Oftentimes when picking fundamentally undervalued companies, you’ll find yourself in a position where your investments revert to standard valuation, delivering some significant alpha.
Sometimes, a company will even exceed these expectations, growing beyond what one might reasonably expect, to provide triple-digit returns in very short timeframes.
This article is about one such company, and how I choose to handle such situations overall today. The reason for the specific article in this one situation is the associated investment size for the company, which provides the opportunity to write about a “large” rebalancing.
(Source: Visit Finland)
While the article specifically is about Kesko (OTCPK:KKOYF) (OTCPK:KKOYY), it’s applicable to any company you find that’s in excessive overvaluation. For those of you that have no idea what Kesko is – which wouldn’t be all that surprising honestly, given where the company is from – I’ll quickly introduce the company, but I invite you to read one of my more in-depth pieces on the company that will shed more light on recent and historical trends together with what valuation I see for the company and what I base these expectations on.
What is Kesko?
The Finnish company Kesko markets itself as a “trading” company. What this means is that it operates in specific sectors, and offers services/products to customers in these sectors. They are:
- Car Trade
Our chain operations comprise some 1,800 stores in Finland, Sweden, Norway, Estonia, Latvia, Lithuania, Belarus and Poland. Combining online sales and digital services with our extensive store site network, we enable a seamless customer experience in all channels.
Together, Kesko and K-retailers form K Group, whose sales (pro forma) totalled approximately €13 billion in 2019. K Group is the biggest trading sector operator in Finland and one of the biggest Northern Europe. We employ some 43,000 people.
Now, as you can see, Finland comprises the absolute majority by a large margin. The fact is, Kesko is the second-largest grocer in the entire nation (the largest isn’t publicly listed and collectively owned) and also operates some of the most popular car sales/representation in the country. That’s not to say its non-Finnish operations are unimportant – but they certainly aren’t as large or as significant as those in their home nation.
To a non-Scandinavian investor, the combination of fields may appear odd at first glance. After all, what company would combine Groceries, Technical trade, and cars of all things?
However, Finland is an interesting country, and it makes for interesting trends in its corporate structures. One must recall that it wasn’t all that long ago that most major companies in Finland were either collectively owned or state-owned (like much in Scandinavia). This provides some very interesting investment opportunities, and Kesko is one of them. I don’t want to go out on a limb here, but Finland’s size and homogenous society also play its part in making the home market quite “closed” to new entrants in most fields. It takes quite a bit to succeed in Finland and win over the populace – and other Scandinavian nations and the comparatively relatively limited market size usually make the geography quite uninteresting for larger players in the first place.
What I mean by this is that Finland actually has a population smaller than New York – and I don’t mean the Metro area.
All of Finland has just over 5.5 million people – and the nation is roughly the size of the state of California.
However, that doesn’t mean that investing in companies here is “bad”. Kesko is a superb company, and it’s been growing better and better for years.
The situation – Kesko is overvalued
When I first invested in Kesko it was a pretty unique stock. How? Well, it was essentially at least in part a grocery company that offered a 6%+ yield. That in itself of course wasn’t the only reason for my investment here. I love market-dominating defensive players – and very few things are more defensive than grocery companies. To the tune of that logic, I happily loaded up a sizeable position of nearly 1.9% of my portfolio, to where it stands at a YoC of 6.89%.
(Source: Nordnet, Kesko)
No, Kesko hasn’t suddenly increased sales by 50%, nor found a pirate treasure in one of its store basements. While recent results have been positive, the development we see above is still one I want to call “unwarranted”.
To call Kesko overvalued would be putting it kindly. Here are the current fundamentals for your perusal.
Based on an NTM EPS, the company currently trades north of 25X earnings, a 5x P/B, and a 0.85X sales multiple. The only thing that sounds even remotely conservative about those numbers is the sales multiple. The company’s previously-excellent yield is now down to 2.8%. As a result, and including FX, my position is up more than 167% in 3.5 years, ballooning the company stake to almost 4.3% of my portfolio. Not only is that actually too big a stake relative to my portfolio goals in terms of diversification, but we’re also looking at a multiple that I don’t think is defensible in any way in the longer term for this company.
This, as they say, is a problem.
But let’s begin by playing devil’s advocate regarding the valuation. I try to provide balance and an objective view – so I want to begin by trying to shoot down my own thesis.
Kesko is, at least in part, a grocery company. I own two Scandinavian grocery companies that actually do trade at 20-28X earnings multiples, and I’ve no plans to start divesting or even considering this here. In fact, I’m pretty famous for banging on about how we should accept premiums for them.
Shouldn’t this play in here?
It’s true that a significant portion of Kesko’s earnings and revenues come from the grocery trade. That’s what makes it such a defensive holding – a sizeable chunk of Finland’s population gets their daily food from a variety of K-stores. This should definitely play in here. While I may not agree with a 25X multiple, the 12-14X earnings multiple I invested in might be no less ridiculous now that the company is doing so well. However, the problem is that Kesko isn’t just groceries, and the technical, and certainly the car trade doesn’t provide the same sort of recession-proof earnings we find in groceries. Therefore, the analogy isn’t one I consider valid, despite this, and I don’t see that Kesko warrants the valuation.
What about earnings trends? Hasn’t the company improved earnings to where this might be considered a good earnings trend and justified?
Well, not quite.
(Source: Börsdata, EPS/Share, Kesko)
While the company has broken somewhat with its historical volatility, it’s only the very beginning of any sort of stability in fundamentals. Revenues show even better development here, but the point is that while recent results have been good, that’s a long way from justifying a 25X earnings multiple.
Analyst estimates would agree that the company has changed and improved. This is clear from the mean price target improvement just over the past year or so, up over 50% in less than a year. Currently, the range goes from all the way down at €16/share up to €21/share, with a mean of around €18/share, which is quite a long way of the current €23/share that the market is currently asking. (Source: S&P Global)
The current mean ~€18/share price target would suggest an NTM EPS multiple of around 20-21X. While this is still high, it’s a number I can get behind on the premise of a high premium for a part-grocery company with an excellent moat. What I mean is that I wouldn’t sell Kesko at ~€18/share. The problem persists even when looking at the most exuberant expectation for the company.
The picture formed by these trends is one I, once again, view as fairly clear. At this point, even if you disagree with my conclusion, you should understand why investors view Kesko with a bit of trepidation here. It feels as though we’re bound for an inevitable correction in the share price.
When faced with such a possibility in any investment, we have a few options.
1. Do nothing
The simplest option, arguably, is simply to sit back and let the chips fall where they may. No one could believably argue that Kesko isn’t a good company. A period of overvaluation shouldn’t cause a long-term investor to panic or to feel as though something needs doing. While yield may be poor here, the fundamental appeal of the company remains strong, and no one can accurately gauge the potential for a share price drop. Not the size of the drop nor the timing. What it means is that reinvestment may mean missing out on future excellent growth for the company. Often, human beings feel as though they have to act when in reality…
…they should simply do nothing. I myself have multiple examples of this in my portfolio, including virtually all of my core Swedish holdings outside of the financial sector. Castellum (OTCPK:CWQXF), Axfood (OTCPK:AXFOF), ICA Gruppen (OTC:ICCGF), Latour (No Symbol), Investor (OTCPK:IVSXF). Logically speaking, this should be no different. So, sit still.
The problem with this approach isn’t all that hard to see. None of the aforementioned companies have reached this sort of premium, while at the same time having outside a pure-play appeal. Axfood and ICA trade at these valuations, but they are nation-dominating grocers, not traders in multiple, in-part-cyclical fields and geographies. Castellum trades close to this, but again, they own large parts of the Swedish public real estate sector, renting to what is essentially government bond-level type safety.
2. Sell it
Another, inarguably simple option. If a holding is overvalued, you simply sell the holding and invest in what isn’t overvalued. The list is long, and the companies on the list are appealing. While I perhaps won’t be able to find a grocery/technical play like Kesko, there are other appealing options out there ripe for the picking. Reinvesting would result, even at conservative yields, in some incredible average monthly dividend increases. The option certainly is appealing. In this scenario, I would essentially reinvest tens of thousands of dollars.
The problem with this approach is that I’ve done this before, and turned out to regret doing so. Years ago, I sold my entire then-stake in Bakkafrost (OTCPK:BKFKF) at a massive, 100%+ profit. Great deal, right? Except, I always wanted to get back into the company once they dropped down to more humane valuations. It’s a great company, and conservative, with an amazing moat.
Bakkafrost never dropped down to my cost basis again. Not even close, as a matter of fact. Recently and during the crisis, I began investing in the company again, at nearly 100% higher price (though what I then considered fair value given new earnings estimates and trends) than my previous cost basis. It proved that the growth in valuation was essentially the establishment of a premium that’s held until now.
The problem with selling quality equity is that you may not be allowed to get back in at even a close to the price you sold for. It makes a case for how badly you want to own the stock, versus how overvalued the company is and how badly you want to reinvest the money.
Still, it’s an option.
3. Sell some/rebalance.
Arguably the “safest” of the three. Since the stake has ballooned beyond where I want any stake to be, the choice might be to cut away the part that’s too much and reinvest it elsewhere. You get to keep some of your profits, you still have a stake in the company, and you reinvest in undervalued stocks, growing your dividends and getting to pat yourself on the back for being the sort of savvy investor who realizes some profits. Rebalancing is fairly common, and something that most investors actually recommend that you do. While I personally would like to espouse a buy-and-hold-forever strategy, this really doesn’t work all that well in situations where a stock reaches what we “know” to be excessive multiples.
Rebalancing, as I use it, is about:
- Taking home profits from overvaluation, selling “high” and buying “low”.
- Rebalancing assets and individual positions to minimize your overall risk and not stray from your risk profile.
It can either be done through the addition of new funds – which is something I do on a weekly basis – or through selling overvalued equities that have become too large a part of the portfolio, thereby increasing your risk profile. This can also be done and is typically perhaps more commonly done, with asset rebalancing, such as a 60/40 stock/bond split where stocks suddenly have grown too far.
When and how to rebalance is, of course, a science unto itself. I can’t speak for others, I only know that when a holding has a triple-digit total return since my initial purchase, I look at it. In some cases, the valuation is justified, and I do nothing, simply letting things ride. However, at 3 points in my last 3-year investor history, I’ve done a large rebalancing as a result of excessive valuation. My error in those cases, was to make the rebalancing either too large or total – meaning a complete sale of the holding. If rebalancing is the choice here, then it would perhaps make more sense to cut Kesko back to what would be a 2% overall holding in my portfolio, though this would essentially mean selling about $20,000 worth of stock in the company.
Rebalancing – an example
Let’s assume that rebalancing is what I will end up doing – because it may actually be what I will do. Let’s also assume that I will cut the stake back to where I want it – at around 2.2% total portfolio exposure, which is really where I want the position size of my companies, based on a fully diluted portfolio of around $1M (some of my positions are 2-2.5% based on that final value, though may be higher now). I would sell down to 2% because while Kesko may indeed drop back down, I also expect the company to continue performing well over the long term.
That means I’ll end up reinvesting around $20,000 worth of capital in different stocks with undervalued appeal today. When reinvesting in this manner, I place importance on maintaining a balanced sector exposure.
Reinvesting this much capital unfortunately has the potential to throw off some of my overall sector balances unless one is careful. Consumer defensive stocks, which is what Kesko is considered to be, is one of the more important sectors I invest in – so reinvesting from current positions into different ones, I want to try to put some of the capital into this sector.
A quick look at my overall valuation list shows me the following companies and opportunities.
1. Philip Morris International
While British American Tobacco (BTI) is technically more undervalued, Philip Morris (NYSE:PM) is the safer investment choice from a fundamental perspective. BTI is another choice on my list, but I value fundamentals over opportunity, which means this company’s 10-15% undervaluation is one I view as very appealing in the sector. PM also happens to be a consumer defensive company. Comparing groceries and tobacco is of course a bit of a stretch, but we also need to remember that Kesko isn’t just groceries. Some people, particularly smokers, would also characterize their vice as something as equally important as food and drink.
(Source: F.A.S.T Graphs)
Even just trading flat, PM would return a total of 44.22% until 2023 based on current conservative estimates. A return to a historical premium would enhance this to nearly 75% total return, or 19% per year if returning to a premium of 18X earnings. Forecast accuracy is very high, making these assumptions with a quite high likelihood of being correct. I’ve written about the company previously, and consider it one of the best tobacco holdings you can own. To invest part of the profits here, there are far worse ideas than that. If I sell Kesko, a part of the realized profits will certainly be headed toward Lausanne.
2. British American Tobacco
Now, BTI is certainly the more volatile of the tobacco companies. I consider the company a class 4 stock, based on its “borderline” dividend safety, and the valuation trends do support this assessment, with the company trading at an incredibly discounted multiple at this time. Looking at the fundamentals, you may indeed be puzzled why the company is discounted to this degree. The payout ratio is fine, debt is on the high side but ‘acceptable’ as I see it, the company even boosted its dividend during the last recession. BTI is simply pressured from the regulation side of things (this being one reason the confidence in BTI has been shaken somewhat), and this seems unlikely to stop at this time.
Margins have also grown, with BTI margins expanding more than 10% in 10 years on the operating side of things. The one thing that has increased over time, though it’s been slowly cut back, is the company debt following a massive rise in 2017.
In short, despite others viewing the stock as materially less safe, it’s not to the degree where I view it as uninvestable. BTI would be a second option for part of the reinvested capital.
3. Walgreens Boots Alliance (WBA)
The company is a bit of a controversial topic following the latest management change. In fact, when presenting this, I want to remind you that these are options. I may end up choosing some, and not others. Still, I do want to say that I believe that Walgreens isn’t as abysmally off as some seem to think.
(Source: F.A.S.T graphs)
I’ll be the first to say that the trends seen above are understandable. We’ve seen what bad management can do to a pharmacy company in the example of Rite Aid (RAD). However, I also believe that what we’re seeing here is going much too far, for a number of reasons.
A. Dividend is safe.
The company’s dividend, at a 36% NTM payout ratio based on a current yield of 5.06%, is safe. It’s been increased during recessions, and the company is 5-6 years off from being a dividend king. While the company may face growth challenges and margin pressures, to expect this to impact shareholder returns in the near term is too far, as I see things. There is no sign whatsoever that the company can’t fund its dividend.
B. Undervaluation is extreme, almost in any scenario
Look, the company is trading at what is essentially a below 8X earnings multiple. The company has never traded there, not even during the financial crisis. Granted, it hasn’t exactly faced the set of challenges it does face today, but I do believe the company is being vastly underrated here.
(Source: F.A.S.T graphs)
Even in the unlikely scenario that the company continues to trade at a 7-8X average weighted earnings multiple for the coming 2-3 years, returns in that scenario would still be positive – even beating most investments in the overall market, looking at current forecasts. Expecting any sort of reversion means that returns have the potential of climbing to 30% annually, and triple digits in only 3 years – though this is probably expecting too much from current management.
However, the point stands. The company is being grossly undervalued.
C. Fundamental challenges may be overstated.
There is a love of bashing Walgreens at this time, but bashers often forget that the company, despite the most challenging quarters in the company’s history, generated more than $660M in free cash flow, which is more than enough to cover the $400M quarterly payout of dividends. The company maintains its BBB rated credit rating, which was also reaffirmed back in April of 2020 with a “stable” outlook. The company, therefore, is not at risk of being cut here. The company actually increased the 2020 dividend by 2%.
This isn’t to say that challenges don’t exist – they are numerous – but the company is in fact an appealing investment with a “Safe” dividend and over 40 years of dividend history if you accept the current market and management risk in the company.
4. UPM-Kymmene (OTCPK:UPMKF)
From Finnish to Finnish companies. While most of you probably haven’t even heard of one of the largest forest industry companies in Finland. The company is in the business of pulp, paper, plywood, sawn timber, labels and composites, bioenergy, biofuels for transport, biochemicals, and nanoproducts. In investing, I would be shifting from Consumer Defensive to Industrial, but this is acceptable to me to some degree.
The best that can be said about UPM is that the company is “slightly” undervalued to future earnings. The company is obviously a cyclical, with the earnings volatility typically associated with a cyclical, but has the capacity for EPS of €1.5-2.2/share with a 3-year average of about €1.85/share, giving us a current 3-year average multiple of around 14.38X (around 17X based on NTM multiples). The company is shareholder-friendly and has maintained its dividend even through the pandemic.
The company has enough cash on hand to handle the pandemic fallout and the quarterly weaknesses seen due to COVID-19. International operations and ambitions are, aside from this, on-track.
The yield on the current dividend is just south of 5%, and it’s likely that UPM will be one of the company’s I rebalance part of Kesko to.
5. Omnicom Group (OMC)
Omnicom Group is another choice I’m looking very closely at for reinvestment. The reason, like with the other ones on this list, is valuation. For those of you who follow my articles, you’ll know that this is probably my #1 choice in the media/communication sector for the time being. The reasons for this rationale are obvious when we go deeper.
(Source: F.A.S.T graphs)
Omnicom has recently re-affirmed its 4.86% dividend and is considered a “Very Safe”, 49% NTM payout ratio dividend with a 31+ year dividend streak without a reduction. The company has a stellar recession history, not having cut the dividend during the last recession either. While the company’s operations certainly are known to suffer during times such as these, they always show a mean reversion as things improve. Current average weighted earnings multiples show a 10.5X valuation, which is on the very low side for a dividend aristocrat with a BBB+ credit rating.
(Source: F.A.S.T graphs)
If you know my articles, then you know I tend to forecast extremely conservatively. So too in this case. Trading at today’s levels, current valuations would provide a total return of 30% until 2023, or 8.5% per year until then. Current company analyst forecasts are right 100% of the time with a 10% margin of error on a 1-year basis, making what I consider extremely indicative forecasts (Source: FactSet). If we consider a mean reversion possible, our returns could trend up towards 70-80% until 2023, or 20% per year, based on a 15X earnings multiple.
The upside, as they say, is convincing. Even trading lower than today, it would take fundamental collapse for your returns to become negative in the long term. This is exactly what I look for in companies such as this.
I don’t want this article to become a 10-12 page piece, so I’ll cut it here. I believe the 5 examples I’ve made here illustrate what I look for in companies when rebalancing overvalued assets. I should also mention that I have allocation goals for each company in my core portfolio – and these allocation goals very rarely exceed 1.5% of my total portfolio, in the interest of keeping a well-diversified collection of holdings and sectors.
Aside from the companies mentioned here, I also would look at CVS Health (CVS), Cardinal Health (CAH), Prudential Financial (PRU), Bank of Nova Scotia (BNS), AbbVie (ABBV), and Federal Realty Investment Trust (FRT) for rebalancing – all for similar reasons as the ones I mentioned here.
The key, I would say, is that I look for moving from overvalued companies to undervalued companies in an attempt to secure higher returns and higher dividend income.
I want to really re-emphasize that I wouldn’t be considering this at a normal valuation premium.
My eyes went up for Kesko after the company exceeded €22.5/share, which was where I considered the absolute limit for the company given its fundamental structure. It takes a lot for me to do what I’m planning here, and I never think it should be done lightly, given that for many of us, there are commissions and fees involved in buying and selling stock. I do, for the most part, encourage a buy-and-hold strategy, but I don’t think you should ignore bubble valuations in any company. If I held Apple (AAPL) stock, this would be something I would consider here, no matter how hard it would be to let go of some of the position.
What about the effects on my overall dividend income, after all being a dividend investor?
At current levels, my Kesko position yields a dividend of around $1,006/year paid in 2 installments. If I carve out what would essentially be my cost basis for the entire position – around 2% and reinvest roughly at an equal level in each of the mentioned companies herein, then that would change the overall annual dividend for that capital to around $1,650/year, marking an increase of around $650, while still maintaining my original, ~2% Kesko stake and increasing/filling several company stakes.
I could also sell out all of Kesko. Investing in a similar way would bring the capital to returns of about $2,200/year. I believe however that the rebalancing idea is a better one for the long-term perspective of the portfolio, given that I still want to own Kesko and it’s impossible to say if the company will ever reach its lowest lows again from this point forward.
So – this is how I could go about rebalancing an overvalued stake in my portfolio. Unlike some, who do this at set points in time (annually or semi-annually), I do this when a stake reaches a certain level or valuation. I do keep constant vigilance on the holdings in my core portfolio to make sure that none suddenly reach ridiculous proportions.
How do you go about rebalancing or handling overvalued companies? Do you sell? Do you leave them be? Do you think that my plan is good, or do you have a better one?
Let me know in the comments.
Thank you for reading.
Disclosure: I am/we are long ABBV, AXFOF, AXFOY, BKFKF, BNS, BTI, CAH, CVS, CWQXF, FRT, ICCGF, IVSBF, IVSXF, KKOYF, KKOYY, OMC, PRU, UPMKF, UPMMY, WBA. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
Additional disclosure: While this article may sound like financial advice, please observe that the author is not a CFA or in any way licensed to give financial advice. It may be structured as such, but it is not financial advice. Investors are required and expected to do their own due diligence and research prior to any investment.
I own the European/Scandinavian tickers (not the ADRs) of all European/Scandinavian companies listed in my articles.