When analyzing prospective investments, Matt Peden has never focused on near-term performance forecasts. He avoids making short-term macro calls about a company’s operating environment.
Doing so would be a mistake, he says, because you can’t reasonably predict how economies and companies might fare in the next two or three years. “We’re often buying businesses where the near-term macro outlook is quite negative, [which is what] may have caused the price to be driven down despite good fundamentals,” says Peden, who, as vice-president at Invesco Canada, co-manages multiple funds and is lead manager of the Trimark Europlus Fund.
Instead, he values businesses on a “full-market cycle basis,” gauging how they might perform during downturns and upturns.
If he likes a company, he makes an initial entry purchase. Then, he may buy more through a number of trades based on fund flows and whether the share price has fallen since his initial purchase.
The hard part is knowing when to let go, which he’ll usually do if a holding is significantly underperforming or outperforming his portfolio—reflecting a belief that the company won’t perform as hoped, or that it has exceeded its fair value.
Here are two cases when he’s had to make that call.
Electrocomponents, headquartered in Oxford, U.K., distributes electronics, automation and control components, engineering tools and consumables. Through its brands RS Components and Allied Electronics, it operates in the U.K., Europe and Asia Pacific. Electrocomponents is the leading global high-service distributer by revenue based on market share, says Peden, but “the company’s position is weaker in North America, where I estimate the company ranks third by revenue market share.”
The company evolved out of two entities: Radiospares, founded in 1937 in London; and Allied Radio, founded in 1928 in Chicago. Those two companies rebranded as RS Components and Allied Electronics, and later came together through a 1999 acquisition.
Putting it through the process
Electrocomponents falls within the London Stock Exchange’s IT sector. But, unlike technology companies like Apple and Samsung that offer consumer gadgets, Peden defines Electrocomponents as a specialized, low-volume distributor of technology for engineers and manufacturers. It’s not exposed to “product innovation risk, or other types of risk you [might] find with consumer technology companies,” he says.
So Peden saw low-risk growth potential for the company over the next decade or two, mainly due to increased adoption of electronic products. He also estimated a rise in industrial automation and expected more R&D in the technology space.
On top of that, he says, Electrocomponents had “high returns on capital, good free cash flow generation, and organic growth possibilities.”
Peden met with the management team. While he wasn’t blown away, he says, “I thought the business was decent enough that it didn’t need an exceptional management team.” (At that time, the company was led by CEO Ian Mason, who in the 2012-2013 annual report said the company’s main goal was gaining global share.)
Peden followed Electrocomponents’ performance for one year starting in 2011, having officially placed it on his watch list. Compared to other technology distributors, he found the company had a sustainable competitive advantage based on its global footprint of warehouses and broad range of SKUs.
Then, on September 28, 2012, he bought his first shares at around 2 GBP—after the stock had descended from a 2011 high of around 2.94 GBP.
The company’s stock appreciated between May 2012 and May 2014, nearly regaining its 2011 high. Peden made his next moves between May and September 2014, when the share price fell to around 2.23 GBP. At that time, he says, “We increased the position by around 10% in unit terms.” He did so again between January and February 2015 when the company’s share price dipped slightly, and then added another 5% to the position in August 2015.
In total, Peden increased his position by 25% between the spring of 2014 and summer of 2015.
As it turns out, that was the right call. A new management team entered the scene in April 2015, led by current CEO Lindsley Ruth.
“I didn’t fully realize how much improvement there could be until the new CEO came in,” Peden says. “Ruth brought in a new CFO, changed some of the regional heads, and he’s really expanded on his initiatives and the strategy for the company.”
Before that, Peden adds, growth was stagnant, even declining in some quarters. But, says Peden, “Ruth really exceeded our expectations. So, we increased the initial value we’d assigned to the business as he continued to deliver. The stock price sort of appreciated at similar rate as we were increasing our valuation.”
Electrocomponents’ valuation rose steadily following Ruth’s appointment, starting about six months into his tenure. Says Peden, “The company’s price has started to reflect what we feel is a fair value for the business with the new management team; we have been trimming back the position over time.”
The company’s share price has surged since September 2015, going from 1.73 GBP to 6.20 GBP as of September 22, 2017. That’s more than three times Peden’s purchase price. Based on strong underlying growth, the company may look to acquire for the first time in 17 years. Says Peden, “They’re building their internal M&A capabilities and starting to identify a pipeline of opportunities.” But there are no plans to acquire anything yet, and Peden hasn’t heard of any such plans.
Peden is not ready to drop the company at this point, noting that the U.K.-based business operates in a “highly fragmented” industry where no companies are significantly beating the pack. It’s also well diversified, likely shielding it from Brexit complications.
He’d normally consider selling a fully valued company but there are exceptions. “Even if a company becomes fully valued, we may continue to hold. Right now, the market is quite expensive in general and we’re finding very few opportunities,” he says.
Bank Pekao (WSE:PEO)
This bank, based in Warsaw, is formally called Bank Polska Kasa Opieki Spółka Akcyjna. One of Poland’s oldest financial institutions, it was founded in 1929.
It was acquired by Italian bank UniCredit in 1999. In December 2016, UniCredit subsequently sold 32.8% of its stake in Bank Pekao to Polish insurer PZU Group (which bought 20%) and the Polish Development Fund (which bought 12.8%).
Thanks to these changes, rumours have circulated that Bank Pekao’s CEO would step down, and that the bank would merge with Poland’s Alior Bank. As of press time, no merger has taken place, but Pawel Surowka replaced Luigi Lovaglio as CEO.
Putting it through the process
Bank Pekao got Peden’s attention in 2013. Even though it was originally founded as a national bank for Poles abroad, it’s become one of the largest banks in the country. Says Peden, “They have the second-largest branch network, with very strong branch network density and density of ATMs.”
He says investing in the bank is an exception, in the sense that both his European and international funds are underweight financials. “In the financial space in Europe, banks tend to be low-return-on-equity businesses and they don’t have any form of competitive advantage,” he says. “In the European fund, it has been our only investment in Poland during my time.”
What set it apart? In Western Europe, most banks have large investment banking operations and high leverage, and the industry is commoditized, says Peden. “But when we looked to Poland, we saw many of the opposite characteristics: Bank Pekao was more focused on basic retail banking in terms of collecting deposits [and] making loans. Even on the corporate side, it was less about sales and trading,” he says.
Even better, Bank Pekao’s customers are loyal and the management team is conservative when it comes to loan underwriting. “They compete very rationally on deposits, too, so they don’t go out and try to aggressively offer high interest rates for corporate deposits,” he adds.
Peden also forecasts increased demand for banking services and products per customer because Poland’s economy is stronger than those of its peers: the country’s purchasing power and GDP per capita are both growing.
Peden snapped up Bank Pekao at about 175 Polish zlotys (PLN) on July 4, 2014—looking at the stock between July 2007 and July 2017, that’s comfortably between the stock’s 10-year high point of 270 PLN that was reached in July 2007 and its low of 67 PLN that was reached in February 2009.
By mid-May 2015, the stock had risen to just above 194 PLN. But it dropped shortly after and has since struggled to regain that level. (As of early October 2017, it was sitting around 125 PLN.)
Peden attributes this fall to measures introduced by Poland’s new government, which came to power in October 2015. During the political campaign, the party had proposed a tax on banks because it felt the institutions “were too profitable,” Peden notes. “They wanted to use that tax to provide, basically, a payment to every family in Poland.”
The resulting tax, which came into effect on February 1, 2016, was “quite high,” says Peden. “It’s as much as 44 basis points of assets, and this is for businesses that return, on average, 1.5% of assets. It means almost a third of the overall profits of the banking industry have been captured.”
In Bank Pekao’s latest annual report, ex-CEO Luigi Lovaglio said Bank Pekao paid 450 million PLN toward the tax, representing almost 20% of the previous year’s profit. Nonetheless, the bank achieved a “level of net profit [that’s] almost the same as last year,” he wrote.
Still, Peden’s cautious. While the bank’s profit for the 12 months ended December 31, 2016 was “slightly higher than average,” he finds the tax has had “a major impact on the long-term value of the business, and that [has] negatively impacted this investment.” Also, the management team changed in early July, and “I haven’t had an opportunity to meet with them yet,” says Peden.
Factoring in low interest rates, the bank’s facing a challenge. “The tax came in at a time when net interest income was already depressed,” Peden says. “And, because the tax is a fixed percentage of assets, it does hurt when your return on those assets is already depressed.”
On the upside, Peden says, the tax’s fixed nature leaves room for greater operating leverage when interest rates do rise. “If the yield on the average return on assets increases, that would drop 100% to the bottom line after the regular corporate tax,” he says.
Peden halved his exposure in early 2016. At that time the stock saw a short-lived rebound, but was still below his purchase price of 175 PLN. Between March and May 2016, “the stock went above the 150 PLN range, and that’s when we cut the position,” he says. “Since then, we’ve kept the position [in] that smaller 1%, range, down from 3%.”
But he hasn’t given up on the holding. “In our universe, we’re looking at our watch list of quality businesses and Bank Pekao does continue to rank quite reasonably. It has a 6.7% dividend yield [as of September 20]; the bank has a lot of excess capital and it’s a growing business.”
The main issue is the banking tax, which caused Peden to re-value the company. “There was also a reset in the market price, however, so the market price versus our estimate of the price is quite reasonable now, and that’s why we continue to hold,” he says.
Though the bank has been a miss, there is upside, says Peden. “The odds of a government imposing a higher bank tax are very low. I think they’re already seeing the negative impacts on the economy when such a steep bank tax is imposed on lenders; that can impede growth.”
If a “more sensible” government is elected in the next couple years , he adds, that could lead to brighter prospects for Bank Pekao, especially as rates rise.