Evenlode Investment View - January 2010

Onwards To The Next Decade

A new decade dawns and while the past ten years have been a struggle for markets overall, a glance down individual stock returns in the UK market is a reminder that it’s not all been bad. The winners can be roughly divided into two categories:

1) Things that come out of the ground:

As the decade began there wasn’t much interest in resources stocks, selling at cyclically adjusted lows at the peak of the technology boom. But as China, India, Brazil et al grew, commodity prices have soared and commodity stocks found their sweet spot. Tullow Oil, Cairn Energy and Antofagasta, for instance, have all delivered returns of more than 30% per annum over the last decade. Even the mining majors BHP Billiton and Rio Tinto have delivered 22% and 14% per annum.

2) Serial compounders:

The serial compounders are our kind of stocks. They’ve not made the headlines much and are not talked about a great deal, but have done a good job of grinding out shareholder value without an overreliance on economic conditions. Other than resources stocks BATs, Imperial Tobacco and Reckitt Benckiser stand out in the FTSE 100 over the ten years, all with compound returns of more than 20% per annum. Unilever, Diageo and Cadbury do not come far behind with double digit returns (although Cadbury needed a bid from Kraft late in the day to get it there).

So even in this ‘lost decade’ for equities, where overall returns were just over 1% per annum for the FTSE 100, there have been pockets of success. This fact nicely illustrates the main reason we only hold about thirty stocks in the portfolio. It means that a few good, undervalued investments can produce attractive returns, regardless of whether the overall market looks attractive at any point in time.

On that note, we take this opportunity to layout some important investment themes in the Evenlode Income portfolio for 2010.

Healthcare

If the 1990s and 2000s might be dubbed, crudely, the investment decades for technology and commodities respectively, we would not be surprised if the 2010s became the decade of healthcare. The world’s medical requirements are growing rapidly as people live longer, and the biggest companies in the industry will play a major part in delivering these needs. Combining this fact with opportunities in the developing world, we suspect the sector will ultimately win back the growth status it once enjoyed. Little of this potential is reflected in current valuations as uncertainty over patent cliffs and US healthcare reform dominate current opinion and debate. Johnson and Johnson, a new holding for us, sold at 40x earnings just a decade ago having spent most of the previous twenty years on an earnings multiple of 20x. Today it sells for 12x earnings. This appears too cheap to us for one of the strongest global healthcare franchises in the world with limited cyclicality and a rock-solid balance-sheet.

Consumer Staples

As mentioned above we are naturally attracted to this sector as a home for businesses with track records of compounding shareholder value. In the UK market the sector is often lumped together with low growth, capital intensive industries such as utilities and telecoms ( ‘defensives’) – only to own if you believe the market is heading lower. We believe this treatment is harsh for two reasons. First, it is not capital intensive – growth can come with relatively light capital commitment, so shareholders end up with a good deal of cash-flow. Second, it is not particularly low growth. Businesses such as Diageo, Unilever and Coca-Cola have more than a third of their business in emerging markets, positions that have taken a long time to establish but are now being translated into positive volume growth and pricing power.

As a footnote, of which we are sure we’ll talk more in coming months, we prefer our emerging market exposure in this form - consumer branded businesses benefiting from domestic consumption growth – than the market’s current preferred play, industrial metals. In particular, we are becoming increasingly worried that China’s current capital investment led growth will come to an abrupt end. If it were in the price of these stocks we would not be so concerned, but we believe the market is discounting a far more benign outcome than may ultimately transpire.

Media

The media sector has been a poor performer in 2009. This is true to form - as a late cycle sector it has struggled to keep up with returns in an early cycle market rally, where ‘canary in the coalmine’ stocks such as financials and house builders have led the way. As a result, some strong media franchises are currently selling cheap. We are particularly attracted to business-to-business companies where structural challenges are much less significant than in consumer media. Our media holdings include United Business Media, Reed Elsevier, Vivendi and ITE Group. If the current economic recovery continues, these businesses will begin to see a pick-up in trading where currently they have only seen stabilisation. If recovery falters, current valuations and cash-flow resilience provide a margin for error.

Support Services

It’s not a secret that the next few years will be very hard for public sector finances in most major economies - not least the UK – and that this will have a knock-on effect on those businesses that rely on government expenditure. But some of these businesses will actually benefit from the government’s predicament, specifically those that have a proven track record of saving the government money. One of our largest holdings, MITIE, has been tarnished with the public sector exposure brush, resulting in weakness that we have used to build our position. MITIE stated in recent results that ‘budgetary pressures in the public sector will create substantial facilities management outsourcing opportunities, although the timing of these is currently difficult to predict.’ These emerging opportunities combined with depressed valuations are providing an interesting entry point into businesses like MITIE.

Takeovers

Corporate takeover activity could be a growing theme in 2010. As we said last month, the current environment is one in which we believe ‘the strong get stronger’. With economic growth likely to be sub-par, a growing divide will emerge between those with access to capital that can look to acquisitions for growth and those that cannot. If we are right and takeovers do pick up, there are two considerations for us. The first is a negative – the vast majority of acquisitions add no value for shareholders, so an eye should be kept on any portfolio businesses looking to be acquisitive. The second is a positive - many of our holdings as small and medium sized businesses with high free cash-flows are potential takeover targets.

Hugh Yarrow
January 2010

Please note, this investment view contains the personal opinions of Hugh Yarrow as at 1st January 2010 and does not constitute investment advice.

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