Why You Should Be a Valuation-Focused Investor

CEO, co-founder, and fundamental portfolio manager at Causeway Capital Management joins The Long View to talk women in investing, fund management, and portfolio advice.

Here are a few excerpts from Ketterer’s conversation with Morningstar’s Christine Benz and Jeff Ptak:

Forget Value, Think Valuation

Benz: You’re a value investor. I guess, I should say, a valuation-focused investor. I’m curious how has your definition of value evolved through the years. For instance, do you own a name now that the younger you would have thought was not value? And I guess, conversely, would you have owned stocks in the past that seemed cheap but you wouldn’t touch with a 10-foot pole now?

Ketterer: We’ve watched what’s happened to value investing in the post global financial crisis years, really the past 13 years in the U.S. from 2009 onward with some small breaks. Investors have reacted to the massive increase in money supply, and they’ve been willing to take on a lot more risk. We brought in our mentality from the late 90s because Causeway started in 2001, and we took that right into the next two decades. But I think that we were a little out of date in the several years prior to the pandemic, so say, 2017, 2018, 2019, where we just were shocked at the valuations, and we didn’t want to participate, and yet we still had to be fully invested, and that often pushes us into stocks that are just going to be more trouble than they’re worth.

That wasn’t true of the whole portfolio. But now, because we spend so much more time on the ability of management to turn the business around, we’ve found a model that will work whatever, wherever, and in any economic environment. So, no, I don’t think we own anything today I wouldn’t have wanted to own before. And we aren’t lenient. We’re not relaxing our definition of value, because it’s naturally evolved with markets to encompass this concept of valuation. And it’s just sort of what I and my colleagues talk to our incoming analysts, and the first thing we tell them is being cheap isn’t enough. A cheap stock can get you into terrible trouble. The key is to find a business that is reasonably well situated. It’s got a competitive environment that we think is attractive. It may not be perfect, but great management or at least management capable of enacting the types of operational improvements that have to happen, and then a balance sheet that can withstand what could be unanticipated other events.

We’ve held some stocks where we saw one problem, like it might have been a product recall, but then we didn’t expect a pandemic to shut them down and/or the closure of the Chinese economy to outsiders and the cessation of air traffic. The key for us is, and we’ve been very good at this over the years, is having that margin of safety, making sure that we’re buying the stock at a low enough valuation and the balance sheet is there, as it was, for example, in 2015 after “Dieselgate,” we ended up doubling our weight in Volkswagen. The stock has long gone out of client portfolios. But the reason why is because we saw this extraordinary balance sheet with so much net cash, and I think it was something like EUR 30 billion. That’s what gave us the confidence to see the new management in the door and see what they could do to fix all the problems. I think that way of investing will always be attractive and can’t be replicated passively. A passive value index is a bunch of cheap stocks based on price/book or price/earnings. And that would not be my idea of long-term success, because how do you know that they aren’t cheap for a reason?

Turnarounds and Firm Management

Ptak: I think we want to dig into that some more, talking about that within the context of turnarounds and the role firm management can play in the success of an investment you make. But before you get there, I wanted to ask you about something that you’ve alluded to before, which is the way you array your research team into clusters that focus on sectors. But we’ve had other guests on who have strongly advocated generalism. Rather than sort of debate which approach is superior or not, can you talk about the trade-offs that specialization entails and what you do to ensure that your teams don’t fall prey to things like relativism?

Ketterer: I would state that question slightly different and say how do you keep your clusters from becoming silos where all they can do is think about industrials, or all they can do is think about financials? And part of that is just cross-fertilization of ideas and people. For example, one of my portfolio manager colleagues, Alessandro Valentini, is in cluster one, so he is immersed in financials, in particular insurance, but he is also running our healthcare cluster. And of course, there’s overlap. There are health insurers in the U.S., but it’s intellectually important to keep people connected. My colleague Ellen Lee, who heads up our consumer cluster, is also working in utilities, and she has come from the energy area. And we rotate people so that they get experience across a number of different global sectors, and that also avoids relativism. They don’t think about how cheap their utilities stock is versus other utilities. They work within a ranking system.

So, my colleague Steve Nguyen, who is one of our portfolio managers who heads up our utilities cluster, right now he is grappling with a really tough but great company listed in Italy called Enel. They’re an integrated operator. They sell electricity and gas in Europe and Latin America with a bit in North America. He doesn’t think about them versus other utilities as much as one of the company-specific reasons we want to be there, how does that get embedded in the two-year price target and then we have a risk score and then where does that stock rank. And it happens to rank very highly, in part due to the concerns about Italy that are hanging over the share price. But we think those are somewhat unfounded, enough so that we’re willing to take the risk of owning the stock. And there’s so much upside in the business; its Latin American business isn’t even in the price. But he also will talk to the other portfolio managers and Conor Muldoon, who heads up our financials and materials. He used to cover utilities. So, he will talk to Steve, and he has got Ellen. So, we take these cluster heads and the analysts as well. We’ve got a number of cluster-one analysts who work in technology in cluster two; they start on fintech and then they’re expanding.

So, I don’t think of them as silos at all, and Harry Hartford, who is our head of fundamental research, doesn’t either. There are areas of expertise. You have to really understand your business in depth. And I’ll go back to the utilities example again. What makes Steve so competent is that utilities are in complex regulatory environments and sweeping it as a generalist could be a little dangerous because it’s really important to understand the specific regulatory environment and compare it to others. That’s one comparison that makes a lot of sense. Sometimes we get some premonition of what’s going to happen in one region based on what has just happened in another, because regulators talk to each other. So, that’s how I think about avoiding relativism, where we work with a ranking system. So, our stocks—think about they all have boxing gloves on, and our risk-adjusted return means they have to compete with each other. They have to knock the other one out to get in the portfolio. And stocks that perform well tend to descend in that ranking. And so, we sell those stocks and reinvest sell proceeds in the higher-ranking stocks. And it doesn’t make any difference. There’s no internal politics that drive that. It’s all about the veracity and the robust nature of the analysis that underpin the two-year price target and then the risk adjustment that gets attached to that and the ultimate risk-adjusted return.

What Businesses Can Be Turned Around?

Benz: Jeff referenced that we want to delve into turnarounds. Turnaround candidates can probably be plotted on a spectrum where there’s invitingly cheap and then there’s sort of hot mess. So, what has experience taught you to focus on when you’re assessing whether a business that’s not executing can actually be turned around? Can you give an example from the portfolio?

Ketterer: Oh, there’s so many. I think one of the toughest stocks that we’ve had to deal with lately in the last four years has been the U.K.-listed aerospace company Rolls-Royce. They make aircraft engines, and they specialize in widebody aircraft engines. And the reason why we bought this stock, and this was prior to the pandemic, was because they had a problem with one of their engine series, and they had a recall. And so, this stock fell, and this company has very few competitors—Pratt & Whitney and GE. So, there aren’t many of them, and that’s often a good sign in terms of pricing. And it’s a razors and blades business, so the engines aren’t the area of high margin. It’s the service. It’s effectively the company gets paid on flying hours. But then the pandemic struck, and planes grounded and especially the international routes. Investors were very negative.

So, we watched this company go from what had been a pretty reasonable financial strength situation to terrible and having to raise capital. And the CEO who was brought into fix the engine problems, Warren East came from a great U.K. company called Arm Holdings. So, he had an excellent track record. But this became a huge operational restructuring story, and it still is to this day. The company has sold off businesses that are noncore. They’ve had to cut costs in ways that I think they never anticipated they would. But in many cases, that was quite healthy. They’ve had to reconstitute their board. They have a new board chairperson. And I think in the next two to three years, it might be one of the portfolio’s best stocks. But it’s been painful for clients. And in part due to a comment I made earlier, we saw one problem that we were convinced was easy to overcome because the company had proved it could do that. What we didn’t see was a pandemic. And then, the Chinese lockdown and the delaying of opening of that economy has—because so much widebody traffic is in Asia—also hung over the company. So, just one problem after another. And the company is now bringing in another CEO―because Warren has done all he can—who will be even more disciplined in terms of enacting operational restructuring.

But this is a longer wait than usual, and I only bring it up just because it’s been such a tough situation. You don’t want to sell a great company out of the portfolio when you know it has the ability to generate cash and there’s nothing wrong with the business. They’re just these exogenous events that have happened in succession then maybe you call it a perfect storm. But we take a long view on stocks like this and especially when we can see that the board is really on the side of shareholders here and determined to get to an outcome that’s very satisfactory.