2011 Annual Report Commentary
Over the year to 28th February 2011, Evenlode Income’s A and B shares rose 17.9% and 17.3% respectively, on a total return basis. This compared to a rise of 14.8% for the UK market and 16.0% for the IMA UK Equity Income Sector. Performance figures for the fund are quoted after all fees and costs incurred.
Since the end of the fund’s initial offer period (19th October 2009), A and B shares have risen 21.9% and 21.0% respectively. This compares to a rise of 18.2% for the UK market and 18.5% for the IMA UK Equity Income Sector. This return has been achieved with considerably less volatility than both the market and the sector (all sources: Financial Express).
Review Of The Year
After a poor summer, all financial assets took off in September and rallied strongly for the rest of the twelve-month period under review. The beginning of this rally coincided with Ben Bernanke’s speech at Jackson Hole at the end of August. In this speech he made it clear that a second round of quantitative easing was on the cards, and in November he duly announced a $600bn extension to the Federal Reserve’s QE programme. One of the explicit aims of this policy was to stimulate financial assets and so far it has been successful.
From a share price perspective the most positive contributors to the fund’s performance were generally smaller and medium sized businesses, a group that were much in fashion during the period. Domino Printing, United Business Media, ITE Group and Diploma all contributed more than 1% each to the fund’s total return, helped by a combination of good fundamental performance and rising valuations.There were no significant negative contributors, but holdings in the healthcare and consumer staples sectors performed least well.
A Reminder Of The Type of Businesses We Like
We like businesses that ‘drown in cash’ – consistently generating more cash than they need for the upkeep of existing operations.These businesses are able to return some cash to shareholders, and re-invest the rest in a virtuous circle of compounding returns. As a result, we call them ‘compounders’. Compounders don’t tend to have much in the way of tangible assets (i.e. factories, infrastructure, machinery and the like), so their capital expenditure requirements are low. What they do tend to be rich in are repeat-purchase products, consumer franchises, intellectual property or technical know-how. These intangible qualities all keep customers coming back for more, and also help keep competition at bay. Examples in the portfolio range from consumer brands such as Coca Cola or Johnnie Walker (Diageo), to the data and intellectual property owned by companies such as Experian and Pearson, and the technical know-how of engineering businesses such as WS Atkins.
As in the biblical parable of the sower, investing in compounders is like sowing seed on fertile, rather than stony or thorny, ground. It makes our job similar to that of a good gardener – tending to our plants, occasionally planting new ones, trimming back here and there, but most importantly letting them grow without much disturbance. Over time, the attractive economics of compounders should do much of the portfolio’s ‘heavy lifting’.
Another attractive quality, particularly relevant given the money printing experiments that central banks are currently undertaking, is the ability of compounders to cope with inflation. We see significantly higher inflation as a big risk over the next decade. Owning businesses that sell products with a lasting appeal to consumers, or technical skills that have a durable usefulness to society, are great ways to protect the purchasing power of one’s savings over time.
Our approach requires a degree of discipline, focus (and sometimes boredom!) that many professional investors, locked into short-term incentive structures, do not have the patience for. As Jean-Marie Evellaird said ‘it is warmest in the middle of the herd’. However, doing what everyone else is doing doesn’t tend to lead to long-term success in investment. The market price of a stock is always set by the prevailing mood of the investment community. The more, therefore, you listen to what the investment community has to say, the fewer insights you are likely to have. We work hard to bring an objective approach to investing, and prefer to do our own detailed research than rely on the views of others (being based in a quiet corner of rural Oxfordshire helps with this task!).
As a result, the Evenlode portfolio will normally look quite different to the UK market. We hope that our shareholders understand that this will, on occasion, lead to a return profile that also looks quite different. However, we strongly believe that this is in the best interests of the fund’s long-term prospects. As a current example, 60% of the UK market is made up of resources and financial businesses (source: Bloomberg). The Evenlode portfolio has less than a 10% exposure to these two sectors on aggregate.
Outlook - Where Is The Value Today?
There is a degree of complacency creeping back into the market, not seen since before the 2008-9 downturn - the UK market has now nearly doubled since its lows. As a result, it is has naturally become harder to find outstanding opportunities.
However, while the platform left to stand on is getting narrower, there is at least still a platform! We see some very compelling opportunities in the healthcare, consumer staples, media and technology sectors at present and have been adding to our holdings in these areas over recent months. Many of these stocks have been left behind in the rush to keep up with a rapidly rising market. But many of them also possess exactly the qualities we are most interested in – repeat-purchase franchises, high returns on investment and strong cash generation. We are happy to wait patiently in these stocks. While the potential for an upward re-rating is clear, as shareholders we also get paid while we’re waiting, thanks to very attractive cash flow and dividend returns.
Elsewhere, there will always be opportunities in the smaller company universe. On aggregate, I think the smaller company universe is overvalued. However, it is such a broad hunting ground that there is always ‘something to do’. As a small fund we are able to take meaningful positions in companies that many institutional investors would deem too small to invest in. This is an area we will not overlook in the pursuit of new and interesting ideas.
Though Evenlode is a small fund with a short track record, I feel very positive about its future and hope to continue managing it for many years to come. Wise - an independent, owner-run business - is a great home for such a venture. I continue to invest all of my own long-term savings in the fund (and if that were ever to change, I would let you know).
Please note, this investment view contains the personal opinions of Hugh Yarrow as at 8th April and does not constitute investment advice.