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.
Our analysis centres on attempting to understand whether the controversy that has befallen a company is temporary (and therefore an opportunity) or permanent (and therefore something to avoid). We are keen to stick firmly within our areas of competence and so, in order to improve the probability of getting these initial calls right, we look for repeating patterns. This involves looking for similar characteristics to other investments we have been involved with, recognising what works and looking to repeat success.
We have identified five separate buckets of controversy, which are detailed below. These different types of controversy do not follow traditional industry boundaries, so our familiarity with them depends upon our understanding of the way they re-appear in different settings and at different times. Each bucket provides a template for investigating a company and the controversy that surrounds it. The characteristics we look for in each bucket are different as are the specific questions we try to answer, because the associated risks can vary a great deal.
(The descriptions below refer regularly to ROIC, which stands for ‘Return on Invested Capital’. 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 profits. Companies that consistently deliver a high ROIC, such as those that dominate buckets one and two below, are often referred to as ‘quality’ businesses. High returns allow these businesses to sustain underlying cashflows and afford them the ability to suffer without threatening their ability to sustain dividend payments. Delivering consistent high returns also means that a company’s ability to pay its dividend is less sensitive to analytical assumptions and to changes in their operating environment.)
Bucket 1: Troubled compounding machines
Companies with a dependable track record of delivering a high ROIC and consistent growth are sometimes referred to as ‘compounders’. They may not be the most exciting businesses in the world, but steady growth delivered year after year, tends to result in extremely impressive long-term share price performance.
Compounders are therefore popular among fund managers, us included. However, this popularity often means a high valuation – some investors would argue that high valuations are justified for these compounding machines and, indeed, that the market doesn’t rate them highly enough. However, our dividend discipline means we don’t need to engage in that debate.
Instead, our focus is limited to buying these compounders when they fall under a cloud. Often the trouble will relate to one part of an overall business (divisionally or regionally), but it comes to dominate the consensus view of that stock. In other words, the controversy provides us with an opportunity to invest in that business at a low valuation, when the share price is already discounting a lot of bad news.
Troubled compounding machines: What we need to know
- How is the rest of the business doing?
- What is the downside if the problem area isn’t fixed?
- What is the upside if it is fixed?
- What are the probabilities of these different outcomes prevailing?
Bucket 2: Ex-growth cash generators
Companies with a track record of generating a high ROIC do sometimes trade at a market discount. Often this is because of some 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, is a good case study of how this can play out deleteriously for a complacent incumbent.
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.
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. 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.
Ex-growth cash generators: What we need to know
- 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?
Bucket 3: Profitability transformation
The stock market consensus has a preference for extrapolation – observing a trend and projecting its continuation into the future. The market struggles to forecast moments of inflection, where a company’s profits take a turn in a new direction, either up or down. The presence of controversy makes it even more likely that the market will fail to anticipate a positive change of fortune.
Companies in this bucket, therefore, tend to be exposed to some form of cycle but it can include any business that has the potential for a positive profit inflection. Cyclical businesses can often be misleading – if they are delivering healthy profits and dividends, we are inclined to be cautiously positive because we know that, at some stage, the cycle will turn. Conversely, a more sensible starting point for us is to look for companies that are delivering depressed profitability within a historic cycle of peaks and troughs.
Calling the turning point of a cycle is notoriously difficult, but our focus on the sustainability of the dividend guides us towards companies that have robust cashflows even at the trough of the cycle. A cost advantage over competitors helps in this regard, as does a clean balance sheet with limited debt. Where we find these characteristics, the emphasis of our research moves towards what is priced into the stock. If the market is discounting an improbably extended down-cycle, the asymmetry of future returns is likely to work in our favour. The length of the down-cycle and the path of the subsequent recovery are typical sources of controversy in this bucket. Sometimes this has specific ramifications for a particular business; other times, an entire industry may be implicated.
Profitability transformation: What we need to know
- How has the industry changed since the last cycle turned?
- How long is the market expecting this down cycle to prevail?
- What conditions do we need to see to have confidence in a cyclical upswing?
- How should returns and profits behave as the cycle reasserts itself?
Bucket 4: Capital intensity
Companies with a high ROIC attract most of our attention (buckets one and two tend to account for about two-thirds of the portfolio’s assets), but lower ROIC companies can also provide opportunity. These tend to operate in more capital-intensive industries, such as property, insurance and utilities, but, as long as a company makes a return that comfortably exceeds the cost of its capital, it can still represent an attractive proposition, especially if those returns are highly durable. A utility business with a revenue stream underpinned by regulation, for example, maybe a candidate for inclusion in this bucket, but we may also include companies which lack such certainty but that have demonstrated historic resilience through a strong franchise and culture.
These are less glamorous than high ROIC businesses, but this means they are often overlooked by other investors. This is an obvious starting point for potential valuation opportunities. When combined with a controversy that we can effectively neutralise with evidence, lower ROIC business can start to look very appealing.
This bucket of controversy has some overlap with buckets one and two, despite the different ROIC characteristics. However, it requires a separate category because capital intensive businesses require a different set of questions to be answered during the research process. Debt levels are often higher, so these opportunities require particular work to test the durability of revenues and cashflows, to mitigate the financial risk that comes with leverage.
Capital intensity: What we need to know
- How important is the company’s credit rating?
- How would changes to the credit rating effect our scenarios?
- How conservative is the company’s financing (debt tenure, interest rates fixed or variable, currencies hedged)?
- How reliable are the company’s cashflows?
Bucket 5: Special situations
Lastly, the special situations bucket typically contains companies with complicated conglomerate structures and complex issues surrounded by uncertainty.
Often the valuation aspect of the investment thesis here will rely on a sum of the parts methodology. The controversy will typically relate to one segment of a business, but it will influence the market’s perception of the entirety. This may lead to other assets becoming underappreciated and the opportunity for hidden value to ultimately be realised.
The complexity associated with special situations can bring additional risk, so our research work needs to be tested against robust downside scenarios, and a slightly different set of questions needs to be addressed.
Special situations: What we need to know
- What is the value of this business if the troubled division becomes worthless?
- What can management do to address the under-valuation of certain assets?
- If each division was independent, how would the market value them?
Bringing it all together
Every investment opportunity we look at will be exposed to several weeks of careful scrutiny, as we try to answer the relevant questions for each bucket, as well as those specific to the unique circumstances of each business. Ultimately, this analysis is brought together to form a fan of potential outcomes, ranging from worst-case to best-case scenarios. These scenarios can be compared to the current share price of the business, to give an informed insight into a stock’s attractiveness.
We also identify several metrics at the outset, against which we can track the operational progress of a business in relation to our investment thesis. These flags represent tangible evidence which will help us to determine which of the scenarios is playing out. In turn, this means our activity and decision-making can be anchored by the fundamental progress of a business, rather than what happens to its share price, which may be influenced by all sorts of non-fundamental factors in the short-term.
Throughout our time managing this investment strategy, we have been determined to stick firmly within our sphere of influence, which is defined by the buckets articulated above. This approach has worked well historically and, given we are doing nothing differently, we are confident of continued future success.