Fay Ren 0207 036 4128 ren@cernocapital.com

Less Cream, More Expensive

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Cerno Global Leaders is a long term equity investment programme designed to identify and invest in high quality, defensible business franchises.

We have been investing in an equal weighted portfolio of such stocks on behalf of investors since 2013. Results, to date, have been very encouraging and the portfolio has exhibited strong performance.

The underlying process is very much tilted toward the research and identification stages with many possible candidates rejected along the way. To render a manageable list of candidates from the global equity universe of 68,000 listed companies, we apply a quantitative screen.

To ensure sufficient liquidity, we screen for companies with a minimum market cap of US$2.5bn. We exclude highly leveraged sectors and deeply cyclical sectors such as banks, oil & gas, basic materials and mining. Positive profit histories and robust balance sheets are also requirements for inclusion. Note that past stock performance is not a criteria.

This naturally gives the screened sample a high quality bias, which is reinforced at the next stage of the selection process. This leads onto the creation of an approved list of stocks, to be invested at the right valuation. With the universe defined, more rigorous qualitative assessment on selected candidates takes place. Our understanding of the probable longevity of their competitive advantage is a key consideration.

Placed against the market-cap weighted MSCI AC World index, we observe a similar country distribution by country of registration. The highest number of companies is concentrated in the US, making up just over half of the names in the universe. Representations from UK, Switzerland and France are less than their market weights. By contrast, China and Germany are more strongly represented.

Country Allocation

Sector-wise, the exclusion of banks and energy acts to bolster the weights into technology and healthcare, whose combined weight is more than 50% of the universe, a much higher percentage versus the MSCI AC World Index. Both these sectors are defined by innovation and disruption, with fascinating longer term potential, well worthy of exploration. The world is heading in a direction where technology is finding its way into new applications, and higher healthcare spending will arise from an increasingly aging demographic. By default however, we steer away from overly complex businesses, and only choose those with a proven track record of profit generation, therefore we tend to avoid early stage tech or biotech companies.

Sector Allocation

On an equally-weighted basis, the current universe sports similar characteristics to the approved list, as displayed in the table below:

Characteristics

(Equal-weighted average)

GLS

Approved List

GLS

Universe

MSCI AC World

Number of Holdings

26

527

2,490

Price/Earnings (1YR FWD)

20.5

19.7

15.1

Return on Equity

21.3

24.0

9.2

Return on Capital/Cost of Capital

1.8

2.1

N/A

Gross Margin

53.5

43.2

30.4

Operating Margin

20.3

20.6

9.9

Debt/Equity

49.1

35.6

79.5*

Free Cash Flow Yield

3.8

4.6

6.9

Companies in the GLS universe do not remain static as we refresh the screen from time to time.  Comparing the current iteration of our universe to the list generated 12 months ago, the most notable feature is the contraction of the investable universe, where the number of companies was reduced from around 800 to 500 today. Further, there are only 300 companies that remain from the previous iteration while 200 new names made their debut into the universe. The changes are dictated by the evolving macro-economic conditions affecting companies’ financial profile and/or idiosyncratic factors occurring at the company level.

Of the companies that have fallen out of contention, the main reason was due to a deterioration in their balance sheets. Over half of the companies have taken up more debt. The average debt to equity ratio of the ejected companies have increased to 130%, whereas the newly cut universe is just 35%.

We believe this has happened as a regrettable consequence of overly easy money policy, extended over several years, which has encouraged companies to take advantage of very low interest rates.

As any user of the DuPont Model know, higher leverage should increase Return on Equity (ROE) if all other variables remain the same. However, this has not been the case as ROE is little change, down a little in fact.

Furthermore, the growth profiles and the returns on invested capital of the supplanted universe are materially worse than the updated (and smaller) universe.

This tells us two things.

Firstly, it underscores the need for periodic re-measurement. Company dynamics do change.

Secondly, it points to a broad scale deterioration in company balance sheets and profits growth within the wider community of leading global companies. All equity investors should be concerned about this.

As a consequence of the second point, in an environment where reliable quality and growth is becoming less prevalent, the good residue is likely to become more highly prized. This seems to be borne out in valuations.

Both our approved list and the universe are trading on mid-twenties Price Earnings ratios compared with teens when the programme was inaugurated.

We draw two conclusions. From an asset class allocation perspective, equity investors should be alive to the dangers of being corralled into “great stocks at the wrong price”. From a security selection process, resampling is key as is patience applied to the buy discipline.

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