Some of the best investment opportunities can arise from strong negative narratives, says Philipp Wörz, a fund manager at PSG Asset Management. “In fact, they are a necessary precondition to finding quality companies at cheap valuations.”
Consider Microsoft, whose products many of us use daily. In 2012, Microsoft’s share price had effectively been flat for a decade, trading in a range of $20 to $30. Over that period, earnings per share had continued to compound by over 10%. The popular narrative at the time was that technological advancements such as mobile, cloud computing and the move away from upfront software licences would significantly impair Microsoft’s business model.
“This view was overly simplistic, given the company’s considerable moat in enterprise computing and the fact that its consumer segment only accounted for a small part of the overall business,” Wörz says. At the time, it had $50 billion in cash on its balance sheet and was generating roughly $24bn of free cash flow. But a wind down of the business had already been factored into the share price, making it available at a compellingly low price.
Fast forward five years. Microsoft has transitioned into the cloud and subscription services, and doubts about its continued relevance are long forgotten. Now it trades at about $76.
Another strong prevailing narrative is the predicted demise in the United States of brick-and-mortar retailers because of the growing dominance of online players. Although the narrative may generally hold true, its broad application across the retail sector has created the potential for significant mispricings, Wörz says.
As an example, he says, US-listed niche brand owners L Brands have become attractive. L Brands has a direct-to-consumer business model and is the market leader in the US lingerie market, with well-known brands Victoria’s Secret and Pink. It is also the owner of the highly successful fragrance and skincare business, Bath & Body Works.
“Concerns about the company’s recent slowdown in trading can largely be attributed to discontinued product lines, while its international business is expected to gain significant traction over the next three to five years,” he says.
L Brands’ share price traded at an all-time high of just under $100 less than two years ago but dropped as low as $35 in August 2017.
“This offered a great opportunity to acquire a high-quality and relevant business in an unloved part of the market at a cheap valuation and large discount to our estimate of intrinsic value.”
As compelling as negative narratives may be, investors should be careful to avoid companies that are out of favour for good reason, Wörz says. “Quality and valuation are equally important considerations, both when prices may be inflated and when they may be justifiably low.”