We’re at an almost unprecedented level of discount, in other words value has under-performed as much today as it has, for example, in the tech bubble.

So, when I think about today’s starting point. I don’t know whether or not the last 6-months all goes well for the next 12 months but when I think about the next 10 years. I feel very reassured as a value investor that it’s more likely than not that we would expect a better environment than a worse environment. It doesn’t mean we’ll get it but it would be unprecedented for us to experience the kind of head win to the last 10-years again for the next 10-years. When I speak to my clients what I’m trying to say is with so much of the markets having moved towards growth investment. As you talked about earlier, I presented a slide recently showing that 90% of managers in Europe were more tilted towards a growth year or into strategy. That is also a reflection of everyone having moved where things have been good and perhaps we should be looking back towards value, as the opportunity for the next 10 years, despite having been the laggard for the last 10.

But despite being on the backfoot from the broad trends. Your Schroders Recovery Fund has done incredibly well, looking through the time periods any time up until the last 10 years. You’re in the top quarter, so the top 25% of funds. Outperforming, no doubt, the passive funds. Do you feel that reinforces this view of yours that even if you are buying in bad times as long as you’re patient the deep value argument holds?

Yes, I think this is why, and we’re going to be seeing a lot more of this over the next 5 to 10 years, with the rise of smart beta products, factor funds. We’re going to be forced, as value investors. I believe value will have its day in the sun but then the battle will be why should I pay-up a reasonable fee for your fund when I can go and buy the value factor elsewhere? That’s where we’re going to be leaning pretty heavily on the last 10 years’ worth of outperformance of the fund and say even in an environment where this has struggled, it’s been the fund manager, the stock selection, that’s allowed us to outperform, even in a head-wind environment. I think it’s also about being able to see the wood for the trees, so some of the great calls or some of the more strongly performing calls that we’ve made over the last 10 years, are things the screen highlights likes the banks are cheap in 2009 because suddenly banks had a really tough time. The crisis begins and the screen says ‘well, the average profits for the last 10 years are pretty good.’ If they can do that, going forward, but the fund manager, the analysis, the detailed stock work, that going through the account says ‘that’s crazy – that’s not possible. That’s been driven up by leverage and that’s unsustainable, so we need things a lot cheaper.

Commodity is a sector that we owned zero weight in the UK and that was nearly 15% of the Index, at the peak. We owned zero percent between 2008 and 2014, 6 years when we didn’t hold a stock and it got cheaper and cheaper but our view was that actually we needed to think about commodity prices in the context of 20 year cycles and real terms. The super cycle dream was totally illusory if you look back over 150 years. Once you put it in that kind of context suddenly we’re able to wait a much longer period of time to buy the stock, so it’s those kind of decisions that are crucial to us generating value, over and above, simply our factor.

You mentioned commodity shares, and from a South African context, you’ve got quite a few in your portfolio that you’ve highlighted, ArcelorMittal South Africa, Anglo American of course, Lonmin, Impala, South32 but I did see that you were lightening those holdings.

Yes, having said we didn’t hold a stock between 2008 and 2014, the truth is I didn’t make any money for my unit holders doing now. You look at a clever benchmark relative but nobody eats benchmark relative returns. You only make money by buying stock, so at some point if you want to make money and things are getting cheaper you have to actually commit some capital. That’s what we did in 2014 and 2015. Yes, we saw a real capitulation, particular in the back-half of 2015, and we started buying into a number of companies that were looking in pretty desperate states at those times, so things like Lonmin, Anglo American, ArcelorMittal South Africa, and so on and so forth. Our view was that a number of those businesses were seeing very challenging times. That wasn’t up for debate but our view was that in several instances they were getting new capital that would allow them to weather 2 or 3 years’ worth of horrific commodity price environment. But that on average, commodity prices were going to stabilise at a level of about the average of the last 20 years, and that being the case, you had some very cheap stocks here. So we committed intensive amounts of capital, 2% positions – 1% position, 3% positions in perhaps the bigger stocks.

We’ve seen many of those stocks have gone on to double, triple, quadruple, I mean in Anglo American’s case, in UK terms it was about £2.70 and now it’s £15, so those stocks have gone up a very long way and this is not the same equation, in terms of value today as it was. So, we are cutting those back. Somebody would think they’re suddenly a terrible businesses. It’s just that everyone else has suddenly decided that they’re good investments, just as all the margin of safety, the share price versus their real value, is reducing. We take the opposite view. We would as contrarians, wouldn’t we?

So, I think it’s about having commensurate risk versus reward or be it commodities have been very challenging for us, not because it’s been difficult to buy them. That’s what we do. The difficult thing has been we’ve had to buy and sell them within a period of 18 months, which is not our MO. On average we hold stocks for 5-years and that portfolio construction is something that we’ve learned over a period of time. Where these stocks are getting much bigger shares, they’re doubling or quadrupling over very short periods of time. You can’t sit back on your hands and just say ‘oh it’s fine – Anglo is now 8% of the portfolio.’ It’s not fine, those are incredibly risky positions, so you do have to manage the fund more actively.

You’ve also gone very big into banks, the Royal Bank of Scotland being an example. Citibank, which is an interesting play, given that Warren Buffett also has a big position there as well, and Barclays. Take us through the thinking there?

I think there’s a top down and there’s a bottom-up approach here, and they both end at the same place and I think that’s very reassuring. The bottom-up is that these stocks will bank screen globally, is the cheapest sector in the world, pretty much, some cheaper than others. Europe is cheaper than the US, for example, but broadly this is the cheapest sector in the world. When we go and do the bottom-up work on the balance sheets and the business models and the divisions, and the net interest margins, and what they’ve been doing. It’s amazing how much has gone on. I think many people still think of banks, there’s a slightly jaded opinion of these businesses, as if it were 2009, at best it’s apathy and at worst there’s that hidden fear that it’s all going to happen again. I think actually, these businesses have changed massively. If you look at the amounts of regulatory capital that’s within them. The costs have been stripped out with the retrenchment that’s gone on.

Employees leave Royal Bank of Scotland Group Plc offices in London, U.K. Photographer: Luke MacGregor/Bloomberg

Some of these companies, you mentioned Royal Bank there. I mean Royal Bank was one of the biggest investment banks in the world and today it has almost no investment bank. Literally £10m to £20m worth of risk rate – for all intents and purposes there’s no investment bank. It’s a radically different business and I think people need to go and do that work and bottom-up, when we look at it, we think these are businesses that are very cheap. But have also, much higher levels of capital than people perceive, so they’re much less risky actually.

Now that’s interesting because I would perceive there as being a 10.000ft view as well, the top-down view, which is the last 7 or 8 years, since the crisis, have turned out to be much better for equity markets than pretty much anyone probably would have thought and sat there in March 2009. Many businesses have exploited that. The environment has been quite good. They’ve started issuing lots of debt again. They’ve gone back to the races, buy-backs are at all-time highs. There’s almost no sector, other than global banking, that has been continuously de-risking since the last crisis. Not altruistically but because of the regulator forcing the boot to the throat saying ‘raise capital, de-risk, get rid of toxic loans, de-risk, raise capital, raise capital, take fines, take over and… These are some of the most robust businesses now, I believe in the world, and yet they trade at valuations that still reflect the last crisis. We always fight the last battle as investors.

Now, what does all that mean? Well, all of that means to us is that when we do the bottom-up and the top-down, this probably should represent one of the biggest positions in our portfolio. And for our global fund we have 7 or 8 different banks. We spread our risk around. We diversify, not in one stock. You mentioned Citigroup, you mentioned Barclays but we also have positions in ING, we have positions in HSBC, we have positions in UniCredit and Intesa Sanpaolo, to the more risky European banks but we have 1% or 2% type positions. Those are the kind of stocks that might do an Anglo, if you like. It might be several fold cheap. We diversify, we don’t know when that will happen but over time, banking looks incredibly attractive to us.

A sector that you’ve invested in, in the United States is higher education. In South Africa two of the stocks that have done very well are education stocks, which really have shot the lights out. Are you expecting a similar kind of rocketing in the US in this sector?

I would bite your arm off if you told me that was coming. I suspect, and not wanting to scare people, but there may be, and I don’t know those stocks particularly well but there may be a parallel here. Actually, the full-profit education stocks were darlings for some period of time. They’re many of the best value investments or stocks that were previously huge darlings, and then fallen on very hard times because that disappointment leads to very negative share prices. They went through a period of incredible growth in the US, funded by a lot more investment in loans. Loans to the full profit education sector in the US, is effectively non-standard learning. It’s university type courses for people who are mature students, who are doing low paid jobs and would like better jobs, who didn’t complete their full college degree and so on and so forth.

That’s all very laudable and positive but of course, there was a feeding frenzy for people to provide this because of all this money in loans that were provided, and a lot of unscrupulous stuff happened. A lot of people signed up for courses that they lent money for and then of course they dropped out because they realised what was involved and what hard work it was and they were on the hook for 10’s of thousands of dollars. Suddenly these long-term loans had nooses around their neck and there was some very bad behaviour and that has taken a very long period, you know having seen this huge run up in enrolments and in share prices and all the rest of it and now this massive scandal and then a cyclical unwind as well, because of course, a lot more people want to further their education when unemployment is high.

When times are tough they think, “Well, actually, in order to get a better job I’ve got to go and do this”, whereas when unemployment is low and there’s a lot of jobs around, people think, “Well, why bother, there’s lots of jobs around”. So there’s been this cyclical downturn as well and all of that has led to a huge crash and we’re now working through that. We had always made very, very onerous assumptions about the level of enrolments that would stabilise, the level of profits these businesses could make. Education is a growth sector, globally. These are businesses that had quite good balance sheets, they were required to by the regulator.

There was a lot of regulatory uncertainty, which if we bought a diversified selection of stocks and we had three or four we could take for our unit holders and they were extraordinarily cheap. We’ve seen something, that one of the sectors that’s directly a beneficiary of the Trump administration getting elected, which people couldn’t have seen and we didn’t foresee certainly, but there’s nought stranger than reality. It’s a bit like people didn’t foresee commodities bouncing either. You never know what’s going to happen, but we always open our mind to one simple question, which is, “What if…?” What if things aren’t quite exactly like consensus thinks and this is a great example where people are now recognising, “My goodness, some of these businesses are quite cheap” and they could potentially go up a very long way, we’ll have to wait and see.

Trump’s views on banks, do you think that could also have a similar kick? Has it already helped.

I’m not as convinced. Trump will be Trump, I think and that may lead, at the margin to some positive reactions to some of the shares that we’re investing in, because there seems to be more leniency predisposed towards areas like higher education, banking, sales business, and wants to invest a lot of money. I actually think the thing that banks have going for them, is that when you go and do the Porter’s Five Forces, which is supposedly the rationale behind whether a business is quality or not and you think about whether or not something has higher barriers to entry, power over its suppliers, competitive intensity, threats of substitutes, they’re very good for a bank.

There’s a reason these businesses probably should be regulated because the barriers to entry to starting a bank are very high because most people don’t move their current accounts and they are very lazy and the power over your customers is actually very high in the end. The competitive intensity is reduced dramatically because all the businesses need to generate capital, because the regulators force them to do that, so they’re all playing nice. It’s hard to substitute a loan. I don’t know whether or not we’ll need oil and gas 20 years from now, but I’m pretty sure we’ll need mortgage financing.

So when you do it, actually these are quite good businesses and I think that hasn’t changed from when Obama was in or Trump. We might see more or less lenient regulation in the short-term and that might be the so-called catalyst to releasing some of the share price value, but we as a house are a value team, we’re not big believers in looking for the catalyst because in my experience, the catalyst sometimes comes from areas that you would never have thought of and by the time you’ve worked it out, the catalyst has appeared, the opportunity is gone.

So, look for what’s really, really cheap, neglected (it could be any sector), do your homework, and work through those 400 pages of regulatory returns and you’ll find the stocks that, if you’re patient, will deliver.

Yes, there’s no magic here. There’s good structure, there’s a rigorous process that’s set up to allow us to do our job with a screening at the start. Then there’s just roll-your-sleeves-up hard work, looking at businesses. We swing a very few companies. The number we buy versus the number we look at, is very, very low, but actually looking through that fear and that uncertainty, it’s not that we see something that others don’t, we just think that in the end that valuation is so much more valuable than the fear that people talk about and then diversify. This is not a ten-stop portfolio type approach, this is a 30 to 70 stop type approach and over time this has been something that we look back and say, “Humans have been humans” and I’ve just seen nothing in the world today that makes me think that we’re going to get anything other than humans being humans for the next 20 years.

Visited 98 times, 1 visit(s) today