Readers know I like to search each week for out-of-favour sectors and stocks. You could call this deep-value or contrarian investing. The aim is to capitalise on market volatility by identifying quality companies irrationally oversold due to negative short-term sentiment.
Sometimes this value emerges because of market events. A savage correction or pullback drives stocks lower, creating opportunity for long-term investors.
Surprise geopolitical events or disappointing macroeconomic news can also drive valuations too low, as investors become blinded by top-down views, overlooking company fundamentals.
At a micro level, outstanding value can also emerge when companies miss their earnings forecast. The market’s ‘sell first, ask questions later’ mantra can create opportunity in companies with short-term earnings glitches.
Then there are scandals. The slightest hint of bad behaviour these days thumps company valuations, even when allegations are yet to be proved.
Scandals keep coming this year. Just this month, we’ve had news surrounding WiseTech Global founder Richard White and allegations about his private life. The news wiped billions of dollars off the valuation of high-flying Wisetech.
Elsewhere, an investigation by the Australian Financial Review this month reported on Mineral Resources CEO Chris Ellison’s personal taxation arrangements. Mineral Resources shares have shed over a quarter of their value since the news.
In the casino sector, Star Entertainment Group remains on life support after its long-running scandal involving breaches of anti-money laundering protocols. Star shares have lost 93% of their value over the past five years.
In retail, Super Retail Group has faced allegations of a toxic workplace and inappropriate behaviour. Shares in Super Retail, owner of Supercheap Auto, Rebel, BCF and Macpac, are down almost 7% month, but up strongly over one year.
In finance, ANZ Group Holdings continues to deal with the fallout from its bond-trading scandal, and Qantas Airways seems to go from one controversy to another. Shares in ANZ and Qantas have rallied in the past few months.
Therein lies my point. Scandals can do great damage to companies, but in some cases also provide outstanding opportunities when the market overreacts. Qantas shares are up 63% over one year, despite its litany of scandals and disputes.
The hard work for contrarians is deciding which scandals can do lasting damage to companies and those that can create an excessive market reaction.
Before I identify two opportunities, a few caveats. Long experience reminds me that the first news is usually not the worst news when it comes to scandals. Often, more bad news emerges as other whistle-blowers come forward, the Board and its advisers investigate, or as more digging is done by the media and authorities.
As Star Entertainment’s experience shows, scandals can run for a long time, do immense damage to valuations and take years to recover from. Contrarians should watch and wait for better value when scandals first emerge.
The second caveat is to differentiate between founder-led companies and those run by career managers. Founders embroiled in controversy, particularly those with large shareholdings, are harder to remove from companies.
Also true is that removing the founder from an entrepreneurial high-growth company usually does far more damage than removing a career manager. Would WiseTech be the same business without founder Richard White?
The third caveat is there needs to be a large margin of safety when investing in companies facing allegations. In this heightened era of Environmental, Social and Governance (ESG) investing, valuations can fall a long way, and pressure from institutions for executive/Board change can be immense.
It’s not enough to buy undervalued companies in these situations. Their intrinsic value needs to be well below the market price, to provide a sufficient margin of safety for the damage the scandal could still and the high uncertainty.
The final caveat is patience. Picking the turning point is hard enough with contrarian investing, let alone when unpredictable scandals are involved. It’s impossible for investors to know if other people will come forward with allegations, such as those who have had sexual affairs with a CEO.
Prospective investors should be prepared to hold these stocks for at least a few years, knowing they have bought when the valuation was depressed. They should be able to withstand further short-term losses that might occur.
Rio Tinto is a case in point. Its destruction of Indigenous caves in 2020 was shocking and shameful. The then-CEO and two senior executives were forced to resign, but Rio shares are well up on prices back in 2020.
I respect investors who refuse to invest in scandal-ridden companies on ESG or ethical grounds. I also know scandals, in some cases, can lead to management change, Board renewal and a stronger organisation culture.
Opportunities
As to investment opportunities in scandal-plagued firms, Qantas looks overvalued after its rally this year. On ANZ, I prefer global banks to Australian banks on valuation grounds, so wouldn’t buy ANZ either.
I’ve written favourably about Super Retail Group a few times in the past few years, but after doubling in the past two years, its valuation looks stretched.
The embattled Star Entertainment Group trades below its intrinsic value, largely due to the value of its property holdings. Even so, the margin of safety is not sufficient given the immense risks Star faces. It’s too speculative for me.
That leaves Mineral Resources and Wisetech Global on this list. These are the hardest contrarian opportunities to analyse because the allegations facing both companies are recent and each is a founder-led company.
I know some fund managers who have invested in Wisetech for years, principally due to the skills of CEO Richard White. I also know a few Australian equity fund managers who rate Mineral Resources CEO Chris Ellison highly.
Of the two companies, Mineral Resources looks interesting. The AFR allegations are concerning but refer to some income years between 2004 and 2009.
Not surprisingly, the Mineral Resources board has backed its CEO on an issue that relates to taxation matters, some of which are two decades old.
Mineral Resources has fallen from a 52-week high of $79.76 to $35.99. The stock lost favour this year as the lithium spodumene price fell, then tumbled after the AFR report. The stock is back to early 2021 prices.
As I noted last month in this column, select lithium producers look interesting after savage price falls this year. The slumping lithium price has prompted miners to cut back production or delay mine expansion – conditions that should lead to supply constraints and a recovering lithium price in the next few years.
Mineral Resources’ operations in mining services, engineering and construction, iron ore and lithium provide diversified exposure – and a lower-risk way to play a lithium recovery in the medium term. The company has three lithium projects in Western Australia.
Morningstar’s valuation of $62 a share suggests Mineral Resources is materially undervalued at the current $35.99. I’m not as bullish but see a margin of safety to compensate for the current allegations against the company.
Mineral Resources suits experienced investors with a longer-term outlook (at least 3-5 years) who can withstand further short-term price volatility. It could get worse before it gets better for Mineral Resources.
Chart 1: Mineral Resources
Source: Google Finance
I’ll cover WiseTech in more detail in a future column. There’s a lot to like about the company’s long-term prospects as the logistics industry continues to digitise.
For now, the stock looks marginally undervalued after recent price falls but does not provide a sufficient margin of safety given recent allegations.
Chart 2: WiseTech Global
Source: Google Finance
Tony Featherstone is a former managing editor of BRW, Shares and Personal Investor magazines. The information in this article should not be considered personal advice. It has been prepared without considering your objectives, financial situation or needs. Before acting on information in this article consider its appropriateness and accuracy, regarding your objectives, financial situation and needs. Do further research of your own and/or seek personal financial advice from a licensed adviser before making any financial or investment decisions based on this article. All prices and analysis at 23 October 2024.
