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Evenlode Investment View - October 2010

The Right Kind Of Growth

From the perspective of an individual business, we believe there are three critical aspects to growth:

1) Growth in product demand
2) Constraint in product supply
3) A lack of need for capital investment

Businesses that benefit from a combination of these three factors possess the ‘right kind of growth’. When all three align, shareholder value creation almost invariably follows.

For whatever reason, most of the investment community spends almost all of its time focusing on the first aspect only – demand growth. Perhaps because it is the easiest one to see – the one on which the most compelling narrative can be hung. Buying emerging markets, for instance, because GDP growth in these countries is likely to be strong over the next couple of decades, appeals to common sense. We’re not against this idea in the slightest - the current portfolio has a more global revenue profile than the overall market. However, it’s only likely to work for businesses that tick points 2 and 3 on the above list too. Consumer branded goods companies such as Unilever, Diageo, Coca Cola and Reckitt Benckiser certainly fall into this category; several of our media holdings (United Business Media, ITE Group, Euromoney etc.) are also good examples. Other businesses we see as ‘cashflow compounders’ geared into new markets include Domino Printing, Hays and Halma.

Equally, we don’t have a prejudice against businesses with a predominantly developed market footprint. There are many businesses that should grow per share value very nicely over the decade without big operations in China, South East Asia, Latin America or India. Some of them may only see pedestrian demand growth, but when combined with points 2 and 3 they will do very well for shareholders.

Severfield Rowen - at the smaller, more cyclical end of the Evenlode portfolio- is a good example, we think. To say that Severfield has had a ‘good’ recession is perhaps a bit glib – the downturn in the UK structural steel market (for stadiums, hospitals, power stations, commercial offices etc.)has been severe. However, in a recent statement the company estimated that their market share of the industry has nearly doubled during the downturn. This is impressive given their market share going into the downturn was approaching 20%, In fact, Severfield Rowen’s entire corporate history has been about taking market share. Set up in the late 1970s it had to cope with the fragmented, competitive structural steel market of the 1980s. The market then came out of the 1990s recession as a more consolidated, rational place to do business, and out of the downturn in the 2000s as an oligopoly. It looks like, when the dust has settled, Severfield will emerge as a virtual monopoly player in the UK market for high-end steel projects. There is an old city saying ‘you make your money in a bear market, you just don’t realise it at the time’. Severfield would agree.

Combining this clear industry supply constraint with Severfield’s track record of high returns on capital (this is not just a metal-bashing business – most of Severfield’s ‘value-added’ comes from design work and project delivery), an interesting argument for future value creation begins to build. This is the case even if demand growth (point 1 on the above list) isn't stunning in the next few years.

An Afterthought – Really Easy Money

Hot off the press is Johnson & Johnson’s acquisition of vaccine business Crucell for $2.4bn. This adds to a long list of corporate activity globally at both the larger and smaller end of the market. Over the last quarter we have had several companies in the portfolio announce significant acquisitions (including United Business Media, Unilever, WS Atkins and Morgan Sindall).

We think the trend is being driven by three things. Firstly, companies are dusting themselves off from the recession, becoming more outward looking and wondering how they can grow and improve their competitive position. Secondly, credit is cheap for those that can get it (Johnson & Johnson, for instance, issued a 30 year bond last month at 4.5%). Thirdly, buying competition for assets remains limited so valuations are generally still reasonable. As private equity group HG Capital put it recently ‘finance is more available, but only for sensible companies at conservative levels of gearing’.

For now, we expect corporate activity to continue and provide a useful support to valuations in the public market. We also think that this is a buyer’s market for assets. As a result, a fair few current deals should prove in hindsight to be that rare thing in the world of M & A– value creative.

If low rates continue for much longer, however, the resultant feeding frenzy could well end badly. As Charlie Munger put it in a recent interview ‘easy money corrupts and really easy money corrupts absolutely’. It’s worth remembering that acquisitions that make sense with interest rates lower than 1% might not look so clever in a few years time. This is an area we will watch carefully.

Hugh Yarrow
October 2010

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

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