Evenlode Investment View - November 2015

Written by Hugh, 26 November 2015

PRINTER FRIENDLY VERSION

Earnings Will Jiggle

The UK market has churned around in November, and is slightly down over the month so far. Corporate earnings reports remain very patchy thanks to a mixed economic picture with the energy, industrial metals and capital goods sectors particularly challenging. Profits warnings and dividend cuts are on the rise in the UK, particularly for stocks with exposure to these end markets. Companies closer to the consumer are in general fairing relatively better, but even for these businesses life is not particularly easy.

We have always said that we look to insulate ourselves from the macroeconomic environment, rather than predict it.  We think our basic checklist of desirable characteristics is helpful in a world faced by macroeconomic and (as the tragic events in Paris this month remind us) geopolitical uncertainties:

-An Economic Moat
-Intangible Assets
-Pricing Power
-High Returns on Capital
-Low Capital Intensity
-Low Leverage

Many key Evenlode holdings also benefit from repeat-purchase, low ticket and/or subscription orientated business models. All these factors tend to help produce high and resilient cash generation, and this gives us confidence that the aggregate portfolio can continue to generate robust dividends (in particular, the fund has zero exposure to the capital-heavy resources sector, where the outlook for dividends looks notably compromised)*.

Earnings Will Jiggle

Even for the most predictable business, however, we are realistic: earnings will not necessarily grow in a straight line each and every year. Headwinds often crop up – at the macroeconomic level, at the industry level and at the individual stock level. In a volatile world the reality is that earnings tend to ‘jiggle’ around somewhat. Investors and analysts seems to be particularly jumpy about these ‘jiggles’ at present.

If anyone wants to follow Teledyne, they should get used to the fact that our quarterly earnings will jiggle. 

I like the above quote from Henry Singleton. Singleton ran the Teledyne corporation between 1960 and 1989. Teledyne was one of the most incredible compounding stories of post-war America (returning more than +20% a year over this period)**. Singleton understood that the progression of this quarter or this year’searnings do not necessarily tell you much about the long-term value of a business – it is the long-term stream of free cash flows that really matters.

There are other limitations to a myopic focus on short-term earnings numbers. One is that earnings growth is easy to achieve if you chuck capital at the problem (particularly at present with debt so cheap). We are interested in how much capital is going into a business to achieve its current level of earnings, not just what that level is.

Another is that companies often present a smoothed picture of reality by using ‘adjusted’ or ‘core’ earnings figures, whereas reported earnings and cash flows will often be significantly more volatile. We look at several years of reported (i.e. not adjusted) profits, cash flows and returns on capital as a starting point for our estimate of future free cash flows. We think this is a much better reflection of the true economics of a business.

It is also the case that earnings numbers can often be met by cutting back on long-term investments. The share price might respond well to this decision in the short-term, but the business is likely to suffer in the long-term.  In his 2012 book Saving Capitalism From Short-Termism, Alfred Rappaport refers to a survey of corporate executives in the US, which found that an amazing 80% of respondents would be willing to decrease discretionary spending on research and development, advertising, and hiring in order to meet earnings benchmarks***. And as the authors of the survey dryly noted, ‘getting managers to admit such value-decreasing actions in a survey perhaps suggests that our evidence represents only the lower bound of such behaviour’! I think this example is a great demonstration of my belief that, while quantitative financial analysis is a very important part of rational long-term investing, it is not the be all and end all. As Einstein would put it, not everything that counts can be counted.

At Evenlode, instead of short-term earnings we consider what long-term free cash flow (and thus dividends) we might expect over the next decade and more given the long-term microeconomics of any particular business.

So when a company is experiencing short-term headwinds we ask ourselves questions such as:

-Is this company’s competitive position improving or deteriorating in this downturn?
-Is it reasonable to expect that this company’s products and services will continued to be valued by society in ten year’s time?
-Does its industry offer good long-term growth potential?
-Is this company continuing to invest in its long-term future?
-Is there a degree of resilient to this company’s cash flows, notwithstanding current tough trading conditions?
-Is this company’s financial position robust enough to cope with this downturn and continue to pay  dividends?

Below are three examples of companies, all holdings in the Evenlode fund, that hopefully help bring these considerations to life. All are experiencing tough markets (and share prices have fallen recently as a result), but in our view are well placed to generate healthy free cash flow and dividends in coming years.

Spectris 

Spectris is a global market leader in the precision instruments and controls sector. These products typically represent a very small part of the customer’s cost base but can have a material impact on a customer’s efficiency and product quality. Sector exposure is broad with end markets ranging from biotechnology to energy. Spectris benefits from a reputation going back decades, intellectual property, research and development expertise and a strong distribution network. Relationships with customers become highly embedded and more than 80% of sales come from repeat customers. Spectris operates in rational, niche markets -  typically facing three or four competitors that don’ t tend to change much over the years. The business consistently turns profits into cash and its balance sheet is strong. Over the last seven years (i.e the current management’s tenure) earnings and dividends have both grown at more than +10% per annum.

Over the last three years, however, market growth has slowed as industrial production around the world has slowed, particularly in China which represents a little more than 10% of sales. This year, organic sales are down -1% so far and earnings will fall as investment continues in the business. In particular, Spectris consistently invests approximately 7% of revenue in research and development and management are currently investing in a new wave of innovative products to help drive future growth.

Analysts have been downgrading earnings forecasts over the last two years and the share price has underperformed as a result. We initiated a position last summer in Spectris and have been adding to this position over recent weeks, at a dividend yield of more than 3% (and more than twice covered by free cash flow). Spectris targets +8% to +10% dividend growth over the cycle and the most recent dividend increase was +8%.

Jardine Lloyd Thomson

JLT has been a long-term investment in the Evenlode fund. It has a strong position in the global insurance broking market, specialising in sectors such as aviation, healthcare, infrastructure and construction. JLT is a capital-light people-business, with strong customer relationships and a reputation for client advocacy. It takes no insurance risk and profits are consistently converted into cash flow. The business is moving increasingly to a fee-based model but approximately 40% of fees are still commisision-based. As a result, JLT has faced a tough backdrop over recent years from a significant decline in insurance rates (driven in part by the drop in global interest rates which has led to a flood of capital into the insurance market). This year’s earnings are also being burdened by JLT’s significant organic investment in its new US insurance business, and the impact of regulatory and policy change in its pensions consultancy business. However, JLT is taking market share in this downturn, taking advantage of lower insurance rates to increase coverage for clients, and driving growth in new sectors such as cyber insurance. Looking ahead, the US business will begin to generate and grow profits, and when the insurance cycle ultimately turns JLT will see a significant benefit to cash flows from its portion of sales that are still commission based.

JLT’s annual dividend growth over the last five years has been +7% and the latest increase was +5%. In my view the potential for healthy dividend growth over coming years is good, and the current dividend yield is 3.5% (and nearly twice covered by free cash flow).

Fidessa

We added Fidessa to the fund last month. Fidessa is a global market leader providing mission-critical software to investment banks, brokers and asset management firms that automate many processes within these businesses. 85% of revenue is recurring and renewal rates are more than 99%. Long-term growth potential is good as customers look to improve efficiency (i.e. automate processes that were previously manual), cope with regulation and compliance, and bring down costs. However, Fidessa’s markets have been difficult over the last two years as its customer base has faced headwinds, slowed spending, and in some cases merged with each other. Meanwhile, Fidessa is making a very significant investment in its new derivatives offering. We estimate that current earnings would be approximately 40% higher if Fidessa stopped this investment and just focused on its existing equity platform, but we’d rather they continue to burden current financial results with this project – the long-term potential for the product is excellent.

Fidessa deliberately operate a very prudent balance sheet with no debt and a strong net cash position. Because the company is capital-light, it needs little of its cash flow each year, so free cash flow is regularly returned as ordinary and special dividends. The current dividend yield is 4.5%***.

The Capacity To Suffer

The veteran global value investor Jean-Marie Eveillard was once asked what characteristic is most important if you want to be a successful investor over the long term. He suggested you need to have the capacity to suffer (i.e. an ability to sometimes endure tough market conditions and hold unfashionable stocks even when it feels uncomfortable).

Along similar lines, we like businesses that have the capacity to suffer. By this I mean the competitive position, financial strength and discipline to continue investing in their long-term futures: even when trading conditions are tough. In my view Spectris, JLT and Fidessa are good examples.

To sum up, our focus with Evenlode is on achieving an appropriate balance between quality, value and dividend yield in the portfolio. Sometimes this involves holding and adding to stocks which are out of favour due to operational headwinds and limited prospects for earnings progression over the coming year or two. But for the patient investor, unfashionable investments in fundamentally attractive businesses are often some of the most rewarding. As Henry Singleton put it, it’s good to buy fine businesses when the price is beaten down over worry. That’s often when they’ll offer a more attractive initial dividend yield too.

Hugh Yarrow
Investment Director
November 2015

Please note, these views represent the personal opinions of Hugh Yarrow as at 23rd November 2015 and do not constitute investment advice.

*Dividend growth has slowed for the stocks we follow, not least due to the currency headwinds that a strong pound is currently presenting for multinational stocks.  However, the average latest dividend increase for stocks held in the Evenlode portfolio – based on their most recent announcement – was +6% (excluding AB Inbev, whose recent +60% increase would skew that number somewhat). We currently estimate the fund’s full year distribution to February 2016 will represent a low single digit year-on-year increase (this is against the tough comparator of a +12% increase last year that included a special dividend from Compass). More generally, our focus on providing dividend growth over the medium and long-term remains central to our approach.

**I wrote about Singleton in more detail in my October 2011 investment view (Lessons From Henry Singleton -  http://www.wiseinvestment.co.uk/2011/10/evenlode-investment-view-october-2011/). If you’re interested in reading more, The Henry Singleton story is very well told in William Thorndike’s 2012 bookThe Outsiders.

***John R Graham, Campbell H. Harvey and Shiva Rajgopal, “The Economic Implications of Corporate Financial Reporting”, Journal of Accounting and Economics, Vol.40, 2005

**** Including special dividend

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