Causeway’s Ketterer on Estimating Intrinsic Value

Published Oct 15, 2024, 1:25 PM

Since the US market can be profitable for European companies, any slowdown in the US economy could harm earnings in Europe, but also alleviate high valuations. On this episode of Inside Active, host David Cohne, mutual fund and active management analyst with Bloomberg Intelligence, along with co-host Laurent Douillet, senior equity strategist for Bloomberg Intelligence, spoke with Sarah Ketterer, Chief Executive Officer and Fundamental Portfolio Manager at Causeway Capital Management, including the Causeway International Value Fund (CIVVX). They discussed Causeway’s value investment philosophy, including its risk-adjusted return ranking model, as well as the criteria she looks for in potential holdings. They also spoke about how AI tools are being integrated into the investment process and where she sees investment opportunities in artificial intelligence. 

Welcome to Inside Active, a podcast about active managers that goes beyond sound bites and headlines and looks deeper into their processes, challenges and philosophies and security selection. I'm David Cohne, I lead mutual fund and active research at Bloomberg Intelligence. Today my co host is Laurent Duier, senior equity strategist at Bloomberg Intelligence. Laurent, thank you for joining me today.

Thank you foroving me.

I wanted to ask you about a recent note you wrote about industrial valuations in Europe. Can you tell our audience how current valuations compare historically and how potential showdown in the US could affect those valuations.

Yes. In fact, the industry lay is a very interesting sector in Europe because it offers many growth opportunities, but also it is the most the second most expensive after technology. Currently trades on a forward peer of about nineteen times, which is the thirty seven percent premium to European equities, and historically it has always treaded at a premium between fifteen to twenty percent. So I mean today, what explain a higher premium for European industrials compared to the market. It's all the clean energy investment. Also you have the rearmament in Europe, and also you have the massive US fiscal programs, which I think are major gross drivers for companies in arrow space, defense and also capital goods. And I think these growth opportunities for many of those companies are not just for the next twelve or eighteen months. It may be for several years to come, so I think it puts them on your growth trajectory, which justifies the higher valuation ratios. Regarding your question about what could happen to European industrials if there is a wobble in the US economy, I think definitely it will be a problem because US is about thirty percent of the sector cells and I think the US market is also quite profitable for European companies, So any wble in the in the US economy will create a problem with earnings, but also potentially are durating on many of those companies given the rich multiple. And the last point I would like to make as well is that if you look at the valuation of industrial companies which are challenged either by the green transition or the adoption of AI, they are currently trading at very low multiples compared to their own history. And I think it's suggests that some of the venues that started to be discounted in the share price. For sure, some of them will be value trap along the line, but I think that potentially some of them could offer some good investment opportunities. So lacking many sectors in Europe stockpicking is key.

Great. Well, let's bring in our guests who can talk about Europe and other international markets. I'd like to welcome Sarah Ketterer, who is chief exggative officer and a fundamental portfolio manager at Causeway Capital Management. Sarah, thank you so much for joining us.

Thank you for inviting me.

Well, I want to start by asking you how you got your start in the investment industry.

Well, the short answer was a long long time ago. But I rose up through the ranks, went to the school of hard knocks in investment banking, and was in business school and more investment banking. And that turns out and it still is today, a resonably good background for fundamental research, and then it instills valuation techniques and skills. The only thing I couldn't get a job at Causeway today, however, because we need so much more than that the next several decades are going to require an ability with data that just didn't exist when I started. Nonetheless, I had an opportunity with my co founder Harry Hartford in two thousand and one to start Causeway, and we've had a twenty three year record of managing predominantly international equity fundamentally, but we also have global equity and we manage quantitative strategies including emerging markets and small cap.

Well, actually, you mentioned Causeway, so you know I like to talk a little bit about it. What would you consider the overall investment philosophy of the company.

We are very much steeked in a value investment philosophy, particularly in the work we do fundamentally to identify companies we believe our training at levels below their intrinsic value. And this is both a combination of very intensive understanding evaluation tools and the assumptions we make about the business layer of subjectivity that comes with experience. So our portfolio managers we have six cluster heads, individuals responsible for in depth work in sectors. They have to make the final decision on stocks and they rely heavily on value and then quantitatively we use value amongst other factors. Albeit, value has a very large weight, So overall, Causeway is very focused on the price we pay in our analysis of the likely return we'll see for our clients.

Great well, I do want to ask you specifically about the International Value Fund, the ticker symbols civv X. Is there a specific process, you know, investment process for that particular fund.

Yes, there is, and it's the same process we've used since our inception. In fact, parts of a date back to antiquity. But the whole idea here is that we sift through thousands of companies outside the US market to identify and nes Laran noted there's plenty of under evaluation. The US market is the most expensive and has been amongst the developed world for a number of years. And you might say rightly so, because of its emphasis more on growth, a greater exposure to technology, and less what we call old world businesses, But that we're indifferent to the types of businesses. We're looking through these thousands of stocks for certain criteria we need looking for income companies that are predisposed of returning capital to shareholders. At the same time, those stocks are generally trading on a price to cash flow basis below their industry average, so they tend to look in expensive. There's capital coming back to shareholders, which in all interest rate environments except zero, is very important. And then from there we narrow the group and do quite a bit of intense research on under standing in this fund where the opportunities are bi sector. And then as we present these incredibly interesting companies that have had some sort of setback and that's why the share price is nowhere near its ultimate valuation, or we call a two year price target, we then decide as a team if that price target is the one that we have arrived at is reasonable, and then we know what we expect the company's return should be including income, and then we risk adjustment using our quantitative risk model, so we can get a risk adjusted return. And all the stocks that we are considering for this fund, we rank them daily on risk adjusted return and it's the highest risk adjuster return stocks they'd end up in our fund with the largest weights.

Given the large amount of data which have to be processed by your equity pms at least, I mean, are you already using or do you intend to use AI to potentially improve your investment process?

Yes, definitely, I have great admiration for our Digital services area and run by my colleague Pete Peterson. He's made a huge effort to ensure that not only do we have access to tools already embedding AI in them, such as Facts or Bloomberg, but we are also developing our own tools so that we can be more productive as a research team. And this is true quantitatively as well as it is fundamentally. We've been working with large language models quantitatively for some time, but that research, some of that translates into what we can do in the rest of the organization. But specifically for fundamental research, we use a chat function that's embedded in a system we have that's connected with facts that that allows us to do queries because if you think about it, we have twenty six fundamental research channels scouring the globe constantly taking notes, meeting with companies that information. We need to be able to access it, assimilate it, distill it, understand better what the management said the last time we met with them, so that we can ask even better questions going forward. So from a productivity perspective, we're at the early stages of implementing AI. What would be more interesting in what we're working on, i'd say next horizon type project is how we can use AI to generate investment ideas, and part of that will come from having our IT experts spend more time with our research channels, understanding better what they go through and how they think about their areas of coverage in order to be able to automate some of that.

Maybe a flow of question on AI as an investment opportunity, which Checter do you think would allow the greatest investment over the next three to five years.

We think about AI in stages and how it's impacting the companies that we could buy. And again I'm speaking to you from the lens of a value investor, so we're not going to pay large multiples that embed growth that we are concerned might not occur, might be vulnerable. But some of the most interesting stocks right now are in the building phase. That's the phase that's focused on getting the infrastructure needed, all the computing infrastructure, and a lot of that are semiconductor firms and they've been pretty awful lately. So the opportunities are considerable. Companies in the microcontroller and power semic inductor area that have an industrial focus, like infinion firm or Renaissance in Japan or We also are very interested in the two big memory non US memory companies, Memory semiconductors, Samsung Electronics and sk Heinex. So they we think they that given the the increasing need for semiconductor content, whether it be in automotive applications or other industrial applications, not to mention in the devices that we all use smartphones, PCs, and then of course there's data centers that the demand will pick up quite significantly in these areas of what we call building, which is predominantly again semiconductors. And then in AI delivery that would be phase two. That would be companies that are involved in network infrastructure and end devices, so we like Marauder manufacturing for example, and then Samsung and Heinex are involved there too. And then I say you said three to five years. At the five year mark, that could be deployment. And so enterprises now Causeway as an example, we're deploying AI, but we know we're early, and we're looking for all we're asking our peers what they're doing, any type of consulting help, if we need it, we get it. We think enterprises globally are at the early stage, particularly those that are already just engaged in digital transformation, they need quite a bit of help. And that's where it services. Companies like Fujitsu in Japan or SAP in Germany, where enterprise software is their main line of business, they should do quite well. And then companies that are just going to imbue AI in their products or embed I would say ten Cent and China is an example of that. So I've just rottled off a whole lot of stocks, and none of them are Nvidia.

Well, I actually do you know you mentioned a video. You know that's obviously you know, trading at a much higher valuation. You know, no one would consider that a value stock. But I do want to ask you a follow up on valuations. You know you mentioned it in your process, and you know you alluded to a few metrics. I guess you know, when you're looking at companies, is there kind of like a cutoff of certain metrics that you would consider? You know, like, how does that fit into the entire process of evaluating companies?

There are we don't have strict multiples where we walk away, but we are we get very uncomfortable when we see that there are high multiples in a stock where we're already observing record levels of earnings or what we call cyclical peaks in earnings. And this is where value investing can be a little bit confusing because it simplistically and per the indices, value investing consists of low pe multi full low price to book, low price to cash flow stocks. But that could be for a deep cyclical stock when earnings are at its zenith, just the absolute long time to own them. In fact, you might be much better off. And we know this and so do our quantitative colleagues through their research that some cyclical companies and Laurent referred earlier to some of the European industrials that they'd make great examples of. We invested in is about two years ago. A French rail operator, rail equipment manufacturer, signaling manufacturer Alstom and Alstam was made a poor acquisition in Bombard det Transport in Canada, so they ended up with an integration problem, They ended up with a cost problem through COVID, and they also ended up with a pricing problem with contracts, so they the earnings were collapsing, so the multiple began to expand, but it wasn't because this was a growth stock, was because it was broken cyclical, and that was precisely time to own it. They had to show up their balance sheet and that gave us an opportunity. So we're very opportunistic. That core of our strategy international is to make sure we own companies that are well positioned as long as we have that, And another example would be in aerospace with the wide body aircraft engine manufacturer Rolls Royce. The pandemic was devastating for them and they bled cash flow and they too had to shore up their balance sheet. But what a phenomenal market position with two competitors Pratt and Whitney and ge and a great business that needed to be better managed. But as long as we have that, and or the companies in fine financial shape, they've just gone. They've just had some mix miss execution by management that makes a huge difference. We're again this is a long with an answer, but there are no specific multiples that are appropriate. There's more a question of what are normalized learnings when can the company get Can they do that in our two year window? How long will it take?

Yeah? I have a question on another important aspect of the investment process, which is ESG. ESG has been a big investment theme in Europe for the past few years, but we have seen a bit of pushback. So how ESG criteria impacting your investment decisions? And as a stock picker, do you think it makes a difference, because there is a lot of debate about the value add of ESG data in an investment process. So what is your view on this topic.

Well, we are convinced that material sustainability factors have the potential to impact investment performance. We've seen it and it wasn't until we hired our colleague in our con area more over five years ago, who helped us create a systematic way to understand ESG within the companies that we were analyzing. And this is important. It's one thing just to ask a few questions about governance. It's another to ask specific questions that we know lead to that when we score them, we can compair all companies on a level playing field within the country of their listing and that's been very helpful. So governance the G. If you were to put ESG together, the G is the one that has we think of the greatest potency, but E isn't very far behind and neither is s and the way we think about ease in terms of companies carbon emissions and water usage, and we get that information from databases and then we supplement within company conversations. But polluters and companies that misused sources are typically badly managed. So there's a perfect or an excellent alignment between what we're looking for, which are which are underlying good businesses that have great potential but something is going awry, and the way they treat the resources they have, So everything about that is aligned with what we do. And as for social our understanding of how they how companies treat their labor and what is what may be occurring in their supply chain such concerns, for example, with modern slavery. The more companies can tell us about that, the more transparency we have into how they run their operations. And again that's totally aligned. So our process involves quantifying through a series of questions and companies ESG, positioning, scoring, and then comparing the scores over time, and we talk about ESG and sustainability at the time we present a new stock, we'll review it if there are significant changes, which there often are. Albeit most of our information comes in annually, and we have discussions with companies about how they are going to reach the goals they've set. And this is true across the ESG spectrum as well as financial and they're often interlinked because that's our job as investors. It's an active approach we take to hold the companies accountable for the goals they have established.

So now moving on more to investment opportunities in different parts of the world. At this stage, I mean, where do you think are the best opportunities globally in terms of Europe or emerging markets? Emerging markets? What are your use potentially on China evens that they are I would say many issues there. And also are you view on geography acquisition depending on what is going going to oppen to the US economy as well.

The opportunities are widespread, and our geographic exposure in the International Fund is entirely a byproduct of our bottom up stock selection process. Okay, but I did mention risk model, and I mentioned it very briefly. If it turns out that we become as portfolio managers too enthusiastic about a certain geography, we will start to see the risk scores begin to increase on those stocks because we will have concentrated risks in one particular area. So it's our quantitative risk model that keeps us diversified when a portfolio that averages about sixty stocks, and that's really important across the whole spectrum of factors, but region is certainly one of them. We've had clients ask us why do you have so much in the UK, and it is a large overweight for our fund, and one of the reasons why is because the companies listed there don't do very much business in the UK, so it's not really UK risk we're taking. An example would be the UK beverages company Dago Dago, known for world class spirits, and they have six percent of their revenues in the UK market, so they're listed in the UK, their headquarters are there, but that is really not where their economic exposure resides. Or maybe more extreme and one of the stocks that we think has considerable upside is the Life in Asia life insurance company Prudential, listed in the UK for historic reasons, and yet they have no revenue in the UK. So the country of listing can be a little deceptive, and we spend time with our clients showing them where the economic exposure resides from a revenue perspective versus the benchmark, typically the EFA or world XUS Index. But our risk model does an even better job of discerning where our risks are geographically and making sure we don't concentrate where the opportunities are. I was going to get to that, which is just about everywhere. I'd say some of these UK companies I mentioned, like Rolls Royce still significant upside, or the financials company Barclays, or in energy we're very much like VP, the integrated oil company. I'm just rattling off a few UK but there are plenty in Europe too, and quite a few listed in France I'd mentioned earlier Alstom, and then the luxury goods company Caring, the owner of Gucci, amongst other brands. Sangobin and Materials are airly keyed in industrial gases, Sanathee in healthcare. All of these companies have a reason they're in the portfolio, and it's it's because their risk adjuster return is very attractive versus the other alternatives. We're not hesitant, however, if their share prices rise, we will be reducing the weight in the portfolio and then recycling those sales proceeds back into higher ranking stocks. But I again would reiterate Europe looks very attractive from a yield perspective, dividends and buybacks versus rescue the world. But there's no there's no one part that we favor over another. They're just where we can find the stocks.

Okay. And so given you your US based investors, given the large positions that you're have in the UK and Europe, all the countries, how do you manage the currency risks? I mean, is it integrated in your risk EDUSM model because some of the currencies could be very volatile. We saw it very recently with the yen. So how do you manage I mean this type of risk as a US based investor in.

Two ways That primarily through as you noted, our risk model, because our risk model does include currency, and our risk model is very because we review it once a week in our portfolio manager meeting with one of our quantitative portfolio managers, it becomes very clear where we are taking large active bets, where our weights in the portfolio either greatly exceed or maybe maybe we are very underweight versus benchmarking currencies. And the end it has been one of them where we've been underweight because our allocation to Japanese stocks has been less than that a benchmark. But as for what the vault of the currency actually does to the portfolio, that we think about at the stock level, So in order to arrive at a two year price target, we have to be very confident in how sensitive earnings are of the particular company to fluctuations, and it's in the currencies that are meaningful to it. Then for a big exporter in Japan, dollar yen or dollar or yen euro can be very important. So we'll look at that and then if it turns out we think the stock is too vulnerable to currency fluctuations, we may that we may hesitate or certainly create a greater hurdle so that we buy the stock even cheaper. The beauty of having a great proprietary multi factor risk models and we blend all the currencies in the portfolio, they tend to negate some of the risks of having too much of any one of them. So there's a there's an element of duristfication that is fair useful in ensuring the portfolio doesn't end up, for example, being taken for a ride by the yen volatility.

You know, we've talked about your selection criteria, what you look for. You know, if we talk kind of about on the opposite side, what triggers or sell. Is it when a company hits its price target or you know the fundamental you know, could a company still be undervalued, but it's fundamentals changed that that could lead you to selling a position.

Yes, so well, we typically sell because stocks drift down that ranking and they're no longer in the top say quartile of the ranking, and then they're no longer in the top half and at some point in time we have to take profit and then reinvest those selle proceeds in the higher ranking stocks. So that's the major reason why we sell. And for some stocks, they can have a very sharp price appreciation and then we have no reason and to raise our price target and then our holding perier turns out to be very short. But that's rare. It's kind of a good day. Most of the time. It takes it takes years. It can take the full two years, if not longer, for companies to implement the operational restructuring needed to improve the business. And earlier you're asking about China, I gracefully skipped over, but it is a good time to mention it because there are It's not that we have many Chinese stocks in the portfolio. We have very less than two percent of the portfolio is exposed to China directly, but so many of the companies we invest in they have exposure to China, and it's cross all industries. We see it in technology, we see it in consumer, we see it everywhere. And one I'd mentioned earlier, Caring, is a great example. This is a stock where we bought too early, there's no doubt about it, and not we underestimated how significant the consumer downturn would be with the Chinese consumer, so that's likely cyclical. And the company has been restructuring it's Gucci division with a new creative director, so that's all good. But this sort of market is very unforgiving, and I think this has become as the amount of capital that's focused in on equities has increased. It is almost as if the discounting mechanism of markets is amplified. So stocks where there's or there will be a weight until recovery, nobody wants to bother, or so it seems, so that's really the finesse. That is part of our job is that we see the stock. It looks very undervalued. It's now buoyed up to the top of our ranking. But is it a two year weight or is it longer? Those are the questions we're asking because clients don't really want to wait longer. They'd like as the time the return perfectly, which is quite difficult. We have to be early. These guys need to be pretty dark for us to get the valuation we want. But we need an improvement in the weather pretty soon. And when there is a setback, we talk amongst ourselves as a team and we say, is this is this has changed? Did something go wrong with this business and now it's we have to sell it out of the portfolio? Or is it just a delay? And vast majority of the time it's a delay.

I mean it seems that in the market, I mean these mentality of techno Prisoner has accelerated over the past few years. I mean, do you think it could change or do you think it is a new state of the market, of the equity market where now as soon as the company disappoints and its evaluation is going to be annihilated.

I think this is the status quo. I believe we are in an farm up where money is very fungible across borders. There are enormous investors out there with maybe shorter timeframes then I would like to see, like lots and lots of hedge fund activity, and they pay the brokerage bills, and so the brokerage firms deliver research that's oriented to perhaps a much shorter time holding period, and that feeds on itself. But if you think about what's happened post to global furnatural prices post two thousand and eight, the amount of money created by central banks globally is just head spinning. The US got up I think nine the FED balanceship and nine trillion and has slipped back to seven. But it was something like three hundred and fifty billion at two thousand and eight, Like where did all that money go? When did a bank reserve and they got lent out? And it's there's just lots and lots of money in the financial system. And that to me is that level of financial liquidity is one of the reasons why markets react as they do so quickly.

No, that makes sense. Before we go, I did you know, I'd love to ask what advice would you give your younger self just starting out in the business.

Sleep more. I stayed up all night sometimes. I first, when I first get into this industry, I didn't I wanted to know what was happening to the other side of the trades. I decided to travel the globe and suit with cell side trade desks. That was a lot of jet lag, and there was always because there's always a market open when you cover non us, not to mention us the granddaddy of them all. So you have to force yourself to sleep because there's always something to be looking at, researching, thinking about. And now that I have put on a few years, I'd say I have to sleep. But when I was younger that would be wise. I think I would have I think I would have sudden a lot more intelligent meetings if I had more than two hours of sleep.

That's a good answer. Well, thank you Sarah for speaking with us today, Thank you for much time in Laurent. Thank you for serving as my co host today. Thank you very much to you until our next episode. This is David Cohne with Inside Active

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