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Good morning. Yesterday we were left with big questions about the FTX meltdown. One was: Will Binance plug the hole in FTX’s balance sheet? We now know the answer is no. Another: Will this matter to crypto prices? Now it’s looking like yes (bitcoin is down 23 per cent in two days). But the big question remains: Why exactly was FTX unable to meet client withdrawals? Where was FTX on the spectrum that starts from recklessness, runs through negligence, and ends at fraud? We’ll find out in time. Meanwhile, we return to two themes we have hit before. Email us: firstname.lastname@example.org and email@example.com.
Some UK companies are really cheap
We recently wrote about the UK equity discount, noting that the valuation gap between the S&P 500 and the FTSE 100 has never been wider. This is not down to sector mix. Though the FTSE is tilted to cheaper sectors such as banking, mining and tobacco, it has not become more tilted that way over the past five years, as the gap has widened. And there is a gap between US and UK valuations within sectors, too.
Is there a macroeconomic reason (slower growth in the UK, particularly after Brexit?) or a policy reason (a moron risk premium)? Maybe, but these are harder to measure. Certainly, there has been a pattern of investor outflows from UK stocks that has picked up in the past five years. Someone is worried about something.
It might help clarify the question to consider it in the context of particular stocks. Simon Skinner, who leads the European investment team at Orbis, suggested two stocks that highlight the trend neatly: B&M, a discount retailer, and Shell, the oil major.
Starting with B&M, it is interesting to compare its financial specs with the US dollar stores, which do not have quite the same business model, but are similar in that they compete on price. I have also thrown in JD Sports, another high-velocity, no-frills, low-price UK retailer, for the sake of context:
B&M’s valuation (on both price/earnings and EV/ebitda, which adjusts for variance in financing) is half that of the US dollar stores. Nor is that all: it has a significantly better record of revenue growth. Its return profile (return on capital, gross profit/assets) is better, too. This looks like a serious dislocation.
The model is that maybe a third of the stores’ floorspace carries basic food items — soda, snacks — that customers come in for, and the rest of the store is filled with stuff that is likely to be an impulse buy, driven by the low prices. The impulse items rotate quickly and change with the seasons and lean towards housewares, personal care and toys. It is made up only of items B&M can source directly and at volume. While choice is limited, price is superior.
What impresses Skinner is how quickly the stores earn back the money invested in them. They are leased rather than owned and are kitted out minimally. The payback period is on the order of 15 months, Skinner says; after that, profits can go back to shareholders or get invested in the next store.
The point here is not to pitch B&M, but to ask why it is so cheap. Skinner thinks that investors are worried about the effect of the weakening of the pound on margins, because B&M imports everything (he notes that the company managed the volatility associated with Brexit pretty well). Fair enough, and you might take the point further. The UK, with its productivity struggles, will grow more slowly than the US. But B&M has shown it can grow against that backdrop already. Why is it trading, like one of its own items, at half off?
Shell is a trickier case, but still the numbers tell a striking story. Shell and its peer BP trade at half what US peers Exxon and Chevron do. The UK companies have slightly weaker returns and growth metrics, which would suggest a somewhat lower valuation, but the difference there is not vast.
Focusing on the Shell-Exxon comparison, it must be noted that Exxon is, by universal agreement, a better-managed company (fewer missed targets, fewer disasters). It has better-quality assets, too: its holdings in the US Permian basin and in Guyana have extremely high returns and relatively low geopolitical risk. Shell’s big upstream projects tend towards lower-returning deep water drilling. But, again: half the valuation?
Why doesn’t the valuation gap tighten? Paul Sankey of Sankey Research thinks that the answer has a lot to with disparate investor bases. The UK and European oil majors remain very large components of their local indices, so local investors are already structurally overweighting the companies. To increase the valuations, global and in particular US money would have to come in, Sankey says. “But it is hard enough to get US investors interested in US oil companies,” he says. The fact that Shell and BP have disappointed investors by missing targets or misallocating capital in the past only adds to that fundamental problem.
Sankey thinks the lack of a natural base of investors can only be decisively solved by changing the companies structurally — perhaps with break-ups. “The market is telling [the companies] that they shouldn’t exist” in their current form.
Something like the point Sankey makes about the UK oil majors probably applies to many cheap UK stocks. The problem is not so much the companies themselves. Instead, the institutional structures that determine global capital flows don’t have any particular reason to send capital to the UK (and, as it happens, the UK money management industry is set up to send capital out of the country). What does a UK investment allocation add to a global strategy that is not available in bigger, more liquid forms elsewhere — other than, at the moment, currency risk? And UK assets aren’t quite cheap enough to change that, especially at a time of local uncertainty. The UK equity discount is real, but doesn’t seem likely to disappear soon.
A few words from Fantasy Mark Zuckerberg
Meta sacked 11,000 staffers yesterday, largely from divisions not dedicated to building the metaverse. Markets replied with a halfhearted thumbs-up. The stock rose 5 per cent but it still languishes at 2016 levels, down 70 per cent this year. Zuck has his work cut out to get shareholders on his side.
The company’s problem is shrinking revenue matched with rising costs, mainly related to staffing and R&D spending. Cuts to R&D are most obvious, having grown thrice as fast as administrative costs (which includes employee pay) since late 2019.
The basic picture is summed up in this chart. The falling dark blue line is revenue, the rest are costs:
Mark Zuckerberg, chief executive, nodded to the need for belt-tightening in a memo to laid-off employees yesterday:
Today I’m sharing some of the most difficult changes we’ve made in Meta’s history. I’ve decided to reduce the size of our team by about 13 per cent and let more than 11,000 of our talented employees go.
Many people predicted [the coronavirus pandemic] would be a permanent acceleration [in revenue growth]. I did too, so I made the decision to significantly increase our investments. Unfortunately, this did not play out the way I expected. Not only has online commerce returned to prior trends, but the macroeconomic downturn, increased competition, and ads signal loss have caused our revenue to be much lower than I’d expected. I got this wrong, and I take responsibility for that.
In this new environment, we need to become more capital efficient. We’ve shifted more of our resources on to a smaller number of high priority growth areas — like our AI discovery engine, our ads and business platforms, and our long-term vision for the metaverse . . . But these measures alone won’t bring our expenses in line with our revenue growth
The change in tone seemed much larger than the change in strategy. What memo from Zuck could’ve moved the market more? It might go something like this:
In the 18 years I’ve run Meta, I’ve been focused on bringing people together. This is a big idea, and thinking big has served the company well. Nearly half the world uses one of our products.
But this year I’ve realised that what’s made Meta successful in the past won’t keep us successful in the future. Today, we are a mature business in a competitive industry, and our management approach needs to reflect this. That’s why I’m announcing four changes to Meta’s strategy.
First, we need to use our most important resource, our people, more efficiently. The pandemic accelerated revenue growth to a pace I thought would continue afterwards, but I got this wrong. Unfortunately my mistake led to a period of significant over-hiring. In 2021 Meta earned $1.6mn in revenue per employee, which has fallen this year to $1.3mn. We now need to get back to that 2021 level, and we are committed to getting there in the next two years. That will, sadly, mean some lay-offs during this downturn, but I’m optimistic that as growth picks back up we won’t need to rely on job cuts anymore.
Second, we need to rethink our investment approach. I still believe the metaverse is the next chapter for the internet. But I now recognise that Meta can pursue that vision in a smarter way. I’ve decided to substantially lower the amount we spend on our long-term vision for the metaverse. Some of the money saved will be spread across investments in short-form video as well as our AI discovery and ad engines. Refocusing on what we do best is the right call.
Third, I’m launching a search committee for a new chief executive. When Facebook was in its growth stage, I believe my ability to set a vision helped us succeed. But a big firm like Meta now needs someone whose strengths are in process, execution and capital allocation. I’ll stay on as chair of the board, helping to steer our metaverse vision and working closely with the new CEO.
Lastly, I’m initiating the process of converting my class A shares, which give me 10 votes each, to regular class B shares over the next five years. This founder-led system helped ensure continuity in Meta’s earlier days, but I realise now that a company of our size needs to give all shareholders a say.
Cue the biggest ever one-day jump in Meta stock. We can dream, right?
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