“Heads we win, tails we don’t lose much” – Contrarian investor Azvalor sees value in unloved mining and oil stocks

Azvalor Javier Saenz de Cenzano

Javier Sáenz de Cenzano heads up Spanish boutique Azvalor Asset Management’s Managers fund. This fund puts its money behind managers, such as Mittleman Brothers and Moerus Capital Management, who share Azvalor’s contrarian outlook on investment. 

Sáenz de Cenzano focuses on the long-term value investing strategy, looking for businesses with strong fundamentals but low market valuations. Despite a decade’s underperformance, he says this strategy always pays off for those investors that can stick with it. Institutional Asset Manager spoke to Sáenz de Cenzano to find out more.

Why has the value investing strategy underperformed in recent years?

The first quarter of 2020 was the worst quarter for value stocks ever, looking at historical data from AQR since 1926. This came on top of a decade of value stocks underperforming the market, making the difference in valuation between expensive and cheap companies reach historical extremes. We were close to the 100th percentile on all valuation spread metrics like price/sales, price/earnings or price/book. The last time we had a similarly bad quarter for value stocks was in the late 1990s, around the end of the tech bubble, and we all know how that ended for super-popular stocks trading at extremely high valuations.

There is an eternal temptation among many investors to justify high prices with narratives about paradigm shifts, something that has cost them dearly several times throughout history. 

In the 1970s, many (fabulous!) companies (the popular nifty-fifty companies) lost 75 per cent of their value, even though many continued to be fabulous 50 years later. The same thing happened with the Japanese miracle, which seemed infallible after the extraordinary returns of the 1980s, and which culminated with the Japanese Nikkei index hitting a record high of almost 40.000 points in 1989. Today, 30 years down the line, the index is still at half of that pinnacle.

In the late 1990s, technology companies seemed unassailable after generating returns similar to those of their current cousins. Cisco was perhaps the best example of that bubble when, after multiplying by 50 times in 10 years, it peaked at over USD 70/share only to tumble and lose 90 per cent of its value in the next year and a half. Cisco continues to be a great company today. 

In our view, what is happening now is not very different from what has happened before. There was always an argument to overvalue the “popular” asset classes, and it always ended in total disaster for the shareholders of these assets. Perhaps it is different this time. We strongly believe it isn’t.

What types of stocks are particularly undervalued today? 

We tend to avoid the most crowded and popular areas of the market, to focus on those segments that have little following and where valuation dislocations abound. We are long-term contrarian investors, and we conduct deep research in companies with a mindset of being minority owners of a particular business.

Through this approach, we have been investing for instance in gold-related stocks for a number of years now. We identified a huge opportunity in this space, where the world’s best-in-class companies were trading at ridiculously low prices, which provided us with a good margin of safety and very interesting upside potential. The opportunity was in line with our approach of “heads we win, tails we don’t lose much”. The market by and large ignored this opportunity for a number of years, but all of a sudden investors started paying attention, including the likes of David Einhorn or Warren Buffett entering the space recently. 

Other areas where we see significant value are in specific companies in the oil, copper and uranium sectors, where the market dynamics are very favourable for long-term investors, and where some companies are trading at very interesting levels. All these areas have been totally ignored by the market in recent years, which has created a great opportunity from a return potential angle, while protecting our investors from very real risks such as inflation or technological disruption, amongst others. 

In our search for portfolio managers on our Azvalor Managers fund, we follow hundreds of professional portfolio managers across the world, and we noticed that many that were in the past very conscious about valuations have now capitulated and have become less valuation-aware and more focused on future growth. 

The underperformance of the value factor has been more extreme and more long-lasting than ever, and it has been very challenging for many managers to stick to their valuation process – it has required a distinctive temperament and long-term perspective that very few have been able to maintain. 

Historically, changing an investment process in the middle of the game has been a recipe for disaster, while sticking to a proven and robust process tends to reward long-term patient investors.

When do you see this valuation gap between growth and value stocks closing? 

We think no one can determine when the gap will close, but we do know we are now at an extreme moment. Valuation divergence between expensive and cheap stocks has never been greater.

History has taught us that extremes don’t last forever and always end up reverting to the mean. We believe that value investing will make a comeback, which may be violent, like in 1929, the 1970s or the late 1990s. This will mean a very favourable tailwind for value portfolios, and there are reasons to think that a trend is beginning in this direction. 

However, it is more relevant for our investments to get the “what” right than the “when”. And everything seems to suggest that the investment alternatives in bonds, liquidity or the most popular stocks carry an unbearable risk for us today due to their high starting price. Our portfolio, with its level of undervaluation, and the long-term earnings prospects of the companies that comprise it, seems to us like an excellent long-term buying opportunity.

How long is too long to wait for a return on an investment?  

From a valuation perspective, cheap stocks have never been cheaper, and historically when you invested in the right companies at these prices, the long-term rewards were material. We firmly believe this time will not be different in the stocks we own. Being a contrarian investor requires a long-time horizon, since under the radar stocks sometimes do nothing for a very long time, but then suddenly realise their potential in an abrupt manner.

Moreover, as the companies in our portfolios generate by and large very strong and recurring cashflows, the passage of time goes in our favour as one gets the benefit of a high free cashflow yield via dividends, share buybacks, debt reduction, or other accretive capital allocation decisions made by top-quality company management. In other words, in a low-yield global environment, we can benefit from a recurring and strong free cashflow stream while we wait for the market to recognise a given company’s intrinsic value.