Kempen Dividend Letter - Capitalising on Uncertainty

Dear Reader,

2016 was a year in which those with an understanding of human psychology prevailed over those without. Vested political parties believed they could sway their electorate by using rationalism - and failed. The winners were those who tapped into deep rooted and often justified emotions. Where life for some has continued to improve considerably, for many others it has become less safe and has certainly felt this way.

Securing safety and control is just one step up from basic physiological survival – stilling our hunger – on Abraham Maslow’s renowned hierarchy of need.  From this perspective the victory of Trump and the Brexit should not seem so surprising. The winning campaigns of 2016 were based on increasing the sense of safety of the electorate.

Understanding mankind's aversion to uncertainty is not just key to winning an election, but also to successful investing. The way to capitalise on the need for safety and control however, is altogether different. Rather than increasing a sense of safety, successful investing is often based on what may feel emotionally uncomfortable but is fundamentally sound. We believe we can profit from this behavioural bias through our reliance on finding companies with a margin of safety, combined with a well-diversified portfolio. Feeling safe in the investment world is achieved by doing what’s popular; this is however unlikely to lead to superior results. If it feels comfortable to buy a stock, an equity strategy or even an asset class, then this optimism is likely to be reflected in the price. The time the asset feels the safest tends to coincide with its being priced to deliver the lowest returns.

We believe skill in investing comes not from seeking safety in what’s popular, but in assessing the value of the business and buying the stock at a considerable discount. By focusing on the intrinsic value of a stock instead of the day to day price movement, you become less susceptible to what is a very strong emotional bias and need.
This focus allows you to concentrate on areas of the market that offer high risk-adjusted returns in exchange for temporary emotional discomfort.
 

“Humans are also emotional beings. We suffer from overconfidence, which leads us to believe we are more capable of assessing situations than we truly are. ”

Stock picking contribution

One example was the purchase of Japanese exporters. This included Toyota and Yamaha Motors. Both companies saw sharp price declines as the Yen strengthened. A strengthening of the Yen negatively impacts exporters, but Japanese manufacturers have a global footprint which makes them less dependent on the movement of the Yen. With share price declines of 30% or more, we believed the market had become overly pessimistic on the sustainable earnings power of these firms. As the market digested better than expected earnings and the Yen reversed some of its losses, these stocks rebounded strongly.

Another sector suffering from short term worries were US refiners. We added to this sector at the end of the first quarter by purchasing Western Refining and Valero Energy Corporation. The stock price of both had been highly volatile, as the market worried about weak short term refining margins.  Following our initial purchase spot margins continued to weaken and the market started to price these stocks as if margins would remain depressed indefinitely. Both stocks continued to have strong balance sheets and were profitable even in a depressed margin environment. We added to our position through our quarterly rebalances. Share prices started to rebound at the end of the summer 2016 as refiners reported strong numbers despite a weak refining market. A subsequent improvement in the refining market also aided sentiment. In November Western Refining received a bid by one of its larger peers, Tesoro. This confirmed our view that the assets of Western Refining were attractively priced, on the basis of informed private market values.

Rebalancing
Our quarterly rebalancing process aids us in capturing the markets aversion to short term uncertainty. Systematically buying low and selling what we believe has become expensive is a process that we believe works over the long term, but can fail to work out over the short term. In investing a sound process may not always lead to a sound outcome in the short term (with the opposite also holding true). In the years leading up to 2016, the markets were driven by momentum and showed limited appreciation for large gaps in valuation. By rebalancing our portfolio every quarter our process remained intact but resulted in a (relative) performance headwind. This appears to have changed in 2016 and our rebalancing has added significantly value, both in absolute as well as in relative terms.

Looking forward we continue to see large discrepancies in the pricing of equities globally. Markets as a whole have continued to do well, depressing future equity returns. We believe pockets of undervaluation remain, but the ponds from which we fish have gotten smaller and shallower. Our investment process remains unchanged and supports us in building a disciplined, diversified portfolio of attractively valued high dividend paying companies.
We are thankful for your continued support and wish you a successful and healthy 2017.

Kempen Dividend Team

Disclaimer 
As asset manager KCM currently has invested, generally for the benefit of third parties, in financial instruments of the companies mentioned in this document and it may at any time decide to execute buy or sell transactions in these financial instruments.

Kempen Capital Management N.V. (KCM) is licensed as a manager of various UCITS and AIFs and to provide investment services and is subject to supervision by the Netherlands Authority for the Financial Markets.

This document is for information purposes only and provides insufficient information for an investment decision. No part of this white paper may be used without prior permission from KCM.


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