Welcome to the IBKR Podcast, I am your host here Guillaume Roux-Chabert from Interactive Brokers Singapore and I am joined with Mary MacNamara, Interactive Brokers US. Value is the keyword, so we’ll hear a lot about it during this podcast titled How Does Value Investing Strategy for Commoditized Sector Works? Our guest star today is Stefano Grasso, Senior Portfolio Manager for Enhanced Value Fund who has over 20 years of value trading experience. So, Stefano let’s have a crack at this fascinating topic with the first question.
Could you tell us more about your love story with value investing and what do you value in value investing strategies?
Absolutely and thanks for having me. I started investing about 25 years ago it was the dot-com kind of era, so it was good timing. But my love story if you want with the value investing started in 2008. I was starting my MBA at Columbia Business School and I got introduced to value investing by Professor Bruce Greenwald.
I remember he gave us an assignment about a stock pick that we were supposed to pitch the following week, and I’ve been working quite hard on that. Unfortunately, the night before we were due to the class for review the assignments there was, I think, a soccer match or a big event and we were parting until very late. So, I show up at in class for the following day quite tired and with the headache and the last seat that was available was in front of the class.
So, Professor Greenwald started inquiring about the assignment, and he asked explicitly about this company that four or five of us picked, which was Dillard’s, the US retailer. And apparently there was not many people, there were like 5 people who picked this case, and he started asking like, who want to talk about this stock? And he started probing the group to kind of raise their hands. So, I felt like being in the front seat I raised my hands, and I had like this 15 minute conversation where he hammered me about all the flows that I’ve done in my analysis of this retailer. Why their real estate portfolio was overvalued and so forth.
So, I got my first baptism with the value investing in a very crash course in front of 150 or so other classmates that witnessed my being educated about this stock. Anyway, it was a fun experience and I got hooked by value investing. It made so much sense to me. I mean buying assets which trade at discount to intrinsic value when the market is mispricing them, for me, made a lot of sense versus what I have been hearing since then.
After that I went to several Berkshire Hathaway annual meetings where I met and interacted with Warren Buffett. So, it was great and every few years I actually e-mail when we don’t meet in person at the New York campus with Professor Greenwood. At the time of my PhD, the stock was trading below $5 per share. I just checked before this podcast it’s now trading 300 plus dollars so it’s like a 60 times return. I always make fun of our conversation with him. I mean, this is kind of return and not even Chamat Palihapitiya kind of having the VC world. So, it was quite fun.
Excellent, any 60 times return is quite exceptional and indeed our common understanding about value investing is like it works like a savvy shopper in front of a merchandise store who would pick the best sweet on sale.
So, with the same fundamentals approach, portfolio managers like you could detect an underpriced financial instrument, which over time will blossom and shine into the market. However, this approach usually applies to wonderful business as per your mentor Warren Buffett’s value investing philosophy is. So, do you believe we don’t necessarily need to wait for wonderful business to apply the value investing strategy?
I mean, ideally you know you get a great business at a fair price that you feel comfortable buying in to. However, great business at a fair price, don’t come by that easily. So, you have really two options. Either you park your money and wait. By the way, today with 5% interest rates, it’s not as terrible as it was like a year ago or so, but you have to wait for potentially a long time.
From 2010 to 2020 you didn’t have big opportunities of buying great business at reasonable price. That’s why many value investors underperform. So, the alternative is to find a special situation or few special situations that have a good risk reward profile. Now this opportunity is not easily captured by Berkshire Hathaway or the likes. I mean for big funds with multibillions position, it’s not easy to build and unwind a position in a short time. So, they are really constraining really pulling the trigger when they see something, they can buy a lot of. It’s a big market cap target and they can move the needle. So, they tend to buy and hold.
However, if you manage, say smaller money, say less than 100 million USD like we do at Enhanced Value Fund or like some retail investor kind of normal portfolio, you don’t have to worry about the size of the position. Many positions you can get in and out without really moving the market and within a day really. So, this is an advantage that kind of nimble players have.
The other advantage is that the universe of opportunities is much bigger because we can look at sub billion market cap companies and still build sizable position whereby again for big funds it would be too illiquid to trade in and out. So, I think the value investing approach evolved over time and many people relate to Warren Buffett, but as he says multiple times during the interviews and the annual letter, he’s very much constrained to what he can do. So, we are more flexible, and we can look at other stuff as well.
So, among the other stuff as well, and maybe among the least expected sector for value investing are the highly commoditized sectors and, in your view, could you name a few of these highly commoditized sectors and give an example on how you would use value investing there?
Absolutely. The traditional definition of commodity is a basic good used in commerce that is inter-exchangeable with other goods of the same type. Traditional examples are oil, where I have a background. I’ve been 10-year trading oil and oil products and gas but can also be grain, gold, beef, all this kind of soft and hard commodity.
But I think for the benefit of your question it’s important also to acknowledge and recognize that there are many more goods and services that are commoditized, so to speak. So, think of you know telecom, if you buy a SIM card when you travel to Vietnam or whatever, you don’t really care if it is a brand name or not. You go for the cheaper option, right? Commercial airline when you buy tickets. Some people are picky, but majority of the people are just driven by price, right? Even micro microchips. I mean, it’s an industry that is to a large extent commoditized. Logistics … you can think of shipping containers. These are businesses that tend to be highly cyclical and to be little or no profitable through the cycle for the industry as a whole.
They go through over investments and then they get hammered with very poor profitability for a long period of time. There are no barriers to entry. There is very little more to what Warren Buffett calls a moat, so there is very little protection for the business. So, these industries don’t look naturally attractive to the typical value investor look. However, these industries offer good opportunities if the investor managed to identify an inflection point in the cycle or a specific trend in the industry or the company.
Like for example, a wave of consolidation in a sub-sector that can make many companies potential targets for acquisition. We see that in the oil and gas industry for example, there are many small-cap upstream producer in North America that are being targeted by bigger guys that rather than expanding production with exploration and multi years processes, they just go there and buy for three times cash flow, five times cash flow these great assets and increase therefore their reserve and their production.
And to be successful in these areas and sectors … like Professor Greenwald words, you want to look for things that are ugly, that are cheap, that are boring, out of fashion, that are small and obscure. You don’t want to look at the Tesla’s of the case. You want to look at something that is not really looked at but that there is some turning point, tipping point in the industry and you want to make sure you get in before the inflection occur and then you want to sell them when the broader financial community has started noticing. So that’s how we look at it.
Great. Boring is great. That’s an important key point and take away indeed. So, considering that logistics is a highly commoditized sector that covers transportation of finished goods within and across country, what can we learn about the economy from the container business? Additionally, what are the key considerations that investors should keep in mind when analyzing this industry?
So, looking at specifically the container business, it’s an interesting one I mean I have no specific expertise, but we have been looking into the industry and we do have an exposure to the sector in Enhanced Value Fund. I’m just going to tell you how we look at this industry, so we see three subsectors, if you want.
One is the liners sort of the mask, the big liners company that move containers from Asia to Europe and US and vice versa. Then you have the ship lessors. So, these are the guys that build ship and lease it to customers for a long period of time. And then you have the container lessors that are few specialized companies that build the containers and lease them to the liners and the other customers in the market. So, if you bear with me with this oversimplification of the market, I want to kind of explore and highlight the differences between these three sectors.
So, the liners are very much exposed to the fluctuation of the rates of moving containers. When COVID hit in 2020, few of our friends that were moving from Singapore back to the US or Europe were paying like crazy prices for moving a container from Singapore to the West, and that was because there were constraints in the chain and the prices were crazy.
The liners were the guys benefiting the most and at the very same guys that now are taking the hit because the rates are coming off a cliff and they are basically taking these lower prices with very little they can do about it.
Differently from these guys, there are the ship lessors. There are a few players in the market and basically the difference for these guys is that they lease ships for a 3,5,7 years period. So, during COVID, they managed to get a lot of orders and they managed to fix a lot of ships for a number of years forward. So, the revenues are sort of locked in for another few years.
And finally, the container lessors and the sub sector are even more cyclical because the ramp up and ramp down of container production is very quick and therefore you have a cycle that is much shorter. And again, during the 2020, 2021 and 2022 logistic constraint situation, they managed to get a lot of containers on lease at very high prices for a very prolonged period of time.
So, these guys are the guys that we prefer from an investment perspective because they have 5-6 years of guaranteed cash flows at return on investment of the single container, that is in the 15 to 20% range and they have as a counterparty the liners company that are very profitable with a lot of cash on the balance sheet and basically very little risk of default or renegotiating the contract.
Given this situation you would expect the market to be to have behaved differently, but instead because these container lessor and ship lessor companies are very like small cap company, very niche companies … with the container market coming off a cliff, they basically came off a lot as well. So, they are now trading at below book value and their book is basically yielding 15-20% for the foreseeable future. So, it’s a different risk reward opportunity depending on which sector you look at.
Understood and as you are located in Singapore running EVF, the Enhanced Value Fund. So as the world has an increased interest in Singapore to further transfer assets here, we see a lot of family offices opening their account here. Could you describe with your insight about Singapore and the region for the shipping and logistic industry?
Absolutely, I think Singapore is a privileged location where the west meets the east so to speak. It’s also logistic hub where oil containers, gold are stored and traded. It’s per say a very interesting location. As you mentioned there are a lot of capital flowing into Singapore. By the way, I’m from Genoa, Italy and there are many — they call us Genovese — people here in Singapore. Many are traders, brokers, insurance guys because of the heritage of our city, a port city in the Mediterranean.
You know, we have also a big network of energy people because of the Singapore attention and focus on the energy, I was with McKinsey Consulting before. The networks that are in Singapore are very useful for both sides of the trade. Both getting understanding of industries and getting capital and access to capital. So, it’s quite easy for us at Enhanced Value Fund to tap into these incredible networks for insights mainly, and we see it as a privileged location to run these investment activities with we think good results as well.
I have a little question for you Stefano if that’s okay. For somebody who has been a longtime growth investor, primarily looking at growth from a technical perspective … and so, if somebody wasn’t doing a Master’s program and they wanted to get started, what would you recommend?
Ongoing is understanding in terms of what is growth and value. So, often even in the Morningstar box has growth as opposed to value. And if you think about Warren Buffett has invested in Apple and many value investors have invested in Meta and Amazon and this kind of stuff.
So, the first clarification I think to answer your question is not necessarily that you do value as opposed to growth, but it’s more like you value the growth — to simplify, in a conservative way.
So, like you take a stock like Nvidia who are trading at 100 plus times sales, and you say what do I need to believe that 5-10 years from now the 100 times sales will have turn into something that makes more sense from a return on capital perspective. And I don’t follow the stock and I don’t know but it’s a quite hard path. Everything needs to go right to get to a reasonable valuation in, you know 5-10 years from now to justify the evaluation.
So, for a value investor I would say it’s a no go because it’s too risky from a probability gain perspective. If you look at the Meta that was trading at $90.00 a few months ago and was trading at kind of single digit normalized free cash flow then you say OK, I’m betting on the Zuckerberg not throwing cash out of the window on the metaverse and … they have like 3 billion monthly active users and stuff like that. So, both are growth stocks, but as a value investor, I can make the case for Meta despite all the noise, much easier.
So that’s one part, the second part I would start from Warren Buffett’s annual letter to shareholders going back ’76, whenever was the first one and they are just a mental framework to kind of understand. And again, you will find arbitrage opportunity, you will find many things he saw. He invested in silver at some point because the demand supply. Currently he’s investing in oil with Occidental and Chevron. So, you’ll appreciate that while investing is much more about probabilities, what makes sense rather than a dogmatic “I invest only in one type of stocks”. And there is a ton of reading, a ton of free material … the MBA is great for the network, but in terms of getting actually your hands on something valuable, you don’t really need to pay that high ticket.
Oh, that’s perfect. Thank you so much Stefano, I appreciate that.
Understood, thank you. We are reaching now the end of the podcast. So,thank you, Stefano for your insight on value investing. I hope it will trigger many discussions on this key trading strategy and expand its fields of application. I was your host here, Guillaume Roux-Chabert from Interactive Brokers Singapore. Thanks Stefano.
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