What You See Is What You Get
The macro-economic risks that lurk in the shadows of financial markets at present are serious ones, and we are treating them with due respect. In particular the head-to-head battle between deflation and inflation remains unresolved. In the red (deflationary) corner is private and public sector de-leveraging, in the blue (inflationary) corner stands incredibly loose monetary policy. In many ways the best outcome for markets and for the economy would be a continuation of this deadlock - it’s easy to create a gloomy prognosis for financial markets if either force decisively wins. Reading Amity Shlaes ‘The Forgotten Man’ or Benjamin Roth’s ‘The Great Depression: A Diary’ (which I highly recommend) chimes enough with circumstances in today’s global economy to send a chill down the spine of any but the most dyed-in-the-wool stock-market bull. Conversely, Adam Ferguson’s ‘When Money Dies’ is a humbling primer on the different sort of problems that monetary debasement can reap on a society.
The push-pull of these conflicting forces has meant a somewhat schizophrenic market over the summer – some days the ‘inflation trade’ has been the only game in town with beneficiaries such as commodity and banking stocks leading the charge. On other days investors have been unable to dump these very same stocks quick enough.
We are happy to sit on the fence of the inflation/deflation debate. The idea behind our investment process is a simple one – buy growing, cash generative businesses that need little capital to produce that growth, and you will be richly rewarded over time. As we have discussed before, these businesses tend to cope well in both inflationary and deflationary environments. We see the great unsung story of the summer as the ability of many companies to keep grinding out growing free cash flow streams while continuing to invest in future growth and pay down debt (the average share in the portfolio, in fact, now has no net debt).
Focusing on this free cash flow for a minute, the portfolio currently produces a 9% free cash flow ‘coupon’. This is after all expenses needed to sustain and grow each business organically – including interest, tax and capital expenditure. Not a bad ‘bank account’ if you are happy to accept a little price volatility along the way – particularly given that we would expect this 9% coupon to grow nicely over the next few years, thus providing some good protection from inflation (if and when it begins to rear its head).
From a dividend perspective, respectable returns also look very achievable. Let’s bravely imagine, for instance, that our largest holding Glaxosmithkline could continue its current dividend growth rate for the next five years, and finishes the period on the same dividend yield as it trades on today (5.3%). This would aggregate to a total return of more than 13% per annum –without any re-rating of the share. A similar back-of-the envelope analysis for the portfolio as a whole produces comfortably double-digit returns on constant valuations. What you see is what you get - and in this instance what you see and what you get is very attractive cash returns. They are worth hanging around for even if the broad stock-market does not enjoy an upward valuation over the next few years (perfectly possible of course).
One of Peter Lynch’s list of Silly Things People Say About Stock Prices was ‘It’s taking too long for anything to happen’. As he put it:
‘If you give up on a stock because you’re tired of waiting for something wonderful to happen, then something wonderful will begin to happen the day after you get rid of it.’
The hardest thing in the current market is the endless list of reasons to decide to get rid of a stock – or stocks in general. The nice thing, however, is that owning high-quality equities is providing a reliable and consistent cash return even in the periods when – like this summer - it takes a long time for anything to happen.
Whilst we are not keen advocates of basing valuation arguments for equities on their relative valuation to bonds, it’s also worth remembering that the fixed income equivalent of these high-quality stocks – taxable, investment grade corporate bonds - yield only 5.3% in the UK. This means you are being paid a very healthy return relative to history for owning the equity of investment-grade businesses. It also suggests a strong possibility that these shares could enjoy a meaningful rerating over any sensible holding period. As Peter Lynch would say, something wonderful might just start to happen.
Hugh Yarrow
1st September 2010
Please note, this investment view contains the personal opinions of Hugh Yarrow as at 1st September 2010 and does not constitute investment advice.
