Agache, the holding company of Arnault, the patriarch of LVMH and Europe’s richest man, offloaded its 5.7% stake in Carrefour, the world’s second largest retailer. The stake had been bought in 2007. At the time Carrefour boasted extremely large multiples between €40 and €55, at the same time as when another company, this time a local one, Assicurazioni Generali, was trading at extremely generous valuations. Anyone who dared to question the multiples of the two companies with an experienced market operator would have been immediately rebuffed with a stern look or motherly tenderness, followed by explanations linked to Carrefour’s alleged real estate assets or Generali’s accounting method of AUM acquisition costs. In reality, if he had done the maths properly, he would have realised that these two elements were hardly enough to justify the premium at which the two stocks had traded against the industry.
What you learn over the years is that you get used to things and end up taking them for granted, even if they don’t make much sense. This is also true in the stock market. However, if there is no concrete reason behind it, things can quickly change. These mental attitudes are the ones that periodically make us accept considerations such as “this time it’s different”. Everything is ultimately worth the cash it generates.
Returning to Carrefour, even the genius Arnault bought approximately full valuations of 47 euros per share. After 20 years, he sold them for €16 with a loss of 65% and a capital loss of over €1 billion. Why should such a person sell now? Logic tells us that there are three possibilities: 1) he needs money; 2) he can reinvest at better valuations; 3) he does not want to remain invested in Carrefour. By easily eliminating the first hypothesis and by hardly endorsing the second, given the low multiples at which Carrefour trades and it’s good work of management in returning to growth, only the third remains. And that is exactly what we believe is the point. After the government blocked the takeover of Carrefour by Canadian Couche Tard, Arnault no longer wanted to remain invested in something where the risks are the entrepreneur’s. But the upside can be limited by a government more concerned about the next election than protecting private property and entrepreneurship.
Macron’s move has put Carrefour in naphthalene for a while. However, with the improvement in the fundamentals, thanks to years of cost cutting and Bompard’s management in the last two years, the results are remarkable. For those with patience, it’s worth waiting on a restructuring story in a defensive sector at low valuations and rising dividends, much like waiting for a change of guard at the Elysée Palace.
Another opportunity is opening up in Japan. Suga is leaving and paving the way for the election of the new leader of Japan’s dominant party, the Liberal Democratic Party (LDP), a leader destined to become Japan’s new prime minister. With the exit from the race of the popular former defence minister Shigeru Ishiba and the recent endorsement of Yoshihide Suga, the way seems clear for minister Taro Kono. The latter, at 58, looks like a child compared to Japan’s political gerontocracy. A charismatic communicator, Taro Kono is the alternative to the continuation of Abenomics that Suga represented. Despite his promises and proclamations, Abe was not able to continue Koizumi’s reform process, relying on the BoJ and quantitative easing to boost the economy, as William Pesek rightly points out in Nikkei Asia (Japan must look beyond the usual suspects for its next leader – Nikkei Asia). Now the momentum is gone and something new is needed. The country needs to modernise it’s labour market, stimulate productivity and investment, attract the best resources from outside, reduce bureaucracy, and increase the participation of women in employment. All the objectives of Abenomics are far from being achieved.
Taro Kono comes from a lineage of famous Japanese politicians. His father, Yohei Kono, was president of the LDP and deputy prime minister between 1994 and 1995. He has an international background and is fluent in English, a rare characteristic in Japan. As it is his language, clear and direct, far removed from the rhetorical rituals of Japanese politics (and not only). For this reason, he is indicated as different, with the potential to partly revolutionise a country that is now closed, timid and insecure, a distant memory of what Japan was in the not too distant past. Today he seems to be the only candidate capable of injecting confidence and courage into the nation and of acting effectively in foreign policy. Investors are hoping for this and are orchestrating a mini-rebound for Japanese equities in recent days. In our view they are doing the right thing as the risk-benefit profile is attractive.
Unbearable lightness of debt
In Milan Kundera’s famous novel “The Unbearable Lightness of Being”, the being cannot be judged as it is itself a victim of events. In the novel, the lightness of being is revealed in all its beauty and utopia. This lightness is able to vanish but the perception of being, on the other hand, become heavy, unbearable, cruel, and painful.
By substituting the word debt for being, some of these themes retain their meaning. Is debt good or bad? This is hard to answer. Is it good if it is accumulated for productive investment, stimulating the growth of a society? Or if it is instead accumulated only to improve the return on equity (which is then the model of private equity)? There are too many possible considerations and different points of views.
Value investors are afraid of debt. Especially in times like these when low interest rates make debt light. However, this perceived lightness can become unsustainable. Value investors buy companies that are perceived to be neglected. They are often overlooked because they are going through a difficult phase. This difficult phase may be temporary, or it may be protracted. If protracted, a high debt load can lead to the death of a company that would otherwise not be. Thus, debt has the power to completely change the fate of an investment. Indeed, when an indebted company goes through a prolonged critical phase, there is a high risk that banks and bondholders, once very generous, will no longer answer the phone. At that point, super-dilutive capital increases can wipe out the old shareholder base. In the presence of debt, therefore, the investment case is simply different, and the allocation must absolutely take this into account. These are platitudes, but it is important to remember them.
Having said that, we must not forget that the poisonous effect of debt can work in reverse, helping equity to take off. Turning what is not risotto into risotto. The big telcos, those who build and own the network through which we enter the digital world, are almost always heavily indebted. It is a regulated business model, or almost so, that in the face of revenue visibility can accept a good level of debt. However, in the last fifteen years something has changed, and due to the unexpected regulatory development, revenues have gradually become less visible and debt more and more bulky. In this context, equity has been penalised and investors have fled.
Today in the industry we have capital structures with debt as high as 2/2.5x the value of market capitalisation. This means that for a 10% reduction in the value of the company (also known as Enterprise Value = capitalisation+debt), equity has to fall by 30/40% to keep multiples unchanged as debt remains static. In some cases, many of them in Europe, with equity near zero it will be up to the regulator and politicians to choose whether to nationalise the industry or to change the rules.
But it doesn’t end there. The rise and fall of company value depends on profits and margins. The telephone companies’ business model is characterised by high fixed costs and low variable costs. So high operating leverage means that a small growth in ARPU (revenue per user) can lead to more than proportional growth in profits. In Q2 2021, SK Telecom, a Korean operator, reported revenue growth of almost 3% thanks to its new 5G network. This translated into an increase in operating income of around 20%.
Today 1) you can bet that the situation in the regulatory and competitive framework for Telcos, especially in Europe, will continue to deteriorate. In this case, equity will probably no longer be valuable, and we will return to the past (an event to which we attach low probability).
Or 2) one can bet that the situation remains unchanged, with the zombie Telcos not dying, but remaining unable to invest in 5G, with significant competitive damage (in the short term this may be a plausible option given the speed of policy reaction).
Finally, 3) you can bet that something in the regulatory, and therefore competitive, environment will change for the better. In this case the operating leverage will greatly amplify the small improvements in revenue, with an incisive effect on profit and company value. An increase in company value which, thanks to the enormous leverage, will be reflected and multiplied in the stock market capitalisation of the company and ultimately in the results of the investment.
We are invested in the sector, and we see great value in it, although so far it has only given us grief. However, being patient and trying to understand how the situation will evolve is part of our approach.
The famous line from Kundera’s novel, “People usually escape from their troubles into the future” seems perfect for the value investor.