How disruption can lead to undervaluations

Disruption is everywhere but its source isn’t always obvious. While some companies or industries may be permanently compromised by new entrants, disruption is a temporary problem in other cases.

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“You can disrupt any business if you have either a better offering or a lower price,” says John Goetz, portfolio manager at Pzena Investment Management in New York, and co-manager of the Renaissance Global Value Fund.

For investors like Goetz, that can create opportunities for finding undervalued stocks.

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“We are typically looking for stocks that price in the bad outcome. And [where] the more reasonable outcome—after our research—is not priced in,” he says. His research involves evaluating the market context as well as management’s plan for facing the disruption.

As Pzena’s Q4 2017 newsletter put it, “If management is right, we can realize a significant upside. If management is wrong and the business erodes, well, that’s what the market expected anyway. Low initial valuation and slow decline of the existing franchise should allow an exit from the position with limited losses.”

Retail is one example of a highly disrupted sector, with the rise of e-commerce threatening brick-and-mortar stores. “It’s probably pretty true, in many parts of the world today, that we would rather stay home and pick out some items, and have them delivered through Amazon Prime, then to bother shuffling off to the local mall,” says Goetz, who finds many retail companies are being identified by the screens he uses to seek undervalued companies.

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The challenge is determining which retailers are most vulnerable to Amazon. With the internet giant’s 2017 purchase of Whole Foods, many worried that even the grocery category was at risk. That perception led Goetz to look at British grocery giant Tesco, whose value had dropped sharply in 2014 and 2015.

He found it wasn’t e-commerce that was hurting the chain. Instead, the threat came from “old-school” German hard discounters Lidl and Aldi’s entry into the U.K. market. Tesco “had created the opportunity for their entry” by increasing its prices on certain items by as much as 35%, Goetz says.

Tesco didn’t address the threat for a year or two, and lost market share. Its management finally addressed the problem when it “lowered the prices on certain products that the discounters could compete in, and then gradually got the traffic back,” Goetz says.

Between 2013 and 2016, Tesco’s margins had fallen from 7% to “near nothing”: around 1% or 2% in some quarters, and losses in others, he adds.

“This is, of course, what created the opportunity in the valuation of the stock,” he says.

Still, Goetz maintains that cutting prices was the right strategy from management. Now Aldi and Lidl are slowing growth as their profits are declining due to reduced traffic, he says.

“That’s one example of a disruption in the market where we figured out that an element of the disruption is temporary and manageable by the right steps of management,” he says. “So we’re excited about Tesco as a very isolated case in the retail market.”

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