Ex-growth cash generators

March 26, 2021

2:15 pm

The three requisite features of every investment we make are: a premium yield; dividend sustainability; and a valuation margin of safety. These are relatively easy to find individually but, in combination they are rare and typically only occur when a company is surrounded by some form of risk or controversy.
Source: RWC, for illustrative purposes only.
Here we take a dive into one of the RWC Global Equity Income Strategy’s five buckets of controversy, with the help of three case studies. The Ex-growth cash generators bucket is normally one of the largest constituents of the portfolio – along with Troubled Compounding Machines, stocks within these two buckets typically make up at least two-thirds of the entire portfolio.

Companies with a track record of generating a high ROIC (Return on Invested Capital) are popular among fund managers. ROIC is an important metric for us because it provides a tangible indication of how good a company is at allocating capital to generate future growth and cash. Companies that consistently deliver a high ROIC are sometimes referred to as ‘quality’ businesses. Their high returns allow these companies to sustain underlying cashflows and afford them the ability to suffer without threatening their ability to continue to pay dividends. Hence, one of our three requisite characteristics – dividend sustainability – is commonly found among these quality businesses.

The other two characteristics – a premium yield and a valuation margin of safety – are harder to find, however. The popularity of these high return businesses often means a high valuation which, given our disciplines, would preclude them from our investable universe. They do, however, sometimes trade at a market discount, which is when we become interested. Within this specific bucket, the valuation discount tends to accompany market concerns about a perceived existential threat that is expected to disrupt a successful business, sending future returns sharply lower. The threat posed to Kodak by digital technologies around the turn of the millennium, or to Nokia by the advent of touchscreen technologies, are good case studies of how this can play out deleteriously for a complacent incumbent.

Case study 1: Harley Davidson’s engine splutters

Harley Davidson is a recent example of an investment that sits in the Ex-growth cash generators bucket. A truly iconic brand, Harley Davidson motorcycles are steeped in history and mystique, from its association with cult movies in the 1970s and the rise of the Hell’s Angels, through to its more recent patronage from a range of rock stars and A-list celebrities.

In 2018, however, the share price started to come under increasing pressure due to worries that Millennials were distancing themselves from a product seen as representative of the Baby Boomer generation. Meanwhile, Harley Davidson’s core demographic was generally viewed as having reached a stage in life during which they were less likely to buy and ride a motorcycle.

This led to market concerns that the brand was in danger of becoming irrelevant. Sales had indeed come under pressure, as a result of declining motorcycle ownership in the US and some analysts feared that this signalled a fundamental shift in the popularity of motorcycling as a leisure pursuit.

Refuting the controversy

Our contention to the popular market narrative of the time, was that motorcycle unit sales have always followed an observable cycle. Our analysis showed that Harley Davidson was actually gaining market share in total (new and used) motorcycle demand and, rather than distancing themselves from the brand, younger generations were simply accessing it in different ways, favouring used, vintage and customised product.

We therefore built an investment thesis around the continued strength and relevance of the genuinely iconic Harley Davidson brand, a strong balance sheet and a commitment to returning all excess cash to its shareholders.

Repeating patterns

In recent years, we have seen a similar repeating pattern play out at other luxury brand companies such as Ralph Lauren, where temporary problems stemming from a period of over-expansion were incorrectly perceived by the market as being structural and permanent. A similar pattern played out at Tiffany, which implemented a successful brand turnaround strategy, introducing new products and expanding its online presence to appeal to Millennial and Generation Z shoppers.

Source: CNBC 12 May 2015, Business Insider 25 January 2016, CNN 25 January 2019.

Although some companies will inevitably face a Kodak-like future, more often than not, we find that the perceived threat is exaggerated. Usually, a combination of headwinds dent growth temporarily but do not amount to anything terminal. This is an opportunity for us. Indeed, the valuation attraction in this bucket can be particularly significant. In mistaking a temporary controversy for a permanent problem, the market will already be discounting a level of risk that the company may go under. In this context, the valuation asymmetry may be skewed even further in our favour. Simply surviving can be enough to deliver a good return, but if the company eventually resumes its prior growth trajectory, the upside is even greater.

We particularly like companies with a strong franchise that have the ability to adapt to the challenges they face. Mature technology companies have demonstrated this adaptability in the past, as discussed in the Cisco case study below. Slowing growth and new competitors can be interpreted by the market as the death knell for a hitherto dominant franchise. However, closer analysis can reveal a different picture. In situations like this, we work on building evidence for a counter-argument. A simple survey of customers, for example, may reveal a strong reluctance to compromise security or performance, not to mention the technical difficulties of changing providers. Where this is the case, a franchise may prove to have significantly more longevity than the market realises. With patience, and by tracking the progress of the investment thesis with some pre-determined flags, we can ultimately be rewarded when growth returns.

Case study 2: Reports of ad agency’s death are greatly exaggerated

Omnicom is a marketing communications business, which offers a range of creative, advertising and related media services to a wide variety of clients globally. Historically, it has delivered better growth than many of its peers and is well represented across the key advertising disciplines. Despite the cyclical nature of its industry, Omnicom’s profit margins have tended to be relatively stable and its returns have been consistently attractive. It also benefits from a highly diverse revenue base across regions, sectors and individual clients.

More recently, the advertising sector has seen a sharp slowdown from mid-single-digit annualised growth to barely above zero. This has prompted fears that the industry is facing structural challenges, with the shift to digital being cited as the key threat. Google and its peers have enjoyed spectacular growth in advertising revenues compared to the likes of Omnicom, which supports a widely held view that advertising agencies are being disintermediated.

Meanwhile, the dramatic exit of Martin Sorrell from WPP highlighted the ‘key man risk’ associated with people businesses and shone a light on the appropriateness of its historic merger & acquisition (M&A) strategy. Omnicom has not been acquisitive, but these issues have weighed on share prices across the sector, with valuations moving from broadly market multiples to a significant PE discount.

Refuting the controversy

The variant perception is simply that the sector is not permanently disrupted and remains relevant for the digital age. While digital is causing a shift in the mix of advertising spend (retailers for example spend less on their overall brand and more on targeted digital ads based on people’s search history), this is not the death of traditional advertising. Thus far, the media industry has been able to deliver modest growth despite the shift to digital and with no negative impact on margins.

Omnicom’s business model remains highly relevant to the current age. It offers a range of specialised skills which, when coupled with its scale and an independent creative view, can deliver a valuable integrated marketing communications service from strategy, through to execution and measurement.

Repeating patterns

The sector fits the repeating pattern of a temporary malaise being mistaken for permanent disruption. Within the retail industry, Next is a prime example of an incumbent business that has used its advantage of scale to ‘out-digitise’ the disrupters, a pattern also seen at Accenture and Infosys.

The characteristics we look for in each of our five buckets are different, as are the specific questions we try to answer. This is because the associated risks can vary a great deal. With respect to the Ex-growth cash generators bucket, some of the questions we seek answers to are:

  • How vulnerable is this business to disruption?
  • Has the company or its industry risen to the challenge of disruption before?
  • How strong are customer relationships?
  • How specialised is the company’s offering?
  • What are the barriers to entry?
  • What evidence is there for wholesale customer switching?
Case study 3: Cisco heads for the clouds

American technology business Cisco Systems literally helped to build the internet. Its connectivity solutions have become embedded in computer networks worldwide, to the extent that it is estimated that 85% of internet traffic travels across its systems.

In 2017, the company commenced a significant shift in its business away from its legacy hardware solutions, and towards software-based, recurring revenue streams. Major corporate transitions are always fraught with risk, and the controversy here initially stemmed from the market’s scepticism about Cisco’s ability to successfully execute this pivot. Meanwhile, concerns about the cyclicality of its end markets resurfaced, impacting its bookings across geographies. These factors combined to lead a derating of the shares and Cisco began to be viewed by the market as an ex-growth legacy hardware vendor.

Refuting the controversy

Our contention was that the slowdown in sales was caused by a pause in spending on key projects, rather than a structural decline. We continued to view Cisco’s technology and services as absolutely core to its clients’ technology strategies and expected investment to rebound. The global pandemic of 2020 has highlighted the risks to companies of underinvesting in their technological infrastructure.

The pivot towards software also looked strategically sensible to us, given the anticipated growth in cloud computing. We viewed the transition more positively than the market, drawing confidence from Cisco’s dominant market shares in the majority of its business lines, and its embedded relationship with its customers. The company consistently scores highly in CIO surveys, being seen as a critical and indispensable partner and a key beneficiary of cloud initiatives.

Instead of viewing the transition as a reason to value the shares more modestly, we concluded that Cisco’s shares deserved a premium rating, courtesy of its recurring revenues streams and a reinvigorated growth outlook.

Repeating patterns
Cisco has a large, dominant and long held market position in an industry that is changing, but not dying. This is a pattern we have seen several times before. Within technology, the situation has echoes of IBM in the early 1990s, when the mainframe computer giant had to transform to participate in the personal computer revolution, and Microsoft in 2012-13, when it commenced its own pivot towards the cloud opportunity.
The RWC Global Equity Income strategy normally has approximately 30% of its portfolio assigned to the Ex-growth cash generators bucket. Currently, 28% of the portfolio is allocated to it, making it the second largest bucket, behind Troubled Compounding Machines. All three of the case studies detailed above are currently held by the strategy, alongside other compelling new ideas such Lockheed Martin and Ambev. We believe this process repeatedly delivers quality at a reasonable yield.

Collectively, we are confident that our track record of identifying and investing in high quality, high return businesses when the market is worrying inappropriately about their future growth prospects, can generate good long-term returns for our investors.
Portfolio holdings are subject to change at any time without notice. This information should not be construed as a recommendation to purchase or sell any security. No investment strategy or risk management technique can guarantee returns or eliminate risks in any market environment. The information shown above is for illustrative purposes only and is not intended to be, and should not be interpreted as, recommendations or advice.
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