Would you invest in Toyota?

Former fund manager David Varley on why his firm bought shares in the then-troubled Japanese carmaker
Asset management

In early 2010, things were not looking good for Toyota Motor Corporation and its new president Akio Toyoda. For the previous few decades, the company had been one of Japan's biggest corporate success stories, rising to become the world's largest carmaker on the back of a legendarily efficient production system and a prolonged period of beneficial exchange rate movements. In 2009, however, a small number of Toyota drivers in America began to report that their cars were starting to accelerate at unintended, and potentially dangerous, times. Keen to put safety first as they puzzled over the problem, by the end of January the following year Toyota had recalled as many as nine million previously-sold cars to have a technical fault corrected.

The gravity of the situation pushed Toyota into crisis mode on three fronts. First, their engineers and mechanics had to work to fix the physical problems. Second, there were huge reputational issues to consider. Japanese automakers had a long and successful history of selling cars across the globe based on superior (and safer) engineering and they needed to convince the world that this would continue to be the case in the future. Toyota's executives and public relations worked to reassure potential buyers of their product, culminating in Mr Toyoda himself appearing before Congress and offering a personal apology. And third, the company's formidable investor relations team set to work to attempt to correct a share price that had fallen almost 20 per cent in three weeks - a huge collapse for Japan's largest publicly-traded stock.

Finding a "good company"

For the fund managers like me who met with Toyota's representatives during this period, the company's shares presented an intriguing, if risky, opportunity. It was a situation that illustrates the stock-picking process in all its complexity.

Fund managers, all other things being equal, like to invest in "good companies". Toyota had a strong record of growing revenues and profits over a long period. Furthermore, analysis revealed strong competitive advantages - the famous production system, for example, and a leaner cost structure at a time when foreign rivals were weighed down with pension and healthcare expenses for former employees. There were interesting new products coming, and a seeming lead in new hybrid engine technologies, such as those used in the high-profile Prius. A qualitative analysis of their competitive position and track record, of the sort a fund manager would perform on any stock, suggested that Toyota undeniably had been a "good company" in the past.

To address the question of whether Toyota was still a "good company", investors leaned heavily on the meeting with Toyota's managers. Asset management firms often place company meetings like these at the heart of their investment process; many advertise to potential clients by trumpeting the number of such meetings they might do in a year. The idea is not that investors might find out significant new information on these occasions - there are laws supposed to prevent that from happening - but rather that the fund manager is able to build up background knowledge of the company and, where senior executives are present, a deeper understanding of the people driving the corporation's strategy. A fund manager might do three or more of these meetings in a day, and a newly graduated analyst might find themselves expected to run them almost immediately on joining a firm - a tall order and one that involves several hours of reading through annual reports and research.

In the case of the Toyota recall crisis, these meetings were reassuring, up to a point. Investor relations experts, who specialize in disseminating all the information that companies feel comfortable with to fund managers, talked at length about the measures Toyota was taking to prevent similar incidents in the future. They stressed the company's strong track record, and did everything they could to calm nervous holders of the stock. These meetings, however, in high-rise towers in London, New York and Hong Kong were inevitably conducted at a great remove from the source of the problem itself. Toyota were unable to definitely declare their highly technical problems to be fixed, and investors remained uncertain.

Uncertainty is not necessarily a problem in fund management. Indeed, in an industry concerned with making predictions about the future, it is a constant. This is where the art of stock valuation comes in: is a share price low enough that it acknowledges many of the bad things that might happen to a company, and is thus likely to move up should events not turn out quite so negatively? Valuation is an area that a young analyst might spend a large proportion of their working day on, and it was a key tool in the Toyota situation.

Adding value

Fund managers value companies in a number of ways, but most of these are variations on two themes: the value of the company relative to its likely profits, or compared to the value of the assets it owns. Making estimates of either of these two variables requires some quite complex spreadsheet modelling of financial statements. Fund managers usually use analysts (either in-house, or as a paid-for external service) to do this task, and this is why almost all entrants into the investment industry are required to learn about accounting very early in their careers. Valuation work generates ratios that dominate the conversations investment professionals have about stocks. The best known of these is the P/E ratio - or price (of a share) to earnings (of the company) - that, valuation being much more of an art than a science, is highly trusted by some fund managers and dismissed entirely by others.

In the case of Toyota, the normal methodology might have been to calculate the P/E ratio and compare it to other companies in the industry to see to what extent the crisis had left shares in the beleaguered company cheap. At this stage, however, Toyota was having to pay out so much in fines, as well as the costs associated with recalling millions of vehicles, that the company was not guaranteed to have any earnings at all. The second method, therefore, of valuing a company relative to the assets it owns, came into play. It turned out that Toyota's stock was trading at around the price that it would fetch if all the assets it owned were sold off (a valuation described as 1 x the book value of the assets). Honda, the closest competitor, was trading at 1.4 x book value. An analysis of historical patterns suggested this was both an unusually low level for Toyota and a discrepancy of a rare magnitude with Honda.

It seemed reasonable to suggest that Toyota's shares were cheap. A young analyst might have spent a number of hours checking and re-checking numbers on a spreadsheet and come to the fund manager with this conclusion. And the fund manager might have refused to buy the stock for a number of reasons that had very little to do with a qualitative or quantitative assessment of the company's future prospects. Where it is the job of an analyst to think about the merits of individual stocks, a fund manager has to see everything in the context of the overall portfolio of shares that they have. So it might have been that the manager already owned shares in too many Japanese car companies, or that adding a stock whose fortunes correlate closely with movements in the yen was a risk too far for them. The way in which a fund manager's performance is judged is also important: a complicating factor in the case of Toyota was that it was such a big stock, and such a large proportion of the benchmark (the Japanese version of the FTSE 100) that many managers of funds investing in Japanese corporates are tasked with beating. The amount of Toyota potentially being bought would thus have had to be carefully thought about in the context of this benchmark.

After sifting through all of these factors (which are the typical inputs into most fund management decisions) - the evaluation of track record and competitive position, the company meeting, the detailed spreadsheet and valuation work, and the consideration of the context in the overall portfolio, I did buy Toyota shares. I was satisfied that my process had been thorough, and that the price was right.

Alternative methods do exist. There are occasions when any pretence of science goes out of the window. For instance, not too long ago, near the height of one of the stock market's recurring manias for technology-related shares, fund managers at my firm met with a pair of young entrepreneurs to discuss taking a stake in their soon-to-be publicly-traded company. The executives refused to divulge any details of their business, other than that it was "internet-related". The fund managers politely declined to invest client money in the venture, but many other investment professionals were not so concerned with details, and soon the stock had risen to several multiples of the price at which it had been initially offered. I thought of this stock as my ever-so-carefully-researched Toyota shares stubbornly refused to move upwards for months and months. The much-later bankruptcy of the internet company finally served as evidence that the stock market might reward thorough analysis and a scientific approach eventually, so I held on to my Toyota stock, and waited.

It looks like David was right. After doing relatively poorly for the past three years, Toyota shares are now trading at a four-year high. Furthermore, they're forecast to outperform average performance in the market in the coming months.

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