The Investment Team compiles questions and answers, asked at our Global Leaders Breakfasts on Wednesday 25th & Thursday 26th April 2018.
Most of the information is public, what do you see in your stocks that others don’t?
It is less a matter of seeking information advantage in the here and now but structuring our thoughts over sufficient long-time horizons where competition is scarcer. The arbitrage is largely in holding great companies for the long term and avoiding the usual pratfalls which are over-leverage and disruption.
Does the hard rebalance contradict the proposition to hold stock in the long-term as you cut the winners?
Rebalancing is consistent with our expectation of each company making a meaningful contribution to return and our time horizon given lower confidence in short term share price outcomes versus longer term fundamental performance. We expect rebalancing to equal weights will add value as it is the natural response of a long-term shareholder to the impact of stock market preferences on share prices. Cutting positions to maintain equal weighting is an important risk control given it minimises the portfolio of major industry disruption to any one position. Our approach effectively deals with the situation of holding an outsized position at a point of minimum medium-term opportunity.
How did you decide on the 20% for hard rebalance?
We back-tested the portfolio to arrive at a number which did not result in excessive turnover.
What valuation metrics do you look at?
The fund is essentially a ‘growth at a reasonable price (GARP)’ strategy. We look at price-earnings and price-book ratios, return on equity and return on invested capital. The companies we own must show that they deliver returns exceeding their cost of capital, and the price of the shares determines if a company stays on the approved list or make it into the portfolio.
Do you look at margin of safety vs. growth rate?
We look for an appropriate margin of safety when investing in a stock. This is a holistic attribute which encompasses balance sheet strength, governance and sustainable earnings power, among others. As such the growth rate is a contributory element. Clearly there are situations where there is a mismatch between growth potential and the overall margin of safety and this is then a judgement call on a case by case basis. However. we would not chase attractive growth opportunities where they come to the significant detriment of margin of safety.
Are the exclusions hard-wired?
Yes.
What is the smallest market cap stock in your portfolio, and do you have desire to go down the cap spectrum?
Renishaw’s market cap is US$4.7bn (25/04/2018). While our strategy will see medium capitalisation stocks such as Renishaw included, the nature of industry leaders operating globally is such that they tend to be medium to large capitalisation companies.
Companies where people are the product, can you explain what you mean by that?
This is central to the business models of Facebook and Google: products which are free but where the consumer becomes the product. On the plus side, these companies are masters of corralling the network effect. However, their value to advertisers is precisely in the intrusive things they do by snooping on their customers activities and preferences. This is largely about ethics in the modern age and now faces long overdue scrutiny. Facebook fails our exclusion test of having an iniquitous equity structure whereby Zuckerberg controls votes form a minority shareholding. That is an exclusion for us. Google fails the test of complexity: you can study the core business: advertising generated by search but the rest is largely unknown and is deliberately kept secret. We see Artificial Intelligence (AI) as a more generic activity in the future, not something that one or a few companies can control.
What has tripped you up in the last 5 years?
One of the stocks we sold was Novo Nordisk, a leading producer of insulin products for diabetes patients, where we felt the industry competitive dynamic was becoming unfavourable. Insulin is not an extremely difficult compound to formulate, at the time of sale, new players were emerging and product differentiation have started to diminish, which we believed would erode Novo Nordisk’s pricing premium going forward. We are always trying to be cognisant of disruption.
What is your thesis on owning Heineken? Is the barrier to entry lower now with craft brands emerging?
Beer is a very simple, high margin business in an industry that is relatively consolidated. While there are many craft names appearing, the end-game tends to be a take-out from one of the larger players, which is easy to bolt-on and the larger entities have sophisticated distribution and marketing which lowers the total cost of ownership. This is an active strategy employed by many large companies in the consumer industry (for example the Nestle-Blue Bottle tie up in premium coffee) to engage more with their customers, in particular the younger generation, as millennials identify themselves more with smaller niche (sometimes called hipster) brands. it is often overlooked who the ‘puppet master’ behind the scene is, if the quality of the product itself is not impaired.
How does the management integrity issue stack up on Samsung Electronic?
Management integrity, including corporate governance, stands as a central tenet in our investment philosophy. Our comfort in the ability, and tendency, of management to act in the best interests of all shareholders helps to navigate around investments which may ultimately destroy value. However, we are also sensitive to the cultural pathways that may have led to the formation of certain ownership structures, for example, in the case of South Korea, the chaebol. Therefore, while the complexity of the Samsung’s ownership is a concern we believe the direction of travel is more pertinent. In this regard, the signs have been encouraging with increasing cash returns to shareholders and the recent cancellation of treasury shares. Crucial is also the question of evidence of stewardship of capital. Samsung is the dominant player in flash memory as a result of the consistent through-cycle investment of its management team. Likewise, it’s near-monopoly in the emerging OLED technology comes from two decades of R&D. This points to an alignment between management and shareholders, in our view.
Can you talk about the engagement with companies in more detail?
We set our own agenda when engaging with companies. Our conversations tend to focus on industry dynamics and management observations on the evolution of the competitive landscape, in particular, we seek to understand how businesses are adapting to technological advances and customer requirements. Our lines of enquiry tend to be strategic and therefore do not fit well with the focus on short term revenue and earnings data typified by analyst calls, therefore our participation in company directed calls and meetings serves to allow understanding of short term price movements which will can provide opportunity via our rebalancing program.
Reckitt has been having problems for a while now, does that change your view on the company?
There is quite a chorus against Reckitt in the UK Investment management sphere and we see as largely on account of the fact that the company has been a darling with a strong following, they have achieved multi-year margin expansion which has now come to a halt. When you look into why, it is mainly on account of the acquisition of Mead Johnson which is a lower margin business. It is very much in the right sector though: consumer and infant health so a good add and, once the unattractive comps are out of the way, will add value. Also, Reckitt has just completed a major multiyear drive to take costs out of its supply chain and now that that impetus is over. Looking further forward, we would support their portfolio shifts and believe there is a great deal of future value in their power brands. The stock price looks to have taken on all the negatives and we remain holders.
James, Fergus, Fay & Mike
To see the previously asked questions at our Launch breakfasts, please click here.