(Ep.50) The Acquirers Podcast: Simon Adler – Recovery Value – Deep Value With Schroders Global Value Recovery And Global Income

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In this episode of The Acquirer’s Podcast Tobias chats with Simon Adler. He’s a Fund Manager on the Schroders Global Value Team., where he manages two funds, Global Recovery and Global Income. During the interview Simon provided some great insights into:

  • Investors Can Learn From Their Mistakes Using The U.S Military’s – After Action Review
  • 7 ‘Red’ Questions To Uncover Value Traps
  • 150 Years Of Evidence Suggests Value Investing Will Be Around For Some Time To Come
  • Deep Value Investing Using Enterprise Value To 10 Year Average NOPAT
  • Schroders Collaborative Approach To Assessing Risk And Position Sizing
  • Common Areas Where Companies Fudge The Numbers

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Full Transcript

Simon Adler: When you’re ready.

Tobias Carlisle: I’m Tobias Carlisle. This is the Acquirers Podcast. My special guest today is Simon Adler. He’s a Fund Manager on the Schroders Global Value Team and he manages two funds, Global Recovery and Global Income. He’s based in Great Britain based in London. Will be talking to him right after this.

Speaker 3: Tobias Carlisle is the Founder and Principal of Acquires Funds for regulatory reasons, he will not discuss any of the Acquirers Funds on this podcast. All opinions expressed by podcast participants are solely their own and do not reflect the opinions of Acquires Funds or affiliates. For more information, visit AcquiresFundsdotcom

Tobias Carlisle: Hi Simon, how are you?

Simon Adler: Good, thanks Toby. How you doing?

Tobias Carlisle: Very well. Thank you. So Schroeder’s is a storied name in finance, been around for several hundred years. I saw on your Wikipedia entry that you finance the Confederacy in the American civil war. Sorry about that. And now you’ve continued the tradition by, you guys have got a Global Deep Value focus set. You’re a Fund Manager on the Global Value Team, what does that mean?

Simon Adler: So we are a boutique within Schroders managing money in a very Deep Value, consistent style. As a team of nine of us, we do that. And one of the team, all of us consider ourselves investors. I co-manage the Global income and Global recovery funds and basically we spend our time deep into the accounts, looking at numbers, trying to find the cheapest companies in the world.

Tobias Carlisle: And divided between those two funds it’s about four billion dollars?

Simon Adler: Yes.

Tobias Carlisle: So just talk very quickly. What’s the difference between recovery and income?

Simon Adler: So they’re very similar is the first thing I would say. Today, the overlap between the two funds is between 50 and 60% that will change over time. But recovery is the purest deepest Value that we go. We don’t care if there’s an income, we’re looking for longterm capital appreciation. Whereas income, we know many of our clients need the income, are living off the income, it’s very important for them.

Simon Adler: So when we find the stock that we think is attractive, will be making a decision as to which portfolio should go. And if it’s really high risk, but huge reward, never going to pay a dividend Global recovery fund. If it’s slightly low risk, if it pays a good yied today, that’s going to be under consideration for Global income. You’re not allowed to laugh at me here. We’ve got a slightly naff analogy, but very important that we use for income.

Simon Adler: So if you think of a three legged stool, if one of the legs gets taken out you’re flat on your face. For that three legged stool, the three legs is income today, the growth and income per unit. So that’s what the person is living off it needs, and the capital growth. Alternately, the best way we can give our clients great income in five years time is to grow the capital.

Simon Adler: And then that allows us to have a good income per unit for the client. So the difference is really the income one less tolerance for risk and more of a focus on income. But ultimately it’s the same process that goes all the way through the team with everything we do. We only look at the cheapest companies in the world. We say no to most of them, and then if the ones that get through all of the process, it will then be divided in that way. Of course, many of them are suitable for both.

Tobias Carlisle: I might be speaking out of school a little bit, but I just wondered how has the performance of income being relative to recovery?

Simon Adler: So over the very long term recovery’s typically done better. So the longest funds we’ve had running in UK, so the UK showed the recovery firm doors in 1970 the income firms later than that. But over long periods of time, recovery’s done a bit better than income. That’s typically what it has been, and in a sense there should be no surprise that the greater risk you take, the higher the return should be. And that’s what we see.

Tobias Carlisle: And that dovetails with some research that Med Faber has put out that choice that if you focus on dividends, if you lean on dividends, you tend to underperform a little bit as a Value strategy, the better Value comes from using some of the other metrics. Let’s just talk about recovery a little bit because that’s the one that might be closest to the strategy that I employ. So how are you identifying stocks? Where are you looking and what are you looking for?

Simon Adler: The answer I can talk to recovery, the answer actually is the same for both. So the process works for the both. I should say just before I answer that, that in the yield funds, we’re quite happy to buy companies that don’t yield today, provided we think the yield will be attractive down the line or the capital can grow a lot. So we don’t screen on dividend yield at all for any of the funds. But in terms of your question on the recovery, which as I say works for income is we screen the world, we look for the cheapest companies in the world. It’s the only way we get ideas. So-

Tobias Carlisle: Developed, emerging no restriction there at all.

Simon Adler: No restriction. The only restriction we apply is a Market Cap restriction to ensure our funds have enough liquidity. So I’ve got huge respect for you Toby, but if you tell me the name of a stock today and you think I should look at that and it’s not on the screen, I’m afraid I’m not going to be polite enough look at it.

Simon Adler: The only way we can ensure to our clients that we deliver to them Property Value, the Value which the academic work shows outperforms over the long term is just to keep on the screen. So we screen the entire world, everything over a market cap of $500 million of free float.

Simon Adler: And that’s our starting point. We then have a, we call it a Huddle. We have a chat, the nine of us on a Monday morning, and we say, “Who’s going to look at what?” Anyone can look at anything. So there are Fund Managers that just manage the UK money, but they can go and look at any company in the world that they want to. And that’s when the [inaudible 00:06:26] starts.

Tobias Carlisle: And so how are you narrowing down that universe, so you’re starting with a totally clean slate just saying that, “Here’s the Market Cap restriction and it’s go anywhere.” Are are you starting with a Value Screen? Are you starting with something like that?

Simon Adler: Yes. So the Value Screen that we use is we use a number, but the majority of the time we’re using a Graham and Dodd Stock Value Screen. So we’re looking at 10 year average earnings. So the one we use is a slightly more complicated one, so we use Enterprise Value to 10 year average net operating profit after tax.

Simon Adler: The reason we use it is, if you and I know you have, if you look at the very longterm data, as you know, if you invested on a Cap basis, cyclically adjusted P/E price to 10 year average earnings that has delivered fantastic long term returns. But the problem with that, again as you know, say if you’ve got two companies with a Cap ratio of 10 this one’s got a pile of debt and the second one’s got a pile of cash. We all know will have the one with the cash.

Simon Adler: So we think like yourself, it’s better to use EV Metrics Enterprise for any metrics. And then Warren buffet, you’ll have heard him say, “If people start talking about EV bit dollar, you should walk out the room and of course some sympathy with that person”.

Simon Adler: So we like to look at operating profit, but then of course if you’ve got a company based in a jurisdiction that is never going to pay tax versus a company in a jurisdiction that pays a high level of tax, that’s a different, they’ve got different Value. So we tax the EV. So we look around at every company in the world for the cheapest companies on EV to 10 year average notepal. We do occasionally look at a price to book screens, but the main one we use employer’s EV 10 year average notepal.

Tobias Carlisle: You’ve referred to a question I was going to get to later, but I would like to ask it now. One of the difficulties I imagine for you is that you have these different applications of accounting. Imagine you’re looking at if for instance some gap if you’re looking at North America as well. So there’s a local implementation of each of those. IFRS type that’s I-F-R-S which is the International Accounting Standard. You adjusting those on a case by case basis. How do you approach that?

Simon Adler: Yes, it’s a case by case basis. So the way the process works, is we screen world looking for those cheapest companies that we can, we don’t make adjustments for accounting standards at that point. Then what we do, that Monday morning meeting we pluck out whichever ones we want to look at. Then we go through a really rigorous detailed, disciplined forensic type of approach.

Simon Adler: And in that approach, the first thing we do is build a minimum of a 10 year model but the model’s going backwards, it’s not looking forwards or what the industry calls Forecasting, but people should call guessing. We’re looking backwards. So a minimum of 10 years to try and understand the cycle. And there’s part of that process that, two questions, we ask seven questions every time. Two questions we ask is, “Is there anything wrong with the EV?”

Simon Adler: So is there something that the screen’s missed? Almost always, obviously. Then “Is there anything wrong with the profits?” Are the profits misleading. Now the profits can be misleading for all reasons, whether it’s they’ve sold the business, whether the accounting is dodgy, but it can also be to your question, different accounting standards. And then we’ve got to go and do some reading. We go read up and make sure we understand the accounting standards and the judgments that are being made for every company and make adjustments where we deem it necessary.

Tobias Carlisle: You come from an accounting family, you got your own book of accounts [inaudible 00:10:17].

Simon Adler: Yes, that’s right. So I often joke that many people in the team had to work hard to become knowledgeable in accounting. I was encouraged to start by my family as an eight year old. So what Toby’s referring to is as an eight year old, I got given an accounts book and then had to keep my own accounts.

Simon Adler: So I think from memory I got paid a penny for each piece of litter I picked up on the road, and I think 10 people or 15 people watering the garden, and that was the end money. And then all my expenses. So you can pick it up now and see what as an eight year old I spent my money on, which basically is one penny sweets or that. But yes so I thought-

Tobias Carlisle: Was that revenue line ever audited some,

Simon Adler: Sorry?

Tobias Carlisle: Was the revenue line ever audited?

Simon Adler: Well, but my father was an accountant, so probably it was audited. He never signed off on it. But yes, so I grew up doing my own accounts, my dad was an accountant, the family table every quarter the phone bill was put in the middle of the table and you had to tick off each phone call you had made, any ones that weren’t ticked off were rung from the middle of the table. As I grew up being very careful with money and making sure I understood the Value of it and understanding accounts from really day one and I love it. [inaudible 00:11:50] .

Tobias Carlisle: When you’re digging into the accounts, what are some of the common areas that you find companies fudge in order to make themselves look a little better than they might otherwise the reality might actually be?

Simon Adler: There’s so many, but one of the ones we see time and time again is the timings of year- ends. So often companies move their year-ends or they time their year-ends for the most flattering time. So tour operators are a classic example. So in the UK, the tour operators have their year-end in September. Now why September?

Simon Adler: Well, all of us in Europe have been on holiday by the end of September, but they don’t pay the hoteliers where we’ve stayed until by November. So the balance sheet looks really cashed up and think, “Wow, this company is really fun.” And then of course what actually happens in the UK, is six, seven, 800 million flows out of the balance sheet within the next couple of months. Now you can’t pick up the phone and ask the management that, it doesn’t stay in the accounts over 700 millions is about to flow out

Simon Adler: Identifying that is a lot of hard work. So you grow up, the interest pay, you gross up the interest received, you look why they got big revolvers? You wouldn’t have a big revolver if you’ve got that much cash in the balance sheet. What’s the covenant set up is, and this is the huge advantage I think we’ve got as a team, is there’s nine of us doing this the whole time day in day out.

Simon Adler: And if you came to the desk, most people would fall asleep with the conversation that’s going on. But it’s the whole time it’s… I’ve seen this with accounting, “Does anyone seen that before? Can you explain this? So I’ve seen that. Look at this note guys, isn’t this funny?” Over and over again, it’s that stuff. So we’re looking at this stuff the whole time year-ends just one obvious one. But it’s stuff you see the whole time and it’s a combined experience that you build up that helps you try and weed out something

Tobias Carlisle: How does the portfolio look? How many positions, how concentrated are you with inception? Do you trim as a position goes up and so on. So it’s a portfolio management question.

Simon Adler: Yes. So we talk about between 30 and 70 stocks. At the moment as there are ideas out there, but it’s not that markets have just fallen 60%. So moment we’re down to between 30 and 40 stocks in most of our portfolios, the market fell very significantly we would expect that to rise. And the way we actually, we do our position sizing is a bit different maybe from other people.

Simon Adler: So let’s say I came to you and I said, “Hey, we’ve got a stock here it’s got 1000% upside.” Every member of the Value teams looked at it, it was on a screen, should be a good start, we’re going through lots the accounting. We’re really confident there’s 1000% upside. And then I say to you, “If I told you maybe about how much of your money would you put in it, you don’t have to say that out loud.”

Simon Adler: And then I say, “Okay, I’m going to tell you something else. I think it’s got a Risk score…” A Risk scores is in all of our companies is 10 out of 10.”…and we all agree that we think there’s a 99.9% chance it goes bust tomorrow.” Now how much money goes in? Much less. Right? And so that’s the way we construct our portfolio. So the biggest positions aren’t necessarily the ones with the most upside but they’re the ones where we think there’s at least chance of permanently impairing our client’s capital. So that’s how we think about position sizing. We-

Tobias Carlisle: Is that a Kelly type analysis or not necessarily an application of the Kelly criteria in just an ad hoc soft Kelly, something like that?

Simon Adler: So the way we’d come up with that number, we spend a lot of time thinking about this because it’s not easy. So do you go down the path of saying “This level of net-debt-EBITDA and this level of cyclicality equals X.” Or do we go down the path of, “Think about it very hard yourself. It’s a scale and come up with your own number.”

Simon Adler: Now the way we’re currently doing it is more of the latter. So we say, “Okay I think the balance sheet risk is there. So I think the ESG risk is that, I think the structural risk is this and that.” That adds up to me, for me it’s a three out of 10. And what we use that for is a signaling mechanism. So then someone else on the team, can say “Well I’ve looked at that as well, but I think it’s an eight out of 10.”

Simon Adler: Okay. We’re seeing different things here. But if three or four of us have seen it and we all think it’s three out of 10, we’re looking at the same pattern. And the reason we did that, is we used to say, “I think this is quite risky.” And if I said, “Toby out of 10 what’s quite risky. Simon and Someone will start risky. Everyone’s going to give a totally different number. So we do it as a way of trying to communicate with each other.

Simon Adler: We know it’s not factual. We know it’s not got a direct linkage, but we find a much cleaner, more superior way of saying our perceived levels of risk and rating them. And I we’ve done a lot of work at going back over time and saying, “Different people have different risk limits? Are we consistent? Are we calibrated?” And that’s work, we continue to do to try and get better.

Tobias Carlisle: So that’s a sizing of say one and a half to 3% say roughly at inception. If let’s say a scenario where a company goes up 100% and one, where it haves, are you trimming as it goes up, are you adding as it goes down?

Simon Adler: Yes. Basically. If we say the risk is the same throughout the whole process, so let’s say it’s a five out of 10 risk or it’s going to be that forever, it obviously won’t be, but for ease of that conversation, if the Risk score is staying the same and it’s getting more expensive, so it’s gone up 100%, it’s going to be a smaller position.

Simon Adler: If it’s going down, it’s getting cheaper, the risk of losing your client’s capital should be lowering and at that point it would be a bigger position. We often start between a percent and 2% actually that’s not very often we’d go straight to something like three, many Value investors we often find we’re a bit early so we like to keep some firepower. So we start one to 2% and then increase it, decrease it, seeing what happens.

Tobias Carlisle: I like that approach. I’ve also taken on the approach of taking about a percent because I find that you can’t really think about a position, you don’t start thinking about it properly until there’s some money in it until it’s theoretical. Do you adopt something like that?

Simon Adler: I don’t know if I think about it in quite that way, but the way in which we think about it’s, so for the Global recovery fund, there’s three of us named managers and let’s say it’s me, you and someone else, it’s myself, Andrew Lyddon and Nick Karrage. If Nick and Andrew want to buy a stock and I don’t, we just don’t buy it.

Simon Adler: If me and Nick want to and so on, all three of us have to want to buy it to buy. And then what we say is, let’s say Andrew and Nick think it should be a 2% position, but I only think it should be 1% it will go in at 1% so it’s always the lowest common denominator. Because we don’t want to get to the place where it needs to be conviction and that it needs to limit the chance of losing our client’s capital. But you’re definitely right once it’s in the portfolio area it concentrates your mind.

Tobias Carlisle: And where are you finding Value at the moment? What countries? What sectors?

Simon Adler: So we’re finding the best Value in Europe continental and the UK, probably then Japan or actually Japan and wider Asia. So we’re seeing in the UK particularly [inaudible 00:19:40 Miners] and banks, we think they look very attractive. In Europe, you’ve got some of the auto suppliers, the auto areas we’re not getting over the line on with.

Simon Adler: We’ve got some issues with the accounting there which we think it’s quite important. Then in Japan we’re finding companies, like [inaudible 00:20:03] with extraordinary balance sheets, extraordinary valuations versus the cash or the securities and you’re paying at very low EV Multiple with very limited chances of losing your client’s capital because of the strength of the balance sheets and often some quite good businesses as well.

Tobias Carlisle: The concern for Japan for a long time has been all of those interlocking shareholdings and the unwillingness to unlock some of the capital that’s been in there. But I understand that situation is improving a little bit. Have you seen something like that?

Simon Adler: Yes. So people that really know what they’re talking about in Japan all belief. Sorry. The people that I’ve spoken to all believe that there is significant change happening, that the cultural attitudes are changing, the government’s working very hard to do that. Companies now have to explain why they own the investments. And if you look at long term graphs of course shareholdings, it does appear that it’s reducing. If I’m honest, that’s not why we’re there.

Simon Adler: We’re there because we think that Evaluations are attractive and the risk is low. And we’re very patient investors. So hopefully we won’t have to be there for 20 years. Our average holding period is five years. But as a team we don’t think about catalysts. We think it’s a dangerous game. Because by the time the catalysts happen, the shares have just gone up to 100% .

Simon Adler: We’d rather be in before that. So we understand that things are changing in Japan, but effectively as we look around the world, the Evaluations were getting and the risk had gone in Japan, it’ materially more attractive than most other auctions around the world. So-

Tobias Carlisle: Do you do Currency hedging?

Simon Adler: No, we don’t. [inaudible 00:21:53] fear with Currency hedging is the one thing you know is that it costs your clients. And the longterm evidence, would suggest that it doesn’t help.

Tobias Carlisle: Right. And it can also be another source of… It’s another potential to lose some money.

Simon Adler: Yes. We just don’t want to lose our clients capital. We look after it like it’s our own capital. Incidentally it is, will have our own capital. We’re all invested in the funds and we just don’t want the fund to incur costs where we don’t think there’s going to be a reward.

Tobias Carlisle: There’s been a trend I think over the last five or 10 years for Value guys to become more growthy because that’s has been where there have been sources of returns and rather than the more traditional lower multiple nearer term cash flows. Are you adapting to that or are you firmly in the more traditional Value Cap?

Simon Adler: We’re pretty stubborn in a traditional Value Cap. If you look at the very long term evidence, because I’m sure you have. The evidence is clear that buying the cheapest companies gives you the best returns. The evidence is also pretty clear I think that buying high quality companies, you underperform. That’s what the longterm evidence says. So today we’re in a period where many investors have moved from Value to quality.

Simon Adler: We are not those and absolutely not. And I don’t think I ever will be unless there’s 150 years of evidence to say we should be, but I don’t think I’m going to be alive if that happens. So we’ve kept in the cheapest part. And I think it’s quite interesting to look at why Value has underperformed. Value has done well in absolute terms.

Simon Adler: Frankly, if someone had said to me in 2009 or even last year, you could get these returns, I would’ve bitten their hands off. It’s just that we haven’t done nearly well as the [inaudible 00:23:52] the relative evaluations between growth and quality versus Value, they’re looking at very, very extreme. And so I’m happy to be patient. I think those valuations are in very dangerous territory and I wouldn’t want to put my clients there. So we keep going with the traditional Value where the academic evidence is, we stick to it and people can call us stubborn when they like.

Tobias Carlisle: I tend to agree with you, but the the US data is… because that’s the data I tend to look at. It’s been an extremely long period of time for Value to underperform. It may not yet be quite as deep as the Dotcom peak, but it’s approaching that level. But in terms of just the sheer number of years, it’s seems to have… I was discussing this with somebody yesterday and they said rather than being turned up to 11 will turned up to 13 or something here. When does it recover? What does it take for it to recover?

Simon Adler: The two million dollar question. I think it’s very dangerous to go down the path of trying to identify the catalyst for why it will cover and trying to say when. The question I continually ask people is, if you go back to the Dotcom, which you mentioned. As you say, the dotcom was very short and sharp for Value to underperform.

Simon Adler: And then, Value had a phenomenal period of out performance. And if you ask everyone you ever meet, what was the catalyst for that period of out performance for Value? I haven’t met a single person yet that can tell me the catalyst despite us all having 2020 hindsight. And so trying to look for the catalyst in the future I think a dangerous game and many people are trying to play it and trying to time it. And, and we both know that the long term evidence of people trying to time markets is not very good.

Simon Adler: So I’m afraid I can’t tell you when and I can’t tell you why, but what I can tell you is that if you invest for the longterm in the cheapest companies, I’m pretty sure you’re significantly out before. I read a book recently, I don’t know if you’ve read Phillip Carret’s book, one of the longest running firm managers.

Simon Adler: He was a real Value man and if you read the book or you speak to anyone that met him towards the end, there’s some interviews on YouTube with them and they say, “What’s the number one lesson you’ve learned?” He managed money for 90 years. That’s not true.

Simon Adler: He died at 101 so he managed money for 70 80 years. He said the number one lesson after all that is patience. That today we’re being asked to exhibit more patients in Value investors who probably ever had to ask before, as to do before and I think this is why we’ve just got to hold onto the seats, keep going, keep talking to each other.

Tobias Carlisle: There’s fewer and fewer of us to talk to because we’ve all migrated into quality and growth.

Simon Adler: Yes.

Tobias Carlisle: Buffet has referred to Carret before. What’s the name of the book? Because I haven’t read that book.

Simon Adler: Now that is a good question. I think it’s called A Money Mind at 90.

Tobias Carlisle: That’s great. I’ll check that one out. Thanks very much for that.

Simon Adler: There’s not many people you can read that invested through the periods that he invested in.

Tobias Carlisle: So he’s got a 29 crash and that presumably, and he’s got an 87 crash.

Simon Adler: Yes. And he managed to find, I think it was called the Pioneer Fund for 60 years or something of that nature. Extremely long term. And you had very good returns for a very, very long period of time.

Tobias Carlisle: I’m interested in managers who survived the 29 crash. So I’ve read some of Graham and also John Maynard Keynes who went through that period and pretty famously evolved from being a more macro, using his superior intelligence and his superior understanding of macro moves to blow himself up two times before he became an investor who sounds much more like Buffet than Graham.

Tobias Carlisle: And he was doing that without knowing that Graham was doing something similar on the other side of the pond.

Tobias Carlisle: I like reading the way Keynes was talking to his investors at the time and to the boards of the dam city that he was managing. And one of them, he said, “If you sell out now…” And one of them listened to him and one of them didn’t and he said, “… if you sell out now… We’re in this position where nothing matters at the moment, either you sell out and we recover or we miss the recovery.

Tobias Carlisle: Or we stay invested and we go to zero and then we destroy all of our money anyway. So basically at this time the only sensible thing to do is to be fully invested.” And he was, he was absolutely right. It took some courage to do that.

Simon Adler: Yes. And all the long term evidence says “You just have to be pretty invested over the long term in the equity market. Trying to time in and out to make sense and it’s encouraging to hear some of that quality of great brain, though the same.

Tobias Carlisle: The document that you sent through to me, you discuss four edges that you guys have informational, analytical, behavioral and organizational. Would you just take us through those and give us a flavor of each?

Simon Adler: So that’s quite right. We think we’ve got four edges that can help us try and deliver great longterm returns to our clients. So Informational is the first edge, and this is the screen which we touched on there, that the only place we get ideas from doing a Evaluation screen keeping us in the part of the market where the academic work says you should have the best returns.

Simon Adler: And so that’s the first bit. It takes half a percent of our time, but it keeps us in the right bit of the market. Then the second edge is the Analytical and that’s where the very detailed disciplined, rigorous work’s happening.

Simon Adler: So that’s the 10 year minimum model, the seven ‘Red’ questions, and those are the ‘Red’ questions which… The teams got over a hundred years experience doing Value, Schroders has launched the first Recovery Fund, as I mentioned earlier in 1970, all of that experience we think has led us to understand this typically seven reasons for Value traps, seven reasons why I can achieve on a screen, but know I actually recover. And you as a reader of the Checklist Manifesto by Gawande. I’m sure you’ve read.

Tobias Carlisle: I haven’t, I’m embarrassed to say, but I’m going to write that down now. I’m sorry the Checklist Manifesto yes, I have read that.

Simon Adler: Okay, that’s great. And it talks about the fact that you need a checklist. So what we believe is we need to ask these seven questions every single time. We can’t just say, “I don’t hid our matters for this company.” So we’ll ask these seven questions every time. So questions like “Is there something dodgy in the EV? Is the accounting funny? Is the profits misleading? What’s the structural threat to this business?

Tobias Carlisle: Is that a business question or is that a capital structure or an industry business structure question.

Simon Adler: A bit of everything. So we’re asking particularly about the business. So at this point we’re trying to understand is there on a structural change question, is there a problem with the business? We also ask can this business survive a financial stress test. That’s a capital structure question.

Simon Adler: Is this capital structure good enough for a very tough period, ultimately none of us know if the equivalent of Lehman Brothers is going to go bust tomorrow or in 20 years time. And we want to make sure this business can survive a very tough period. As I say, the arbitrage only occurs five years. They often go through difficult times, the companies we’re investing and we want to see them through.

Simon Adler: Till profits turn into cash, that’s a really detailed accounting piece of work we do. Taking apart the cashflow statement, rebuilding it our way and saying, “Is this a cash profit business? And if not, why not? Is it a CapeEx problem? Is it a working capital problem? Is it cash tax P/E tax and so on. Then we will always ask what’s the quality of the business?

Simon Adler: We have to be very careful to explain because you’ll be unsurprised to know we are not quality investors. I often say I’m happy if we buy the worst business in the world. If we pay a penny and a pound or a cent and dollar on your side of the plot. And many people say to us at that point, “Sure I agree with you.” And then I give them the example. Let’s imagine the worst street in the town you live, the worst one. And then imagine the worst house on the worst street in the town you live.

Simon Adler: Let’s say every single one of these houses is identical except for the one you’re looking at, and they’re all worth a hundred grand. And the one you were looking at stinks absolutely horrific, it has mouse infestation, they’re all dying under the floorboards, no one wants to go near it. But we all know that in two years time that smell is gone.

Simon Adler: And if you could buy that for a thousand every other house on the streets where for a hundred grand would you buy? Everyone says “Yes, of course you would.” We just bought the worst house on the worst street. And so we’re not quality investors, but we want to understand the quality of the business we buying.

Simon Adler: Because if we’re buying the worst house on the West street, we want to make sure we’re getting a very material discount to buy it. Equally, if we’re buying a really high quality business, we want to make sure we’re protected if that business becomes lower quality.

Simon Adler: So we’re very conservative with the multiples we put on companies. So that’s one of the other questions. Then the final question is whether the ESG risk, Environmental, Social Governance, and that’s about saying it on the governance side is the management aligned to us? Do they own shares? Is the remuneration structure good? Is the board got diverse views feeding into it. And second-

Tobias Carlisle: How are you assessing that? How are you assessing the views of the board?

Simon Adler: So we don’t know the views of the board, but what we look at is we look at their biographies. If every single one went to the same university, the same school, same background, we know we haven’t got diversity, but if you’ve got engineers, political scientists, people of all different backgrounds, that means you’re more likely, not guaranteed, but more likely to have a variety of views informing the board.

Simon Adler: And that’s important. As many different views going in. When we look at our own team, we want to have a variety of different views and backgrounds feeding in to make sure we’ve got as diverse of thought process as possible. And the second part of the ESG is stakeholders.

Simon Adler: If you’re last 10 years of profits, which is how you got onto the screen for us, have been generated by abusing your stakeholders, whether that’s overcharging your customers, not paying your suppliers on time, not paying your pocket tax rate, massive environmental externalities and so on and so on. We need to make adjustments going forward and we need to understand that. And so we always ask that question as well. So we’re asking these seven questions, a lot of detailed work and that gets us to the end of the analytical edge.

Simon Adler: But the problem with that is at that point we’re all biased. That’s fact that the this Japanese company we looked at, we found some hidden assets or we hate the fact that the board’s not diverse in the balance sheet poll. So the third edge is the Behavioral edges. How do we make objective consistent decisions? And that is about distilling all of that work into two numbers, reward, what’s the percentage upside in the shares and a Risk score.

Simon Adler: So we touched on earlier out of 10 what is the chances of losing our client’s capital? 10 out of 10 high chance, not out of 10 no chance. And then weigh it up. So if we’ve got a company with a Risk score of five an upside of 10%, no thank you. Then we go to the company of the Risk score five and upside of 150%, yes please. If we’re looking for those asymmetric trade offs, if we find a company with a Risk score of 10 you want hundreds of percent of upside.

Simon Adler: So it’s about trying to understand that trade off. And then at that point, something we do is, let’s say I looked at it first other i then say, “Okay, someone else should have a look at this.” So I looked at a company in the last bit of time, which Juan Torres on our team looked at first, then Vera German, looked at, I’ve now looked at it and I’ve now flung it out for Nick Karrage, Andrew Lyddon and Andrew then Amnon to look at it. At that point we’ll have all looked at it basically independently.

Simon Adler: Our own numbers on the whole, going through the seven ‘Red’ questions. We settle the Risk score and then we could sit around and have a debate and say, “Okay, well, four out other five of us think it’s a Risk score of two, but one person has got 10. Okay, there’s something you’ve seen, which we haven’t, or we’ve seen it and we’ve discounted it Let’s chat.” Or the reward is 200% 200% 200% five or 10, where’s the differences? It means we can really drill down.

Simon Adler: We’re not a team that’s trying to brow beat and I’ve done the most work, I know all the answers, don’t challenge me. We all want to have done equal amount of work and there’d be able to have a thorough debate. Frankly, if I have missed something and someone sees it, I’m delighted, I’m genuinely not embarrassed, I’m “Fantastic, that’s really helpful that you saw that coming which I missed.” Or whatever it might be.

Simon Adler: And we’ve worked very, very hard on the culture of the team to encourage that debate. We took a day out with a psychological safety expert as a team to try and get really good at being able to challenge each other in a progressive, open, positive way. And so we didn’t have that debate. And at that point, at the end we could say, “Okay, we all agree this is attractive.” Then we move onto the fourth edge, which is the Organization edge, which is the Value archive. Every single bit of work we do, we save.

Simon Adler: And it all goes into the Value archive. So the 10 year model, the seven ‘Red’ questions, the Risk award score. And then if it’s a buy, sorry, we have the fair Value. So if we’re saying buy a dollar, but I think it’s worth three dollar, it’s in the system. But most of the time we say no. So the last time we did a check, we’ve been saying no to the 95 to 98% of the companies we look at. Most of the time we just say no. And at that point we have to set the price we buy them. So even if it-

Tobias Carlisle: The maximum price that you would pay for it?

Simon Adler: Well, this is one where we said no… So yes the maximum.

Tobias Carlisle: I see.

Simon Adler: So let’s say it’s the same stock it’s trading at a dollar. I think it’s worth one dollar 20 but I want 100% upside. So I say in the system “Okay 60 cents, I’m a buyer.” And then we set, it all goes into this Value archive, it’s now approaching one and a half thousand entries in it, all but some of them are the same company. And then if it gets down to 60 cents, great. I’ll go and have a look again or Juan or Vera or Nick or Kevin.

Simon Adler: Someone will go and have a look again and then say, “Has anything changed? Is there any different to the reward, the risk and so on. Nothing’s changed.” Great. If something’s changed, okay, well now I want it a bit cheaper. Well actually it’s got better, so we buy whatever. And if it’s in the portfolio, it stops us ever having a portfolio that’s too expensive because we can’t fall in love with the company because it hits the Fair Value, someone has to justify on the team if we’re going to keep owning it.

Tobias Carlisle: So that dovetails nicely is something that we discussed before we started recording. I’m interested in, because this is something I’ve been thinking about a little bit recently, Errors of Omission and Commission. So you have an archive of all of your decisions, whether you put something on or didn’t put it on. Have you revisited those to see whether the threshold is too high or too low? Do you manage that process at all?

Simon Adler: Yes, absolutely. It’s one of the biggest advantages of the archives. So what we did is we started the archive in 2014. We look back now and go, “What were we thinking? Why did we not start this the day we were born.” I started my accounts as an eight year old. [inaudible 00:00:40:27]. So we started in 2014 I have page I said it’s five years. So last year was the first time, five years on. So we literally pulled out the drawer and looked every single company we looked at in 2014. And we wanted to do it with a very systematic approach. So we used an After Action Review, which is when we went to do all the reading at the Evans did a lot of reading on this and he thought that was the best way of working out the-

Tobias Carlisle: What is that? What’s an After Action Review?

Simon Adler: It’s something the US army actually developed. It’s been adopted around the world and it’s effectively having a systematic process. What do we get right? What do we get wrong? By asking the same questions every time. So one of the issues, if you’re trying to assess an investment, is if you ask different questions each time, you’re not getting a proper assessment. So we asked every single company from 2014, “Did we get the sales well? Did we get the margin on? And so on and so on and so on. We can then build that up.

Simon Adler: The team joke that I call it a Coding machine. I’m not the most technological guy on the team. But we then have all of those, get the sample size to a level that’s credible and then we can say, “Okay, over every company, how good were we at sales? How good were we at the margins? And so on. Are we better in this sector than that sector? This country, that country, this individual, that individual.

Simon Adler: Now at the moment we’ve only got 2014’s numbers, but as we go on each year we’d be able to look at this over very big sample sizes and that promises and will hopefully be a phenomenal resource for us as a team, we are determined as a team to get better every single year. But we want to get better on the basis of data and evidence, not conjecture and not cherry picked thoughts, which are brains are prone to do so. So we did on evidence, we do it on data and we will try and get better and work out how we can improve it.

Tobias Carlisle: I guess there are two questions for me from that. One is do you adjust for confounding variables? This might not be a representative market, last five years have been difficult for Value, more of a growth style market. And then did it reveal anything? Are there any biases? What did you find?

Simon Adler: So on the first one, one of the reasons we don’t look at the share price performance as a prime, we do look at that, but that’s not what I want. We’re looking at the sales and the margins is to try and limit that issue. However, that is still an issue. It’s been a good economy for the last five years. We’re very cautious and prudent investors. So the moment we assume most companies sales are going to fall because the cycle’s been girth.

Simon Adler: And so we’re not able to see what actually happens in a normal environment because it’s been a good environment. So that is an issue. So now the reason why we want to learn the lessons over a longer period of time when we’ve seen a full economic cycle. So we think about that very hard and it’s not an ideal environment to measure it, but there’s no excuse for not measuring it and we can learn some things.

Simon Adler: And onto your second question. Yes, it did reveal some interesting things. Now we’re cautious about how we share, about the weaknesses that were identified, but we’re also cautious because the sample size isn’t that big and the economic cycles being one way, but it did reveal something. And then when we go through 2015’s numbers, we’ve got that hypothesis and we can say, “Okay, cross the biggest sample.”

Simon Adler: Which looked at more companies in 2015 and 2014, is that still true? One of the difficulties of 2014 is if you want to know it down by country, individual sector, actually the sample sizes aren’t big enough to be credible. But as the years roll by and those sample sizes start getting towards a thousand, that excuse goes and we’re about to see if what we may have identified is something we need to adjust or not.

Tobias Carlisle: I can understand why you might want to share some of the weaknesses or areas that you’ve made. But what about framing it as for other Value investors out there? Where might they pay a little bit more attention? Where should I be looking?

Simon Adler: Yes I’m sure you don’t make any mistakes Toby.

Tobias Carlisle: I make a lot. I mostly make mistakes.

Simon Adler: Well, so when we Value a business we try and normalize the profit stream. We say “What’s a normal environment sales like? What’s a normal environment profit like?” And one of the things that we had is a hypothesis, and this is exactly why you need to do things on data and evidence, is that in our heads we thought that we were quite good at normalizing the margin, but less good at the sales .

Simon Adler: The narrative that we had in our heads was that the companies were buying, of often growing quite quickly, they take it on lots of unprofitable sales. So to get back to normal, they get back to the average top margin, but they have to share the load of sales to get that. Make sense and it’s intuitive and it’s exactly why now narrative it’s dangerous. Because the data and the evidence suggested that actually we were better at forecasting the sales than the margin.

Simon Adler: And the lesson I think that we can take from this as Value investors is all investors is if you try and learn lessons or narrative and on what your brain tells you, your experiences, you’ll probably make mistakes.

Simon Adler: Whereas if you try and learn lessons on the basis of data and evidence and not memory, but what you actually wrote down five years ago, you’re in a much better place to try and learn your lesson. So we’re thinking very hard about how we can try and improve that. And it’s the whole point of the Value archive, because if any of us try and remember why you made a decision five years ago, we’re kidding ourselves if we think we’re going to get that right. Whereas if you’d written it down, it’s that black and white

Tobias Carlisle: That’s fascinating. What do you attribute, why are sales easier to forecast than margins? Are you being conservative and then it’s exceeding expectations, what’s the driver of that?

Simon Adler: We don’t really know yet. We’re going to need a bigger sample size where we’re cautious about putting a narrative onto it. And in terms of what we’ve seen so far, I think we can’t draw really big conclusions from it. Because the sample size isn’t big enough really, the standard deviations are quite wide and so on. So I think we’re not drawing from conclusions at all from this.

Simon Adler: And we’re very cautious about doing that. If however, when we’ve looked at one and a half thousand companies, we’ve had two economic cycles and so on . And if it’s still telling us the same thing, then we’re going to go and have to do some serious work. But at the moment we’re in the investigative stage. We’re still investigating, still trying to learn, we’re still trying to get better and we’ll see how that goes when we pull out the 2015 draw and see what it tells us. So in this time next year, I may have a better answer for you.

Tobias Carlisle: Well I’ll have you back on and then hopefully I can persuade you to publish or something like that because I’m, fascinated by that process. Can we just move on… I’m sorry.

Simon Adler: So I was just going to say it’s a critical way of trying to get better because we want to be the best Value investors we can be. And if we don’t look at the evidence of the mistakes we’ve made, we’re not going to become better investors. And for our client’s sake, for our own sake that we regard that as a parliament, part of our culture on the team.

Tobias Carlisle: Let me just take you back to assessing quality. So how do you define quality? What are your metrics and what are you looking for?

Simon Adler: So we think the return on capital is probably the easiest way of doing it. Because it’s so easy to look at a company and think, “Well this looks like a great business for these reasons or those that, it’s got a great brand, it’s got a big moat.” But if it doesn’t make a good return on capital in our view, the ultimate measure. Is it objective, it’s a number on a page, and that’s our preferred way of looking at it.

Simon Adler: We want to include leases in there so we look at return on NISA adjusted capital employed. And that’s our preferred one. We think cash conversion is something to think about as well. So ultimately is the cash return on capital invested is our preferred way of looking at it because it’s objective is a number on a page., we’re looking at a long period of time and if a company has made very poor returns, however good everyone else thinks is probably not very good.

Tobias Carlisle: Do you make any adjustment for main reversion for the business cycle through something like that?

Simon Adler: Yes. So we make sure we go back as as long as necessarily to get a full economic cycle. So for Miners, we went back 30 years. If a company has made a a good or bad return over 30 years, there’s no cycle excuse, that’s what you’ve been making. Then one of the checks we do is we look at what in our normalized estimate of profits, what return on capital is that implied.

Simon Adler: If the history is 10% and we’re implying 20 we’ve got to check out our numbers again. If the history is 10% and we’re implying 10% that can give us some confidence that we’re in the right place. But we totally and utterly believe in mean reversion and that’s an important part of our process. But we’re going to look across enough of a cycle where the average is representative of what-

Tobias Carlisle: That’s the main.

Simon Adler: Yes. Exactly.

Tobias Carlisle: You’re trying to identify. Folks who are interested in breaking into an investment firm, can you talk a little bit about your own path and perhaps the path of some of the other folks in your team?

Simon Adler: Yes. So about half the team started their careers as graduates at Schroders. So myself personally I did an internship at Schroders. It was at very top of a market, so they’re offering anyone a job. So I was lucky enough to get in and always thought of that. And so I then started as a grad and-

Tobias Carlisle: What’s your undergrad? Or what did you study?

Simon Adler: I’m an Investment Analyst was on the UK Equity team analyzing sector to start off with, and then after a few years I was .analyzing five or six sectors. And that for me that was brilliant because I was surrounded by Value investors, some Growth investors, some more core style investors.

Simon Adler: I was feeding all those mouths as it were and I was able to very quickly and over time recognize where my natural fit was, which was very much Value. And so I think for most people it’s very important to look at various different investment styles and see which one works best.

Simon Adler: Because if you’re going to follow an investment style, there’s probably going to be periods where it’s tough and you need to really believe in it to keep going. Like now for Value. Some of the other members of the team have come from a variety of backgrounds. We’ve had people, Juan Torres had been looking at emerging markets, he’d studied in various different countries Vera German, had come from a growth investment background and decided she wanted to do Value. We’ve had a mixture of people.

Simon Adler: We’ve got someone on the team Andrew Evans that had worked on the sales side for a period of time. Then worked on the buy side somewhere else and then came to the team. So that’s deliberate. We want people from different backgrounds, different experiences to to feed in. Because when we’re having those stock debates, we want as diverse of views going into them as possible.

Simon Adler: So people who’ve come from all walks of life. I think it’s very difficult to give advice as to what the best Value is. I think I’ve been extraordinarily lucky to end up where I am, but the people that when we have gone and looked for, for new candidates, the people that are the most impressive, are the people that have, academic excellence, worked in teams, had some experience of the real world, done some interesting stuff.

Simon Adler: People that have traveled, people that have worked in tough places. We want to have a variety of people, we find the teamwork is very important us and we want really bright people. That bright person doesn’t have to only be bright on a bit of paper, it’s all around intelligence that we want.

Tobias Carlisle: What did you study? Did you study University presumably?

Simon Adler: Yes. So I went to Uni and my degree is in Politics, but I did two years of Accounting and two years of Economics. So it was a four year degree. So I did for the first two years I did Economics Accountancy and Politics. And then I… you’d call it majored I think over there my degree is in Politics. We’ve on the desk, we’ve got people with Engineering degrees, Economic and Political Science degrees, Economics degrees, a variety of degrees,

Tobias Carlisle: A variety of backgrounds. Simon, we’re coming up on time. If folks want to get in contact with you or the team at Schroders, how do they go about doing that?

Simon Adler: So we’ve, we’ve got a website which is called the Value Perspective, and on that website we blog, we put some of our ideas up, some videos up and on that I’m sure there is contact pages and you can get in touch with the team there with a Value Team that’s focused on buying the cheapest companies and then weeding out all the ones that we don’t need to recover and ending up with a concentrated portfolio of what we hope are the most attractive shares in the world within the cheapest 20%. We’ve actually got UK and European funds as well, in the respective regions we invest and we’re always delighted to hear from interested people.

Tobias Carlisle: That’s absolutely fascinating. I’ll put a link to Value Perspective in the show notes and hopefully I’ll have you back on when you update that next year’s results and we’ll find out what you’ve learned and maybe will get some answers from me.

Simon Adler: Thank you. Sorry to be coy on that.

Tobias Carlisle: Thanks very much Simon Adler Schroders Global Value Team in London.

Simon Adler: Thank you Toby.

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