David Samra, Managing Director of Artisan Partners and lead portfolio manager of the Artisan International Value Fund, explains why ABB should split into two separate companies, why he expects further divestitures at LafargeHolcim and what he likes about Novartis, UBS, Nestlé and Richemont.
David Samra is one of the most influential investors in the Swiss stock market. He is the lead portfolio manager of the Artisan International Value Fund which has approximately $20 billion in assets under management and a portfolio of around forty holdings. Among his core investments are Swiss blue-chip companies like ABB, LafargeHolcim, Novartis and UBS.
Oftentimes, Mr. Samra bets on companies where he spots potential to create value by focusing on the businesses' core strengths. ABB is a classic example: «We think ABB is an unwieldy conglomerate that needs to be slimmed down further,» says the experienced value investor in an exclusive interview with The Market.
In his view, the transaction to sell ABB’s power grid business to Hitachi for $11 billion is only the first stage in a fundamental reorganization of the Swiss engineering group. «Now, we would expect that the logical next step should be a further division of ABB into two or maybe even three separate companies,» Mr. Samra says during a conversation at the Artisan offices in San Francisco.
He also has a clear opinion regarding the turnaround of LafargeHolcim: «LafargeHolcim is earlier on in the process of simplifying itself than, let’s say, ABB,» he states. After the divestiture of the Southeast Asia business, he expects the cement giant to follow through with further adjustments of the organizational structure.
Mr. Samra, international stocks had a smooth start into the year. Now, the ride is getting bumpy. What is your outlook for the second half of 2019?
At Artisan Partners, we don’t try to forecast the stock market. The market is driven by an enormous amount of liquidity and overlaid with the emotions and motivations of people. Also, there are unthinking machines like ETFs and algorithms which trade without too much attention to price.
So what is your investment strategy?
What we focus on is the value of securities that are trading in the marketplace. We look for four key characteristics in a company: First and foremost, it has to be undervalued. In addition to that, it has to be a good quality business with a strong balance sheet and a management team with a track record of building value over time. This intrinsic value of a business doesn’t move around nearly as much as the stock market. As value investors, we take advantage of these emotions when they represent some sort of inefficiency, either on the upside or the downside.
How do you invest in this kind of market right now?
While we don’t know what’s going to happen in the stock market, we generally like volatility. Right now, we actually see value. Since we started our fund in 2002, we measure the aggregate discount to the intrinsic value of our portfolio on a daily basis. At its widest, this discount was 40 to 45% and that was in the middle of the financial crisis. The narrowest discount we ever experienced was at the end of 2017 when it was close to 5%. Today, the discount is in the mid-20s which gives us a good opportunity to compound our shareholder’s money.
Almost one quarter of your assets is invested in Switzerland. Did you also spot new opportunities in the Swiss stock market?
No. We have not purchased any new securities in Switzerland.
One of your top positions is ABB. What do you like about the Swiss industrial group?
We got involved in ABB several years ago upon the recognition that most of its businesses were - and still are today - operating at margins that are below their peer group. At that time, the management team was new and embarking on a restructuring program which would start to repair the operating profitability. Also, the company has a clean balance sheet and leading positions in each of its segments. That would imply that ABB should achieve at least peer group operating profitability. Given their leading positions, they should be able to achieve even higher than peer group profitability and better growth rates. Unfortunately, over our holding period the management’s execution has not been good, but I think ABB is finally headed in the right direction.
In a recent transaction, ABB sold its power grids business for $11 billion to Hitachi. What should be the next step for the company?
Many years ago, we started communicating directly with the board of directors, helping them understand the benefits of focus. There are many empirical studies indicating how inefficiencies creep into an organization when it goes from a focused business to a conglomerate like ABB. We spent months going through ABB’s product list and sent this list to the board of directors. We weren’t sure that they knew of everything the company manufactures. People think of ABB as a factory automation company selling high-end robots and software systems. But ABB also sells things like giant ship propellers, office furniture and several products through Home Depot like exit signs. That’s why we think ABB is an unwieldy conglomerate that needs to be slimmed down further.
Why do you think a trimmed down ABB would achieve a better operating profitability?
Out in the marketplace, there is ample evidence that this works. You see a larger and larger trend: Philips for example many years ago sold PolyGram Records and their semiconductor business NXP which is now listed as a $30 billion market cap company. Siemens, in the same industrial space as ABB, now starts to slim down as well. ThyssenKrupp is moving in the same direction. The management is not executing well, but they’re attempting to slim down the company slowly but surely.
So what should ABB do next?
Empirical evidence shows that when you take a large conglomerate and change the structure to enhance focus, the benefits are significant: You get better profitability and better growth rates. Incentives are more aligned and there are fewer resources wasted. We’ve sent these empirical studies to ABB’s board now twice along with letters indicating that we think that a stronger and growing company is far better for the shareholders, the employees and all the stakeholders than a company which is inefficient, has low levels of profitability and poor cash-flow generation.
Where do you see opportunities to improve ABB’s structure?
The divestiture of the power grids business is a first step in that process. We’re encouraged by the internal changes that have been made by taking down the matrix structure and aligning the incentives of each of the remaining four units. Now, we would expect that the logical next step should be a further division of ABB into two or maybe even three separate companies. Two separate companies make sense rather than three, but we won’t really know until these product lines get narrowed down and we start to see the benefits of focus.
What should a further division of the group look like?
Electrification products and factory automation: Such a split would make obvious sense from the outside of the organization. I’m not sure if we need a third step. The factory automation piece should be kept together. Then, within that business, a more focused management will start to prioritize amongst the products where ABB has a distinct competitive advantage. So you will find things like office furniture starting to be divested.
Today, ABB’s operating margin is around 8.3 to 8.4% on an EBIT basis. What kind of improvement are you expecting after a split-up?
ABB’s business units already have some advantages in terms of scale and product range. I would expect that each of the remaining divisions should be able to improve their EBIT margin at least 200 basis points from today’s levels.
Headed by Peter Voser, ABB’s board of directors is looking for a new management team. What qualities are needed from the future CEO?
I don’t have a wish list. But ABB’s board of directors is well equipped to find somebody who is able to improve on the execution of the last management team. The prior management was very strategic in its orientation but less focused on operating the business in a profitable and growing way. That’s why we think we need less strategy and more operating capability.
What is your general investment approach when you see hidden value in a company like ABB?
We are long-term shareholders. In our portfolio, we’ve held securities for seventeen years. We don’t look at stocks as pieces of paper to be traded. We look at them for what they legally are: a small piece of ownership in a business which has some long-term enduring intrinsic value.
And what happens when you feel a company is headed in the wrong direction?
We’re not activist investors. But we like to communicate actively with the board when a company is not moving in the right direction with respect to the interests of its shareholders and other stakeholders. We don’t do this lightly. But at certain points, the corporate governance that’s in place stops working for you and starts to work against you. In particular, we’ve had such a case in Switzerland with Panalpina.
So where do you draw the line between active investing and investor activism?
Since we’ve looked at thousands of businesses and owned some of them over a very long period of time, we have a fair amount of experience. But we’re not going on boards of directors. We start expressing our opinions only in cases where we start to identify behavior which is not creating value. In that sense, we become active in our communication policies and try to move that company towards creating value for the shareholders. To do that, we use the corporate governance system in place: our ability to vote and to protect our legal rights as minority shareholders. That is the fundamental difference between being an active shareholder and an activist shareholder.
The Artisan International Value Fund is also a significant shareholder in LafargeHolcim. What’s your investment case there?
We think the valuation is very attractive. LafargeHolcim is earlier on in the process of simplifying itself than, let’s say, ABB. The difference is that Lafarge basically operates in one industry: cement. They also have aggregates and ready-mixes, but these are related businesses with similar characteristics. So if you had to categorize the company as a conglomerate, it would be geographic distribution which we think is too widely spread.
Why do you think geographic distribution is too widely spread?
There are several issues. For instance, LafargeHolcim rightly operates with a corporate governance that is dictated by the developed world in which the company is incorporated. Unfortunately, it competes significantly in parts of the world where those corporate governance standards are not utilized by their competitors which gives them a big advantage. What’s more, some of the other shareholders – not us – want the company to pay out a fairly significant dividend. This constrains Lafarge’s ability to properly re-invest enough cash-flow in projects which may be necessary to maintain and grow market share. This need to prioritize investments dictates a necessity to reduce the geographic diversity.
Five years ago, the merger between Lafarge and Holcim was based on the idea of expected benefits through consolidation in the cement industry. What went wrong?
The cement business is a local business. Geographic consolidation doesn't create any value. I think the company has recognized this. Most importantly, the reason why we got involved is the addition of Jan Jenisch as the CEO. He had an excellent track record at Sika and we applaud his efforts so far. If he continues along this path, the company will be highly successful. We think divestitures are going a long way towards helping to fix the balance sheet and giving LafargeHolcim the type of financial flexibility that’s necessary to run a large company like that.
LafargeHolcim recently sold its businesses in Indonesia, Malaysia, Singapore and the Philippines. Where do you see potential for further divestures?
We applaud these divestitures and think the CEO should go even further, consider other geographies to simplify the organization and improve the balance sheet. As we discussed earlier, problems crop up in certain emerging markets. We think the management is addressing some of these problems which might exist in Asia, certainly in the Middle East, in Africa and perhaps for a couple of their businesses in Latin America. However, we leave that to management. It really comes down to opportunities and valuations. If you have a developed market asset and somebody is willing to pay a high price, you should probably consider such an offer, too.
Where else do you spot value in the Swiss stock market?
We’ve been involved with Novartis for many years. It’s a very good business, but two management teams ago, they did something silly which is the same thing ABB had done: They made a lot of acquisitions, paid high prices for them and created an unwieldy conglomerate which was financially weak. Then, slowly but surely the company realized that it is very difficult to manage businesses in all different sectors. Now, Novartis is unwinding that complexity and narrows its focus.
An important move was the recent divestiture of Alcon. What’s next for Novartis?
Alcon came out and achieved a $30 billion valuation. Today, it’s a much healthier company and will grow. Going forward, I think Novartis will end up doing the same thing with Sandoz. Generics is a different business than branded pharmaceuticals. It requires a low-cost structure and a low-cost culture. That’s different than a culture which is required to take calculated risks on very expensive drug developments. Consistent with our thesis on many of our portfolio holdings, we think that there will be a day and time when Sandoz is better off under a different structure.
What about the 33,3% of bearer shares Novartis holds in Roche? Should Novartis sell this stake, too?
This stake is a product of the historical structure. It’s irrational that Novartis holds these assets and we have expressed the desire for them to dividend the Roche shares out to the shareholders. Novartis also owns other things like a vineyard and fine art. None of that belongs inside of a pharmaceutical organization. That’s why I think the board of directors should be straight up with the shareholders and talk openly and honestly about what they are going to do with these assets.
Another important position in your portfolio is UBS. Why do you think the Swiss banking giant is an attractive investment?
The sentiment towards European banks is very negative. There are still large problems with the big German banks and with the Italian banking sector. Also, political and social attitudes towards banks are very negative. That lends itself to judicial activism, lawsuits and fines. Some are justified and some are not. What’s more, interest rates are at historical lows. So sentiment is at a very low level. But at the same time, banks are much safer than they used to be.
Then again, UBS’ share price is at its lowest level since the fall of 2012.
Unfortunately, the company has hit some headwinds. Most recently, they had some judicial activism in France where a large and unjustified fine was levied against them. But post crisis, a lot of conservatism has been pushed into the culture of UBS. Most importantly, the wealth management business is a very good and valuable business. UBS has a phenomenal franchise around the world, especially in Asia. And, because the wealth management business requires low amounts of capital, the company has the ability to generate solid returns on equity; much higher than the mundane 9 to 10% which you could get out of a straight retail bank. So you should get 14 to 15% return on equity out of UBS, and Credit Suisse for that matter.
Why did you pick UBS over Credit Suisse?
UBS has a stronger capital base. Remember, we look for four key characteristics in a company and one of them has to do with the strength of the balance sheet.
Looking at other Swiss Blue Chips in your portfolio, Nestlé is one of the strongest performers this year. What do like about the company?
Today, Nestlé is closer to the end rather than the beginning of our investment horizon - mainly as a result of what has now become a quite steep valuation. Several years ago, we’ve observed that Nestlé’s growth has slowed down, that acquisitions have been made in non-core parts of the industry and that the strategy needed to be changed. Then, a new CEO came in and started to narrow down the focus. The growth rate picked up a little bit, they cut some costs and the share price has reacted. That’s why the stock is not that interesting anymore although it’s an excellent company.
Just a few weeks ago, Nestlé entered into negotiations to sell its skin health business. What should the company do with the proceeds when the deal is done?
Create value. Doing a buyback at a very high valuation is not value creating. Neither is making an acquisition at a high price. There are some businesses they could buy which would fit well with their own. The question is the price. In the absence of that, they could pay out a special dividend or pay down debt. Hopefully, they are focused on where they can create the most value.
Last but not least, you also own a significant stake in Richemont. Where do you see value there?
We love Richemont. It’s a great business and attractive at these valuations. The brands are strong and durable over a long period of time. In the long-term, the distribution is advantaged through the acquisition of Yoox Net-a-Porter. Also, the balance sheet is strong and fits our profile. The family control has been very good for this company over many years. Their long-term ideas about value creation is very consistent with our own thinking.
However, China is an important market for luxury goods. What happens if growth in Asia slows down further?
We think China is in recession. So in the short-term that would create a headwind. But we don’t think it dents the long-term value of Richemont's brands in any way. In the short-term, economies go through ups and downs. But the intrinsic value of a business is the present value of its future cash-flows and they don’t end one year out. They keep going and that’s why the stock market is a wonderful thing: When people get nervous it creates opportunity - and people are oftentimes nervous when it comes to money.