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Evenlode Investment View - October 2009

The Triumph Of Hope Over Reality

The UK stock market has come a long way since the first quarter of this year, when a whole segment of companies were being priced on the basis that their continued existence was in serious doubt. The survivors from this list have subsequently seen very healthy gains as the market reappraised their risk of extinction. The list of best performers since March confirms this trend, it is a list of those stocks that were most in peril back then. On the face of it, this pattern makes sense - if investors’ perception of a company’s chance of survival moves from 40% to 80%, for example, its stock has a good chance of doubling in price.

However, we think the valuations of more economically fragile businesses are now reflecting a market mood in which hope is triumphing over reality - perhaps mainly because the initial rational re-pricing of risk has been gradually superseded by a fear on missing out on the excitement. In contrast, we are seeing a very good opportunity in that segment of stocks that, if you were being unkind, you might refer to as boring. No problem for us here - the right kind of boring stocks have a habit of making a lot of money for investors as the years roll by, and all things being equal this is the section of the river we’d far prefer to cast our line into. Veteran value-investor Jeremy Grantham recently argued that US high-quality stocks as a group are at their cheapest relative valuations for years. He describes this anomaly as ‘substantially the most outlying bet available today in all global equities’. We look at our own measures of quality for the UK market and are seeing a similar pattern - high-quality stocks in the UK are now at their cheapest valuation relative to low-quality stocks this decade.

What this means in practice is that we have a list of investment candidates that can be used to build a portfolio that is both high quality and cheap. To put numbers on it, this list of 28 stocks is trading on a free cash-flow yield of more than 8%, and a dividend yield of 4.3%. This is versus the market’s free cash-flow yield of slightly more than 4%, and a dividend yield of 3.4%*. So a tick in the valuation box, but a tick in the quality box too; these cash-flows are being produced by capital-light businesses (with an average return on assets of slightly more than 20%, compared with the market average of 7%), and they are also generating these cash-flows using substantially less debt than the market average (net debt to EBITDA for the list is 0.4x versus the market average at 1.8x).

It is not a collection of businesses that can be accused of being fly-by-night operations either. Diageo’s brands, for instance, include Guinness (enjoying its 250th birthday), Johnnie Walker (first appearing in a Scottish grocery store in the 1820s), and Smirnoff (which Muscovites started drinking in the 1860s). De La Rue, owners of the Bank of England mint, printed their first banknote for Mauritius in 1860 and Kone, a Finnish company (and still a family business today), began installing and maintaining elevators in 1918.

We see good potential for cash-flow growth from the list too. Not in a dead-straight line - in city nomenclature stocks are often categorised as 'cyclical' or 'defensive', but in reality every business lies somewhere along the spectrum of cyclicality. We are happy with deviations, as long as they are deviations above and below a nicely improving trend. Take Diageo again, and stocks such as Unilever and Coca Cola. These are true global franchises that we believe have a long runway ahead of them. These businesses have enormous growth potential in their newer markets - not breathless, capital-draining growth but steadily establishing businesses that should develop over time into powerful engines of value creation.

In summary, this is not a get-rich-quick list of companies that we are looking at. However, businesses with sound fundamental economics have a good record of churning out healthy compound growth for shareholders down the years, often when nobody is looking. That is the reality, and we would rather invest based on this reality than on hope alone.

Hugh Yarrow
1st October 2009

Please note, this investment view contains the personal opinions of Hugh Yarrow as at 1st October 2009 and does not constitute investment advice.

*Source: Collins Stewart, market free cash-flow, return on assets and net debt/EBITDA ex financials.

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