Key Takeaways
- Columbia Threadneedle Investments looks for good companies trading below their intrinsic value. We do this by undertaking fundamental analysis and an assessment of the potential opportunity a firm has to outperform market expectations
- Often companies trading below their intrinsic value have fallen out of favour with the market due to ‘self-inflicted’ wounds, and with an appropriate change in strategy there is potential for the firms to turn around
- However, history is littered with examples of companies which have put in place performance improvement plans, only for them to fail and investors to lose out. So, how do we try and avoid this?
- With intangible asset growth increasingly a driver of performance growth, a core research theme for us is ‘human capital’ – a central component of intangible value
- Our sustainable research team looks at how firms are managing their workforce and aligning their HR strategy in support of the recovery plan
- This research intensity, and engagement with senior managers and leaders, allows us to understand how a company’s culture and new strategy are being integrated, giving us an additional perspective
The price isn’t right!
Often these short-term share price movements are due to self-inflicted wounds such as an ill-judged acquisition strategy, or poor product, pricing or marketing decisions, leading to a loss of competitive positioning. For many companies, earnings disappointments will continue over a substantive period, leading to further share price decline and the company trading at a significant discount to its intrinsic value.
Value trap or recovery stock?
At Columbia Threadneedle Investments we screen for stocks which have strong financial track records, impressive historic returns and solid balance sheets – and whose share prices have statistically underperformed their long-term average. A fundamental assessment of the potential upside in a company’s valuation (assuming performance recovers) is carried out by the sector analyst. They will consider among other things: whether the firm operates in a sector which has a favourable industry outlook; the level of concentration in that sector, for example, is the industry an oligopoly; whether the firm has significant intangible assets, such as a strong brand; and, critically, its current level of cash generation, which may be required to fund the turnaround or restructuring of the business.
The analyst will also consider trends in quarterly earnings and certain signals3 that may indicate the firm is a potential investment opportunity. One of the most important of these is senior management change at the board level. A new management team enables a fresh perspective of the company’s current and future strategy, unburdened by past decisions.
This level of scrutiny by Columbia Threadneedle’s investment team is to ensure we do not invest in ‘value traps’. This is where investors perceive that a particular stock is undervalued because it has fallen out of favour with the market, but where there is actually a valid reason for the decline in valuation4 – for example, a new technology has made the company’s product redundant, such as the move from physical media to streaming that spelled the end for Blockbuster.
Top down …
Where a company has been identified as a recovery stock, whereby its share price may not reflect its intrinsic value, Columbia Threadneedle will engage with the senior management team to understand and judge whether the initiatives set out in their recovery plan will lead the company back to profitability. In addition, the Columbia Threadneedle Governance team, alongside the portfolio managers and sector analyst, will meet with non-executive directors such as the Chair and the Senior Independent Director to identify whether the Board collectively has enough experience and knowledge to support the executive team to implement a turnaround. This also enables Columbia Threadneedle to judge whether the Board provides enough checks and balances to the Chief Executive Officer (CEO) and Chief Financial Officer (CFO) to ensure they are sufficiently challenged as they execute the new strategy, being prepared to review the process as necessary.
… versus bottom up
However, history is littered with examples of companies who, despite appearing to have a comprehensive strategy to improve performance, fail to resurrect their revenues and earnings. While, as Warren Buffet acknowledges, this can sometimes be due to a ‘mis-evaluation of the company or the industry in which it operates’5, it is often the case that the company’s new strategy has not been appropriately disseminated throughout each managerial layer of the business. Senior leaders and managers not fully on board with the changes required of them and their teams cannot articulate the ‘what’ and ‘why’ to their direct reports, who in turn fail to enact the necessary changes. A study by Towers Watson found that only 25% of change initiatives were successful over the long term6, suggesting that making substantive changes to an organisation without attempting to ensure the business’s values, vision and culture are adapted accordingly is counterproductive.
In order for a company’s new strategy to have the best chance of success, senior management must make distinct efforts to proactively align their internal culture to their new vision. This includes enabling employees at every level of the organisation to understand the plan, what is expected of them, and how it will support and put the company on a stable footing in the longer term.
Putting it into practice
Human capital thematic research
A core research theme for Columbia Threadneedle is ‘human capital’. We prioritise this because the way firms create value has fundamentally shifted over the past 50 years from one based on tangible assets, such as equipment, buildings and inventory, to one based on intangible assets including intellectual assets – such as patents, brands, R&D and customer relationships – all of which are derived from a firm’s human capital (employees). Indeed, management teams often refer to their employees as their ‘greatest asset’7. Therefore, assessing how firms are managing their human capital and aligning their HR strategy to support their business strategy is critical to our investment thesis.
To help us do this we created the “Five ‘S’ framework of human capital management”8 (Figure 1).
Figure 1: the Five ‘S‘ framework of human capital management
Source: Columbia Threadneedle Investments, 2023
The ‘S’ of ‘strategy’ is the levers a firm can pull to manage and align its human resource to its corporate strategy. This includes investing in training to upskill employees so they can adapt to changing technologies, customer expectations or the marketplace, or offering flexible working arrangements to support recruitment and retention.
However, the most fundamental element of a firm’s internal strategy is the culture, vision and values management promote internally. This is particularly true within a company looking to improve performance after a sustained period of underperformance. Employees are being asked to adapt to a shifting internal landscape, which may include job or business line losses. To ensure the successful execution of a turnaround strategy, employees throughout the organisation must understand the reasons for the changes they need to take, otherwise there is a risk that ‘culture will eat (the new) strategy for breakfast’9.
Engagement
To understand how a company’s culture and new strategy are being integrated, Columbia Threadneedle will engage with a company’s senior management team and, importantly, its senior leaders. Because although the Board comes up with the ‘turnaround’ strategy, it’s the senior leaders who are responsible for its implementation. These leaders may be the ones setting the remuneration policy to encourage employees to focus on implementing the key elements of the corporate strategy. Or they may be the ones in control of managing and allocating resources efficiently and effectively between departments so that each business line has the required technology and skillsets to support the new plan.
By meeting these individuals, Columbia Threadneedle can understand how well the new plan is understood throughout the managerial hierarchy. We will ask them to: explain the practical changes they will make within their business units to implement the recovery plan; say how they are communicating and demonstrating to their direct reports why the changes need to be made; find out whether they are adapting their performance assessment and remuneration policies to motivate employees to align their actions with new business priorities; and explore how senior leaders are monitoring progress and making any necessary revisions, and if there is a reporting mechanism back to senior managers of what is and isn’t working well.
Research intensity
Fixing a poor culture or refocusing the vision of the organisation does not ensure the company will make a good investment; however, our engagement does give us an additional research perspective for our assessment of the future financial performance of a company.
At Columbia Threadneedle we believe in research intensity. This is through collaboration between different parts of the firm including sector analysts, governance, portfolio managers and the sustainable research team exchanging
insights, perspectives and ideas. This exchange of views leads to better insights, and better insights – we believe – lead to better performance for our clients.
By undertaking the core fundamental analysis of a potential investment trading below its historical norms and incorporating views from meetings we have with executive management and senior leadership, including perspectives on how the company aligns human capital to its turnaround strategy, we gain greater insight as to whether a company is genuinely a potential investment opportunity or simply a ‘value trap’.
Case study: Unilever10
‘The culture is right’
As a consumer company established in the 20th century but with its roots in the 19th century, Unilever has, by function of its longevity, experienced periods of strength and weakness. However, following a period of extended operational underperformance, driven in part by a failed acquisition strategy and a shift of focus away from its core values, the business hired a new CEO to set out an action plan to improve its strategic focus and growth.
Following a thorough fundamental assessment of the potential upside opportunity of investing in the company if it was able to consistently execute its new ‘action plan’, we initiated engagement. Given Unilever’s poor recent track
record we met with the executive management team, the Chair, and with senior leaders such as the Chief Talent & Reward Officer to understand the depth and breadth of potential change the business was undertaking.
In our meetings we were reassured that a bottom-up approach to implementing fundamental changes had been taken. Stretching goals were incorporated within incentive plans. In addition, incentivisation at every level of the organisation – from employees ‘on the shop floor’ to the executive management team – was changed to improve the line of sight between individual performance and company results. A third-party consultant was hired to initiate a thorough assessment of the skillset needed across the firm’s senior leaders and managers in order to sharpen the business’s current and future performance. This resulted in four out of the five business division leaders being replaced.
Overall, the meeting highlighted that Unilever was aiming to align its human capital strategy to the CEO’s turnaround plan by coordinating its culture and skillset accordingly. These additional insights further indicated that the intrinsic value of the business may indeed be higher than the current share price – and therefore the company could indeed be a potential turnaround investment candidate.
