The Opportunity Set Continues To Narrow
As previously discussed in this monthly, we have increasingly moved away from smaller companies and more economically sensitive businesses, and towards high quality blue chips where we see the best opportunity set at present. However, we would like to take this opportunity to remind investors that the fund has not and will not always look like this.
When we started the fund as a ‘paper’ portfolio in the spring of 2009 it had a large weighting to smaller companies (and, incidently, had no healthcare exposure). Then, when we launched the fund in October 2009, our weighting to larger companies was still significantly smaller than it is today. It has increased steadily since then (from 40% to 65% of the fund). Our basic investment strategy - ‘head for the cash-flow!’- rather than an attempt at macro-economic forecasting, has been the driving force behind this shifting allocation of capital.
We still regard the small (and micro) stock universe as a rich source of potential ideas. Often under-researched and off the radar of larger institutions we are very willing to look for ideas in this area– as long as we see a minimal chance of permanent capital loss and a high chance of healthy cash-flow returns. When we find smaller companies able to grow and compound cash-flow in a fairly steady pattern, we get interested. We are still finding and investing new monies in the odd one that meet our quality and value critieria (as one would expect given the broad sweep of this territory). But we look forward to the smaller company ‘sweet shop’ re-opening in a more general manner – at some unpredictable point in the future.
We are also happy to invest in economically sensitive, ‘cyclical’ businesses, as long as they are well financed and can compound cash-flows at a decent rate from peak-to-peak of their earnings cycle. As we have said before, the term ‘cyclical’ is only a matter of degree when talking about business – all companies display some amount of earnings volatility. But to generalise, we currently see the best opportunity set in the area of the market that displays the lowest earnings volatility. In particular, the ‘emerging market premium’ currently applied to many industrial and commodity related businesses is higher than we are comfortable with. These are deeply cyclical industries which, other than a brief respite in 2008/9, have effectively been in the up-leg of their cycle since the turn of the millennium.
Our current exposure to larger companies is not just the mirror image of a lack of opportunities in the alternatives mentioned above. We are positive on the prospect for good absolute returns from them and disagree with the view that you can’t make money in larger companies because they are over researched and too big to grow. Other than for rare periods (such as the the early 1970s when the ‘Nifty-Fifty’ group of stocks became fashionable) stock markets make a habit of persistently undervaluing durable franchises. Apparently, this was just as much the case in 1938 as we think it is today:
“Several times every year, a weighty and serious investor looks long and with profound respect at Coca-Cola's record, but comes regretfully to the conclusion that he is looking too late.”
Fortune Magazine, 1938
When asked to name the greatest invention in human history, Albert Einstein simply said ‘compound interest’. The great franchise businesses of the world, like Coca Cola, are a great demonstration of this point - but think of the hundreds of good reasons you might have sold this stock over the last 72 years.
There is not much of a warm glow left for investors from the days when ‘decent’ money was made in stocks such as Coca Cola and Microsoft in the US, or GlaxoSmithKline and Sage in the UK - they are suffering from the ‘what have you done for me lately’ syndrome. You have to go back as far as 1999 to truly relive that warm glow. At the same point in time, Rio Tinto was viewed as a cyclical commodity stock rather than a ‘secular’ growth story, and Gordon Brown sold the government’s gold stocks off at $275 a troy ounce. As all this demonstrates, times do change - and they’ll change again.
Currently, we are very happy to sit with a high allocation of capital to this group of global businesses. We view them as the stock market equivalents of AAA inflation protected bonds and are receiving very adequate compensation for owning them. We are also, however, ready to reallocate when opportunities present themselves elsewhere - as they inevitably will do again.
Hugh Yarrow
February 2011
Please note, this investment view contains the personal opinions of Hugh Yarrow as at 8th February 2011 and does not constitute investment advice.
