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Quarterly Report
Q1 2017
02 THE BIG PICTURE
Despite headline valuations, markets
continue to offer opportunities for
value investors.
04 FINDING VALUE
Stock Highlight: Vallourec
FUNDAMENTAL
VALUE
EQUITIES
Our selection process in action:
An attractive price and convincing
transformation plan put Vallourec
in the mix.
06 RESEARCH BRIEFING
Healthcare M&A
Finding value within the Healthcare
sector amid a flurry of merger and
acquisition activity.
Concentrating on long-term value
08 VALUE STRATEGIES
Value strategy updates, performance
and portfolio characteristics.
Fundamental Value Equities Q1 2017
THE BIG PICTURE
Barry Glavin, Chief Investment Officer, Fundamental Value Equities
Following a strong year for value in
2016, the opening months of 2017 saw
a slight reversal of that trend.
It’s not unusual for any trend to falter, but after a decade
of relentless headwinds for value investors, the brevity of
the outperformance period left many wondering whether
2016 was a simple correction rather than the beginning of
something potentially more long-lasting. As value
investors, we look to the data for answers.
Driven primarily by unprecedented central bank
stimulus, equity markets rebounded off the lows reached
during the financial crisis to the point where, at a
headline level, they are now overvalued relative to
history. Investors flocked to low volatility, stable growth
companies even when valuations became increasingly
stretched, but in most of 2016 investors began to focus
again on valuation. To suggest that, after a nine-month
rally, it is too late to participate in the upside potential of
value stocks seems premature, given the continuing
dispersion of valuations within the market.
But, of course, there are no guarantees in investing. We
accept that the future is uncertain and there is an infinite
spectrum of possible outcomes. Therefore, our approach
is to seek cheap investments that can deliver across the
broadest possible range of those outcomes.
Overvalued Market
Equity markets have been on a bull run for almost nine
years, and the MSCI World Index remains close to record
levels. As one would expect, headline-level valuations are
no longer cheap, as the following table illustrates.
MSCI World Index
Price/Earnings
Price/Book
Source: Factset, SSGA as at 3 April 2017.
2
31 March
2017
10-Year
Average
16.5x
13.5x
2.2x
1.8x
The market is not excessively overvalued, but in order to
progress, either multiples need to expand or earnings
need to increase. There would seem to be little room for
sustainable multiple expansion from these levels, but the
case for earnings growth is also challenging. Earnings are
already at record levels, as are profit margins; the bull
case for the global index requires that these record levels
continue to be topped. This is of course possible, but on
the range of possible outcomes, it represents a very
narrow or specific result.
Undervalued Stocks
The simple principle underpinning our approach is that
low prices should lead to above average returns, while
high prices usually lead to below average returns. As
active value managers, we aim to outperform by seeking
stocks that are cheap. Despite the maturity of the bull
market and its valuation metrics, we believe there are
opportunities for the price-sensitive investor due to the
valuation dispersions across stocks, across sectors and
across regions.
Across Stocks
The differential between the cheapest and most expensive
quintiles of the market (represented by the MSCI World
Index) is at historically wide levels. We have tracked the
relationship between them over time, as measured by the
median price-to-book (P/B) ratio of each.
The differential widened from 2009 to mid-2016 as the
most expensive stocks led global equity markets higher.
The gap peaked in early 2016 with the median P/B of the
most expensive quintile at over 10 times that of the
cheapest quintile, a level previously only seen during the
dot com bubble.
Significantly, the value rally in 2016 only narrowed this gap
in relative P/B ratios to 8 times, which is still above the
20-year average of about 6 times.
Across Sectors
When analyzing where P/B valuations
sit today, the divergence in global
sector valuations becomes evident
(Figure 1). There would appear to be
less value in information technology
and consumer sectors in particular,
which are now rated toward the top of
their 10-year P/B ranges. More
economically sensitive sectors on
the other hand, such as financials
and energy, present more value
according to this metric.
Figure 1: Sector Valuations
Price to Book (P/B)
5.0
4.0
3.0
2.0
1.0
0.0
Cons Info Tech
Staples
10 Yr Range
Health Industrials
Care
Cons
Disc
Telecoms Materials Energy
Utilities Financials
Current Price to Book
Source: Factset, SSGA as at 3 April 2017. Universe is the MSCI World Index.
Across Regions
The dispersion in regional valuations
is equally dramatic (Figure 2).
North American equities are
trading close to the richest
multiples in a decade. Elsewhere,
multiples in the eurozone, Asia
and emerging markets appear to
present more attractive valuations.
Figure 2: Regional Valuations
Price to Book (P/B)
3.0
2.5
2.0
1.5
1.0
0.5
0.0
Developed
10 Yr Range
Emerging
North
America
Europe
Eurozone
Asia Pacific
ex Japan
Japan
Current Price to Book
Source: Factset, SSGA as at 3 April 2017. Universe is the MSCI World Index.
Time, Not Timing
The question on the minds of many remains: is now the time for value? The period of value
underperformance from March 2007 to February 2016 was the longest since the 1940s. Yet our
analysis informs us that periods of value outperformance can also be persistent. Based on what we
have seen, and our interrogation of available data, we are optimistic for the outlook of value.
Ultimately, it’s never the wrong time to buy something for less than its worth. Value, as a
philosophy and discipline, needs time to work to capture the benefits of the performance premium,
as short-term results are typically random. History shows that a valuation-based approach
outperforms*, but that the pattern and timing of returns is lumpy and unpredictable. As value
investors, we maintain discipline, patience and a long-term perspective as our core principles, even
when the market pendulum shifts in favour of value.
Today’s markets, despite the outperformance of value stocks in 2016 and high headline valuations,
remain attractive to value investors like ourselves. By focusing on stocks, sectors and regions with
low multiples, coupled with the possibility of a recovery in earnings, we believe our concentrated
portfolios of value stocks are well positioned to benefit from today’s market dynamics.
* Source: Dimson, Marsh & Staunton, Credit Suisse Global Investment Returns Sourcebook, 2016. Past performance is not a guarantee of future results.
State Street Global Advisors
3
Fundamental Value Equities Q1 2017
FINDING VALUE VALLOUREC
**
Lisa O'Sullivan, Research Analyst,
Global Resources
Vallourec’s share price
experienced a significant drop in
February following the release of
the company’s full-year earnings
for 2016 and its guidance for 2017.
This market reaction brought the
valuation to an attractive level at
a time when our due diligence
process was providing clarity
on the company’s ability to
successfully implement its major
restructuring plan and improve
return on investment.
The Context
Investment View
Competitive Position
Changes in return on invested capital will be vital for
Vallourec's performance over time. The following
factors will be key to improving this:
HIGHER MARGINS
These have the potential to grow as fixed cost
absorption improves, alongside greater volumes and
reduced costs as a result of restructuring.
Headquartered in France, Vallourec is a long-established
leading manufacturer of steel pipes — mainly for the oil
and gas industries. The nature of its business means that
it is sensitive to movements in the price of oil as that
ultimately feeds through to demand for its product.
However, Vallourec’s profits had fallen significantly below
the peak levels of 2008 even before the oil price tumble
started to take a toll in 2014.
Pricing pressure from global competition, the decline of
activity within its power generation business, and a large
high-cost European operation led to a decline in operating
profit from above €1.5bn in 2008 to €0.5bn by 2012.
Capital spending by oil and gas companies then collapsed
with the oil price, further hitting profitability – the
company posted an operating loss of more than €500m in
2016. Vallourec’s response has been to initiate plans to
radically restructure its operations.
In comparison with Tenaris, its closest peer, we can clearly
see an important source of lost competitiveness (Figure 3).
Vallourec’s labour productivity declined from 160 tonnes
per employee in 2007 to below 100 tonnes by 2014. With
the oil price decline of 2014, productivity declined further
to below 70 tonnes per employee by 2015. This reflects
Vallourec’s large high-cost European manufacturing
operation and growing capacity in Brazil and the US.
Figure 3: Production Per Employee
Tonnes per employee
HIGHER ASSET TURNOVER
With higher production on a reduced footprint
as a result of Vallourec’s decision to concentrate
manufacturing locations.
200
150
100
50
0
2007 2008 2009 2010 2011 2012 2013 2014 2015 2016
Vallourec
Tenaris
Source: SSGA, Vallourec, Tenaris, Bloomberg Finance LP.
**The specific security listed does not represent all of the securities purchased, sold,
or recommended for advisory clients. You should not assume that investments in the
security identified and discussed were or will be profitable. This information should not
be considered a recommendation to invest in a particular sector or to buy or sell any
security shown.
4
In the period 2007 to 2015 Vallourec’s productivity as
measured by tonnes produced by employee fell by 54%,
while productivity of its main competitor fell by 35%.
Transformation Plan
Capacity
Vallourec has already reduced its European capacity by 50% and created two competitive production hubs in
Brazil and China.
Balance Sheet
Strengthening the balance sheet by raising €950 million in new capital.
Payroll Costs
Reducing the workforce by 3,500 from 2014 levels.
Earnings
Targeting incremental EBITDA (earnings before interest, taxes, depreciation and amortization) of €525m by 2020,
on the assumption of flat volumes. If volumes return to 2014 levels, the company projects delivery of EBITDA of
€1.2 to €1.4bn.
Restructuring Progress
We see the Transformation Plan as key to Vallourec regaining its competitive position and achieving cash flow
returns commensurate with the attractive structure of the industry.
An examination of Vallourec’s results for 2016 revealed initial signs of success for the Transformation Plan as
productivity remained at 2015 levels despite a 10% fall in production. Coupled with a reduction in employee
payroll costs and an improvement in other conversion costs per tonne, this gives us confidence in the
improvement in productivity as a driver of return on investment as production volumes increase.
Outlook
Oil and gas drilling activity will be a key driver of
Vallourec’s profitability. In 2017 we expect an increase in
pipe volumes, particularly in the US where the rig count
is increasing, as is the pipe usage of those rigs. This will
take time to feed through to Vallourec’s financial results
as just 20% of its sales are set at the market spot price
(with 80% of volumes contracted at 2016 prices).
However, the eventual improvement in US capacity
utilisation should boost operating leverage. Although
volumes are likely to remain below historical peaks,
higher asset utilisation on a reduced footprint will be
beneficial for productivity and efficiency gains.
Our Assessment
Vallourec has been added to our portfolio on the basis
of our comprehensive due diligence and assessment of
its valuation.
The near-term outlook can be difficult to determine.
Indeed, the company outlined in its February guidance
that losses (per EDBITDA) would be in the range of
-€169m to -€119m in 2017. This was below market
expectations and free cash flow implications for the
balance sheet appear detrimental. However, the improved
pricing environment today is likely to flow through to
company performance over time. With the stock trading
at a discount to intrinsic value and given our outlook of
improving earnings, we believe Vallourec is an attractive
investment for our portfolios.
Figure 4: Revenue by Region
%
100
80
60
40
20
0
2001
Rest of World
2002
2003
Europe
Source: SSGA, Vallourec.
2004
2005
South America
2006
2007
2008
2009
2010
2011
2012
2013
2014
2015
2016
North America
State Street Global Advisors
5
Fundamental Value Equities Q1 2017
RESEARCH
BRIEFING
THE ANATOMY OF HEALTHCARE M&A
Joe Lawlor, Research Analyst, Global Healthcare
As value investors, we think a lot
about the deployment of capital.
Finding the right stocks at the right
price governs our thinking. A key
question for us is how effectively
companies re-invest their cash flow
and use their balance sheet to grow
their business and create
shareholder value.
The healthcare sector has witnessed significant merger
and acquisition activity over the past 30 years, and
questions arise as to whether it’s a good use of capital,
creates shareholder value and drives outperformance.
There are a number of reasons why healthcare companies
venture down the acquisition route:
• Expansion: To acquire new products quickly and with
less risk than developing in-house
• Synergies: Merge operations and reduce costs
• Market share: Reduce or eliminate competition
• Scale: Broaden into other markets or regions
• Opportunism: Purchase a competitor at a
distressed price
• Solution: Offset a problem in the acquirer's business
Long Term Deal History
Data provided by Credit Suisse HOLT gives some insight
into 400 of the largest deals in healthcare from 1992 to
2010.1 The research looked at the combined companies
cash flow return on investment (CFROI) – a gauge of a
financial performance that measures the cash flow a
company produces with its invested capital.
Figure 5 shows that the three-year CFROI of the
combined health care entities was marginally lower than
at the starting point and the initial forecasts. However,
the three-year outcomes are better than other sectors
and exceed the cost of capital.
Figure 5: Achieved Cash Flow Return on Investment (CFROI) Post-transaction
CFROI
14
12
10
8
6
4
2
0
All ex Financials
Merged CFROI
IT
Financials
First Forecast CFROI
Cons Disc
Materials
Industrials
Health Care
Energy
CFROI 3 Years Post
Source: Credit Suisse HOLT. Universe: 9,972 Global Public Targets From 1992-2010.
1
6
Credit Suisse HOLT. “Worth the Premium? A Systemic Approach for Assessing Acquisition Skill, Tom Hillman, Chris Morck, January 2015.
Cons Staples
Telecoms
Utilities
The Shareholder Return
Focusing on the 42 largest deals (> $4bn), we observe that
the acquirers have underperformed the sector by an
average of 7%. Furthermore, 52% of the deals are in
negative territory, compared to 41% in the 1992-2010
research.
The market rewarded acquirers in the healthcare sector,
with average outperformance of about 30% cumulative
over the three-year post-deal window. However, 41% of
deals resulted in acquirer underperformance; the spread
in average share price performance between the top 20%
and bottom 20% of stocks was around 250%!2
Of the underperforming deals, both the acquirer and the
acquired business are under severe pressure and
management teams are struggling to generate the
expected synergies. Many of the problem deals are in the
generic and speciality pharmaceutical space, where
acquirers overpaid in overleveraged deals for businesses
that subsequently faced serious price pressures.
The most successful deals saw returns and growth in
assets increase, while the least successful deals saw
marked declines in both metrics. The data reveals that
deals typically fail for a number of reasons:
• Overpayment for acquisition due to unrealistic
assessment of revenue potential of the acquired
company
In contrast, ‘outperforming’ deals – often in the medical
technology sector – have typically seen revenue growth
on both sides of the deal at acceptable levels and
integration is generally proceeding as planned.
• Undisclosed or underappreciated problem in the
business of the acquiring company
M&A – A Good Use of Capital?
• Botched integration; expected revenue and cost
synergies failed to materialise
Recent M&A Boom
Approximately $1 trillion of healthcare M&A deals were
consummated in the 2014-2016 period (Figure 6). These
deals were agreed when the sector was trading at a
historically high valuation (in excess of a price-toearnings (P/E) multiple of 18x). Moreover, when the
average premium of 35% that acquirers paid for control is
added, it seems safe to conclude that many will have
overpaid for the assets.
Figure 6: Cyclicality in Healthcare M&A
$bn
P/E
500
20
400
16
300
12
200
8
100
4
0
It is our view that downward pressure on drug and device
prices and the search for new growth opportunities will
lead to more M&A within healthcare.
While M&A can be a viable means of creating shareholder
value, a large percentage of deals will likely fail through
over-payment, over-optimistic assumptions and poor
integration.
In thinking about how we deploy capital to healthcare
firms, we have similar instincts to many acquirers. We
are looking for well-run companies that place an
emphasis on organic growth, that have a history of not
overpaying for assets and historically have managed
integration well. From time to time, our value discipline
has allowed us to identify a diamond in the rough, acquire
it at the right price and benefit when another company
has been willing to pay a premium for control of the
shares we own. And we would like to think we wouldn’t
own a serial acquirer that habitually overpays for growth.
That is not to say we have not owned companies that
made deals that turned out poorly. However, by sticking
to a process of buying cheap well-managed companies, we
believe we are more likely to own the stocks that other
companies pay up for.
2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 0
(LHS) Total Deal Value
Source: Bloomberg
(RHS) MCSI World Healthcare Index, P/E
Past performance is not an indicator of future results. MCSI World Healthcare Index returns
reflect capital gains and losses, income, and the reinvestment of dividends.
2
State Street Global Advisors
7
About Us
For nearly four decades, State Street Global Advisors has been committed to helping our clients, and the millions who rely
on them, achieve financial security. We partner with many of the world’s largest, most sophisticated investors and financial
intermediaries to help them reach their goals through a rigorous, research-driven investment process spanning both
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State Street Global Advisors is the investment management arm of State Street Corporation.
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The information provided does not constitute investment advice and it should not be
relied on as such. It should not be considered a solicitation to buy or an offer to sell a
security. It does not take into account any investor's particular investment objectives,
strategies, tax status or investment horizon. You should consult your tax and financial
advisor. All material has been obtained from sources believed to be reliable. There is no
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have no liability for decisions based on such information.
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shall have no liability for decisions based on such information. Investing involves risk
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Equity securities are volatile and can decline significantly in response to broad market
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Actively managed strategies do not seek to replicate the performance of a specified
index. The Strategies are actively managed and may underperform their benchmarks.
An investment in the Strategies is not appropriate for all investors and is not intended
to be a complete investment program. Investing in the Stratgies involves risks, including
the risk that investors may receive little or no return on the investment or that investors
may lose part or even all of the investment. Value stocks can perform differently from
the market as a whole.
Value stocks can perform differently from the market as a whole. They can remain
undervalued by the market for long periods of time.
Past performance is not a guarantee of future results.
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