PRINTER FRIENDLY VERSION

Consumer Brands Revisited

Global stock markets have fallen during June. In a quiet month for fundamental company newsflow, investor eyes have turned to economic developments – not least the uncertainties that Greece’s current predicament presents to the world. Elsewhere, the possibility of rising inflation and of a US interest rate rise towards the end of the year have been at the forefront of investor minds. An uptick would represent the first Federal Reserve rate hike for seven years. The Bond Proxy Narrative Whether interest rates in the developed world do rise by any significant degree in the next year or two remains to be seen. But the prospect of rising rates has led to a rise in bond yields in recent weeks and a narrative has formed in the investment community that stable dividend paying sectors such as utility and consumer branded goods (‘bond proxies’ as they have become known) should be avoided, hence their recent underperformance. Due to our sole focus on capital-light business models, Evenlode does not invest in utility stocks. However, we do have a significant exposure to consumer branded goods companies, which make up a little over 30% of the portfolio. In light of the bond proxy argument, it is worth reiterating that (at a time when outstanding value is generally not as prevalent across the market as it was a few years ago) we think our holdings in this sector remain attractively valued and offer good risk-adjusted total returns for the patient investor. Below are some thoughts to help explain our view. Cash Flow Is Key We like companies that are able to grow at a healthy rate while routinely converting earnings into free cash flow. Put simply, these businesses tend to keep on giving us cash, rather than keep on asking us for cash. There will always be year-by-year fluctuations in working capital and investment requirements, but over time this characteristic of high cash conversion is a key driver of long-term shareholder value creation, and a common thread across Evenlode companies. Repeat purchase consumer goods businesses exemplify these capital-light qualities thanks to their strong brands and consumer loyalty. Below are the five largest holdings we currently have from this sector, and the average percentage of earnings each has been able to convert into free cash flow over the last fifteen years*:

	EPS-to-FCF conversion (15 year average)
Unilever	100%
Diageo	84%
Imperial Tobacco	99%
Procter & Gamble	109%
BAT	99%
Average	98%

This rate of cash conversion makes every pound of earnings extremely attractive, particularly when compared to asset-heavy business models such as resources, utilities, telecoms or heavy manufacturing companies where cash is routinely absorbed by capitalised investment for growth.

Valuations

The five companies mentioned above trade on an average Price-to-Earnings (PE) multiple in the high teens. But thanks to their strong cash conversion, this converts to a free cash flow yield of nearly 5%. This cash flow gives healthy support to an average dividend yield of 3.5%. A look back at dividend growth over the last fifteen years for these holdings is a reminder of the solid cash compounding abilities these business models possess:

	15 Year DPS Growth (p.a.)
Unilever	+8%
Diageo	+7%
Imperial Tobacco	+13%
Procter & Gamble	+10%
BAT	+14%
Average	+10%

They have seen their global markets slow somewhat in the last couple of years and currency has had an impact, but fundamental performance has remained resilient, as has dividend growth. Even for Diageo, which has had the toughest two years operationally of any of the companies on the list, dividends continue to increase at a healthy rate and the outlook for free cash flow is improving as headwinds begin to abate**. In our view, the long-term prospects for steady revenue growth and operational leverage remain compelling for these globally diverse businesses. Inflation Protection Whilst on the topic of rising interest rates and inflation, it is worth revisiting something I have written about several times over the years in these investment views: the idea that capital-light businesses are well equipped to insulate investors from rising inflation and interest rates.  Warren Buffett wrote an excellent piece on this subject in his 1983 Berkshire Hathaway shareholder letter, which distilled the lessons he had learnt through the very difficult investment environment of the 1970s. As he put it, for years the traditional wisdom – long on tradition, short on wisdom – held that inflation protection was best provided by businesses laden with natural resources, plants and machinery, or other tangible assets (“In Goods We Trust”). It doesn’t work that way. Asset-heavy businesses generally earn low rates of return – rates that often barely provide enough capital to fund the inflationary needs of the existing business, with nothing left over for real growth, for distribution to owners, or for acquisition of new businesses. No business can protect perfectly against the challenges that inflation brings. But asset light businesses tend to have pricing power, and are far less exposed to replacement spend on rapidly escalating asset bases than capital-intensive companies as described by Buffett above. They also tend to operate with low levels of debt, which means that the impact of a rise in interest rates, and therefore the cost of debt, is less pronounced. As a result of both of these factors, shareholder cash-flow emerges relatively unscathed. If the world were to enter a period in which interest rates and inflation rose significantly, in my view these stocks would ultimately become highly cherished by investors, just as they were in the inflation of the 1970s. Hugh Yarrow June 2015  Please note, these views represent the personal opinions of Hugh Yarrow as at 24th June 2015 and do not constitute investment advice. *Source: Evenlode Investment, Canaccord for all figures in this view. **After two and a half years of significant share price underperformance relative to the UK market, Diageo shares perked up this month on rumours of a potential takeover from AB Inbev. In many ways I hope a takeover doesn’t materialise. Diageo shares are one of the highest quality pieces of equity available in the UK market, with a portfolio of irreplicable brands (Johnnie Walker, Guinness etc.) that have roots going back hundreds of years. It would be a shame to lose this unique asset from the UK market, and with it the stream of long-term dividends likely to accrue to holders.