Interview

«The Valuation of Pharma Stocks is Astonishingly Attractive»

Sarah Ketterer, Co-Founder and CEO of Causeway Capital, is betting on defensive stocks after the wild rally in cyclical sectors. The value investor says why she likes European pharmaceutical stocks such as Novartis and Sanofi, why she is sticking with ABB and why she thinks the new Chairman of Credit Suisse will have a positive impact on the troubled banking giant.

Christoph Gisiger
Drucken
Teilen

Deutsche Version

Value investors are looking back on a difficult time. Since the financial crisis, growth stocks, particularly tech names, have dominated the stock markets. But now there are increasing signs that the trend is reversing and companies with favorable valuations are developing momentum.

Sarah Ketterer is well positioned for such a reversal. The head of Los Angeles-based investment boutique Causeway Capital manages about $47 billion in assets and has plenty of experience when it comes to value strategies. Her team-oriented investment approach is characterized by combining quantitative research with fundamental analysis on individual companies.

«As value managers, we just constantly assume the worst – and, if a stock or a whole industry still looks attractive, then we sort of ring the bell in the hallway and everybody jumps up and down,» Ms. Ketterer says. One of the main risks she sees is that the U.S. government's planned infrastructure program will have a less rapid impact on the economy than investors think.

Having previously focused on cyclical equities, she has used the rally in recent months to shift into more defensive sectors. Accordingly, European pharmaceutical stocks such as Novartis, Sanofi and Roche currently make up a significant portion of the portfolio. She also sees the setback in Credit Suisse shares as an opportunity.

In this in-depth interview with The Market NZZ, which has been edited and condensed for clarity, Ms. Ketterer explains what she expects from António Horta-Osório as the new Chairman of Credit Suisse and comments on other investments in the Swiss stock market such as ABB and Richemont.

Ms. Ketterer, for the first time in years, there is real hope for a lasting renaissance of value strategies. How do you perceive the current market environment?

There is an inescapable connection between interest rates and the success of value vs. growth. Since the Global Financial Crisis, central banks are more accommodative than ever, and this has been exacerbated by the pandemic. With this kind of monetary and fiscal stimulus, it’s no surprise that value was clobbered in much of 2020. In a way, it was like a crescendo of terrible performance. But now we see a shift to value. It’s the cognizance that the price of money is rising, and that being eternally patient with very risky growth companies is probably not that wise.

Is this trend really sustainable? Or is it just an intermezzo?

As rates rise, investors get much more careful about what they pay. In some ways, it feels like coming out of the TMT bubble in 1999 and early 2000. At that time, we didn’t own any of these bubble stocks. We didn’t understand why people were paying such exuberant prices, but we had the chance to buy very high-quality defensive names, and it paid off for years. This was a golden area for value because at the time, value was considered low beta. I think value goes back to that environment again, where we won’t be the risk managers anymore. As rates sort of stabilize higher, it will be clear that investors who were buying speculative stocks with no earnings and no cash flows are actually the ones taking the risk.

How do you approach this market strategically?

We think a lot about economic scenarios, because there’s a risk that we call this wrong and the US goes into a period of negative rates. It’s not like this didn't happen elsewhere. Shockingly, there are still $15 trillion of negative yielding bonds out there. We think this is unlikely for the US, but after all the money we’ve poured into the economy, we could fall over a bit of a cliff. If some of the infrastructure spend will take time or some of the checks that were sent to individuals will be slowly spent, maybe this gigantic fiscal spend will be stretched out over time. That could be the case in Europe as well. So as value managers, we just constantly assume the worst – and, if a stock or a whole industry still looks attractive, then we sort of ring the bell in the hallway and everybody jumps up and down.

Until recently, Causeway Capital has been strongly positioned in cyclical sectors. Does that still apply?

We sailed into 2020 with a large exposure to cyclicality. And of course, that was devastating as markets seized up and fell to the low on March 23. So we decided that this was our opportunity. As in every market sell-off, any halfway decent manager should use that opportunity, that irrationality to upgrade the portfolio. So we added even more cyclicality, but we did so in areas that were acutely and heavily impacted by the pandemic: Aerospace, travel and hospitality. For instance, we found software companies that specialize in travel like Booking.com, Sabre or Amadeus that were just crushed. But they were so capital light that we were convinced they could make it through the crisis.

And how are you positioned now?

This massive amount of money creation brings about a situation where investors are willing to buy anything, and they did: On November 6th, when the first vaccine news burst through, markets went wild. That’s when this shift in re-rating cyclicality began, especially rewarding pandemic affected companies. So a lot of our stocks in that area, energy, financials, materials, consumer discretionary and the more cyclical parts of information technology like semiconductors went through the roof. But when a stock performs like that, usually our expected return diminishes. So to our clients embetterment, we scraped those stocks out.

ABB is one of the cyclical stocks in your portfolio. Is there still potential for the shares after the recent gains?

ABB has a great management, and that counts for a lot. CEO Björn Rosengren is extraordinary and really competent. Today, the valuation has sort of caught up with events, but the automation space is going to pay up for years. So we took the weight down, because we wanted to lock in a lot of enthusiasm about the stock, but we’re not out.

What do you expect from ABB's management moving forward?

One of the big issues for ABB is growing in China which is maybe even more of an issue for US companies. For ABB, the challenge is how to take advantage of increased automation. Remember, Covid originated in China, and the desire to use less human labor and more automatization may be quite significant. This is one of the most important challenges for the businesses ABB serves.

ABB has just launched a $4.3 billion share buyback program. Is this a wise move? Or would the group be better off focusing on value-creating acquisitions?

It’s signaling. They are not going to abandon their efforts to grow. That’s their primary mandate. But if they have the cash flow and their balance sheet is so strong that they can reinvest in the business and if there is money left over getting it back to shareholders, a buyback makes a lot of sense. So the signal that the new buyback program conveys is very important. It just shows confidence. If they were hoarding their money, we would be a little bit more nervous about them.

The group is putting three of its 21 divisions up for sale. Should ABB consider selling other divisions, too? Or would it even be worth divesting the Electrification business in order to streamline the portfolio?

That’s what we’re expecting from every management. Their mandate is to maximize the value of the business. In your models, we’re not giving ABB any credit for divestitures so if they do that it will be icing on the cake. Here’s an important difference between just buying a passive value portfolio and paying for active management: I strongly believe it’s worth it to pay for a research team that’s working alongside managements, pushing them, making sure they’re accountable - and if they don’t reach their goals, complaining bitterly to the board to get management replaced. This may sound a little aggressive, but we don’t have time anymore. As value managers, we either become quasi activists or we disappear.

In this respect, ESG criteria, which are in line with environmental protection, ethics and exemplary corporate governance, are also becoming increasingly important. As a value investor, how do you deal with this trend when it comes to investments in the energy sector, for example?

Some clients just prohibit any energy companies. So we’ve attempted to circle back to some of them and explain that we've never met anybody who was more focused on the transition from fossil fuels to renewables than Bernard Looney, the CEO of BP, one of our holdings. The company has the cash flow to make these acquisitions, and they will achieve their net zero targets and then some. But it’s important that these energy companies have the cash generation not just to make this transition successfully, but also to be able to pay shareholders in the process. With Total and BP, there are a couple of big European energy majors that are well positioned in this regard.

Where else do you spot opportunities with respect to ESG strategies?

Valuation matters, it ultimately has to matter. That’s why we hold RWE, the German utility. Because the company has coal fired plants, a number of funds can’t own the stock. But RWE is in the process of moving out of coal, and they’re doing so at pace. Here’s what’s fascinating about that: When they complete this transition, there will be a flood of investors who then have to own the stock because of the E in the ESG context. But it’s kind of too late by then. What’s more, we’re taking very little risk since RWE is a regulated utility business. So the low valuation of the stock is quite striking. Especially, when you think about all the power we’re going to need to run this new world of EVs.

As far as electric vehicles are concerned, there’s a lot of speculation in the market. What do you think about investments in this area?

One interesting way to get access to this area is through Samsung Electronics. We have a very large weight there. One of the reasons why is because of the work they're doing in battery technology through their subsidiaries. They’re just a phenomenal IT company, and the valuation has always been perplexingly low. Besides, we think we will get some more income out of that stock as their governance improves over time.

Volkswagen has also been among Causeway's top positions for some time. The shares have advanced by up to 60% since the beginning of the year. Is VW still worthwhile to invest in now?

We’ve held the stock from early 2015. It has been quite a ride: the horrors of Dieselgate, followed by restructuring. But importantly, the company has a strong balance sheet. So we knew it would make it through that difficult time. In January, the preferred was still trading at around 4x earnings, as if this was an entirely fade to zero internal combustion engine business. But then, CEO Herbert Diess decided to emulate Elon Musk and adopt the Tesla playbook: vertical integration, building their own Giga factories and their own proprietary software stack. And then he started to do some PR, and as a result, VW’s stock just went wild. This is why being patient is so important. The returns typically aren’t delivered in a nice, consistent fashion. The entire return can happen in a month.

What does this mean for your position in VW?

We’ve sold most of our position at around €235 and €245 a share. Now, we have only a very modest holding. What we see is a serious semiconductor shortage. A lot of work has to be done around batteries, and a lot of capital expenditures lay ahead. The best time to own a value stock is when capital expenditures are being curtailed and free cash flow starts to increase. VW is actually in the opposite position. But this market is very thematic. Investors just can’t get enough of it, so we happily have to give it to them. And, we have been reinvesting the proceeds from some of these very ebullient cyclicals in defensive areas like consumer staples and healthcare.

Novartis is one of Causeway's core holdings. What makes the shares of the Swiss pharmaceutical group attractive?

We’re just flabbergasted at how astonishingly attractive pharmaceuticals stocks are valued. If you take all the pharmaceuticals stocks in the MSCI All Country World Index, the P/E ratio based on 2022 earnings for the sector relative to the market is beyond the twenty-year low, it’s at a record low.

Why is the market not willing to pay more for pharmaceutical stocks?

We think it’s election risk. We’ve seen the same pattern when Barack Obama was running for office, and then when it looked like Hillary Clinton might beat Donald Trump, and then again with President Biden. This election risk is typically fleeting because it’s not just that the pharmaceutical lobby is powerful, but many of these companies are so important. They have been at the forefront of vaccines. In the US, we have so many other priorities that it’s unlikely that we are going to nationalize our pharmaceutical industry’s pricing power. That’s why we think this is a transient period of suppressed valuations.

And what is particularly compelling about the investment case for Novartis?

We’re able to buy Novartis at a 2022 P/E ratio of 12. Think about that relative to the market which trades at something like 16x earnings. It’s incredible. Novartis is innovative, they’ve got great sustainability in their base business, and it’s not like that they have been sitting still. We’ve seen them making very savvy acquisitions and spin-off Alcon. Also, they have very low exposure to pricing reform in the US. But the market doesn’t care.

An ongoing topic with Novartis is a possible sale of the generics business Sandoz. What would a spin-off offer shareholders?

This is sort of the same conversation we had with VW: Why don’t you list your Porsche business because it’s much more valuable than your main line? That transparency would lift the entire valuation. But we’ve stopped worrying about whether Novartis will ever sell its stake in Roche or spin-off Sandoz. They are generating so much cash. But most importantly, our number one criterion for pharmaceuticals is that they are innovative. Innovation is what leads to pricing protection and pricing power. These are such good businesses, and there’s also a huge disconnect compared to the sky-high valuations of all these speculative biotech stocks. Many of these firms don’t even have any product. It’s just all Phase I or II research, or maybe pre-clinical vs. a fully-fledged pharmaceutical business with cash flow and growth. But instead, people basically want to go to Vegas, putting it on red.

And why do you prefer Novartis to Roche?

We like Roche, too. Roche is the world’s largest biotech company, thanks to Genentech. Especially, what they’re doing in diagnostics is fantastic. We’re all focused on diagnostics again, and they just started to reveal their capabilities to the world. That stock trades at a dividend yield of close to 3%, and Novartis is close to 4%. These are world class companies and impressive dividend yields. It’s almost too good to be true.

Causeway also holds a significant position in Sanofi. Why do you generally like European pharmaceutical stocks?

It’s part risk reduction if we call the Biden administration incorrectly. If we misjudge their determination to force the pharmaceutical companies into strict price cuts - for example for all government supply of Medicare and Medicaid - that could be a problem. So mitigating that risk by focusing on these great European companies helps, since they’re not as dependent on the US market as their US peers. That’s one part. We also think they’re well managed. Sanofi is just coming out of a period where it really underperformed, but in immunology, they’re really good. The market hasn’t figured it out yet, because people used to think about them as a diabetes company. Meanwhile, we get close to a 4% dividend yield just to be patient at a really low valuation. But the market can’t be bothered with these companies. Investors, they all want to own things like Coinbase, and pay enormous amounts.

Where else do see potential for upside when you think about the Swiss stock market?

We own Richemont. They’re going to E-Commerce, and that’s what’s so exciting about them. They have fantastic, very valuable brands, so E-Commerce should make quite a difference. It’s going to get the company a whole other set of channels, and low-cost distribution. That’s our bet. We don’t have a huge weighting there, but it’s big enough to participate. We’re getting Richemont at low 20 multiplies. That may sound expensive, but not relative to its peers. Kering or LVMH are much more expensive, and we think Richemont is just as good or maybe even a better business.

Credit Suisse is also in Causeway's portfolio. There has been no shortage of negative headlines here recently.

Two major scandals in a short period of time, is pretty extraordinary. But the additional capital should return CS to a very strong capital position of 13% CET1, similar to the levels pre losses from Greensill and Archegos. The replacement of senior members of management, improved risk control systems and reduction in leverage in its investment bank are all part of the company’s plan to reinstate full dividend payout and resume share buybacks. The additional capital raised should also facilitate growth in wealth management, boosting group profitability. And, we can look forward to the arrival of the new chairman, António Horta-Osório.

The former CEO of the British financial group Lloyds will take up his new position at the beginning of May. What exactly do you expect from him?

Mr. Horta-Osório, we think, is going to transform the company. He will likely encourage management and the board to reevaluate the group’s future business mix in a strategic review. Meanwhile, the dark cloud of losses has weighed heavily on the stock, making the upside potential very attractive vs. other banking stocks. We expect CS to trade higher in the ensuing months, narrowing its current approximately 40% discount to tangible book value.

Did you take advantage of the setback in recent weeks to increase your position in Credit Suisse?

We had a very small weight, and were able to buy more with the expectation that the company will be better managed, and as a result, investors will get rewarded. But in general, we’re being kind of cautious. We sold off a lot of other European banks in that big cyclical upturn because we didn’t need the risk, and there are so many challenges facing these banks. But when a company makes a mistake, when it trips up, whether it’s a bank or another company, you’ll find us. That’s our chance. If a new CEO or chairperson can guide the business into a better direction, that gets our attention because it’s all about operational restructuring. That’s what value really is. Value isn’t just undervaluation, it’s all about what management can do to grow the topline, make the company generate more cash flow and then return a chunk of that to shareholders. That, to us, is the nirvana of value investing.

Sarah Ketterer

Sarah Ketterer is the chief executive officer at Causeway Capital, fundamental portfolio manager, and is responsible for investment research across all sectors. Ms. Ketterer co-founded the firm in June 2001 and is a member of the operating committee. From 1996 to 2001, Ms. Ketterer worked for the Hotchkis & Wiley division of Merrill Lynch Investment Managers (HW-MLIM). There, she was a managing director and co-head of the firm’s international and global value team. From 1990 to 1996, Ms. Ketterer was a portfolio manager at Hotchkis & Wiley, where she founded the International Equity product. Ms. Ketterer earned a BA in economics and political science from Stanford University and an MBA from the Tuck School, Dartmouth College. She is currently a member of the Stanford University Board of Trustees, a board member of the Los Angeles World Affairs Council and Town Hall, chair of the investment committee for the Music Center Foundation, and serves on the Girls Who Invest President’s Council.
Sarah Ketterer is the chief executive officer at Causeway Capital, fundamental portfolio manager, and is responsible for investment research across all sectors. Ms. Ketterer co-founded the firm in June 2001 and is a member of the operating committee. From 1996 to 2001, Ms. Ketterer worked for the Hotchkis & Wiley division of Merrill Lynch Investment Managers (HW-MLIM). There, she was a managing director and co-head of the firm’s international and global value team. From 1990 to 1996, Ms. Ketterer was a portfolio manager at Hotchkis & Wiley, where she founded the International Equity product. Ms. Ketterer earned a BA in economics and political science from Stanford University and an MBA from the Tuck School, Dartmouth College. She is currently a member of the Stanford University Board of Trustees, a board member of the Los Angeles World Affairs Council and Town Hall, chair of the investment committee for the Music Center Foundation, and serves on the Girls Who Invest President’s Council.