Jeremy Hewlett, portfolio manager for the Mirabaud - UK Equity High Alpha Fund, provides insight into the team’s thinking on value and quality in UK equities.
Navigating valuations
Today, valuation challenges are unique in history, given the pandemic background and that policy rates and risk-free returns are effectively zero. Navigating these changes is key to finding high quality investments.
UK equities in aggregate are relatively attractive for trading on lower multiples of profit (and of enterprise values) than any of the world’s other major equity markets and, stock specifically, many UK listed companies that compete successfully against US counterparts (in the US and globally) have substantially cheaper enterprise valuations.
The pandemic has, overarchingly, shaped winners and losers. Many businesses that serve their customers through the internet (‘the digitals’ and the ‘home services’) have barely skipped a beat in trading, with demand growth in many cases strengthened and accelerated as a consequence of the pandemic. Furthermore, Covid has revealed and then pierced the Achilles heel of numerous companies conventionally thought to be of secular growth and hence of remarkably high quality, exposing them instead as highly vulnerable and extremely risky.
However, where we see practices and behaviours changing, we see share prices that appear high, but which can go a lot higher through incremental margin growth: Demand growth is ostensibly of the virtual and on-line economy, itself typically characterised by high operational leverage, which enables strong profits growth. This lowers seemingly high valuations relatively quickly in a world that prizes cash-flows from corporate profits exceptionally highly. Such companies are resilient in managing changing economic and market conditions.
Our high conviction approach
Stocks must not only fit what we look for in selection, they must also fit into the Fund’s structure. We think of the Fund’s strategy as of two parts, ‘product’ – i.e. its structure and composition - and ‘process’ – represented by the underlying stock selection. As a product, the Fund is benchmark agnostic or unconstrained; to enforce high conviction disciplines the Fund’s top 10 positions always exceed 50% of the Fund’s value with 2.0% holdings considered the minimum weighting, which means that the Fund has relatively few holdings in total (currently 25*).
Given the composition, we are cognisant of the need for diversification, i.e. that stocks are not positively correlated to each other. Finally, in stock selection (process) we do not think in terms of a ‘growth’ vs ‘value’ style bias. This is because in our view, all investment is about value, either value now or value later.
Our definition of value
When it comes to stock selection we adhere to our own determination of value, which is the gap between a business’s quality and price and proportionate to it.
As price is exogenous to the quality of a business but endogenous and hence reflexive to the quality of an investment it follows that a high quality company and a good investment are not necessarily one and the same thing (by definition, investors who pay the highest price receive the least for their money). It also follows that whilst all cash spends the same, it is not all created equally and so for the same value gap we would always prefer the higher quality company to the lower quality one.
Our definition of quality
We look for three core characteristics when defining investment quality:
Scalability is about the degree to which the strain of growth does or does not constrain the growth itself. Companies that scale the easiest are typically asset lite, highly digital enabled, borderless, and the best are those that can ‘build once monetise many times” (either through multiple channels or via multiple client ‘touch’ points and frequency of revenue points); they are typically close to their end customers in distribution (they truncate value chains through disintermediation) and they address exponentially large markets; customers are likely tied in, revenues typically repeat and unsurprisingly, margins are high, capital needs are low and strategy settled and consistent.
Optionality represents a state of potential for which investors are not being asked to pay, i.e. an adjunct activity that has not been widely recognised or is simply being overlooked for unjustifiable reasons. What we love about optionality is that it is a free lunch, which is not supposed to exist in financial theory – yet in the stock-market free-lunches abound. Optionality (when recognised) not only drives growth, but in doing so it lowers investor risk and hence it drives a shift in risk premia, meaning it drives re-ratings wherein investors make most of their investment returns.
Low risk. Risk is mitigated by not paying too high a price and by concentrating on conservatively financed business with secular growth (or businesses underpinned by tangible assets) and with discernible competitive advantages. We eschew financial leverage, purposefully avoiding companies that have financial leverage and operational leverage combined (as these are businesses most in risk of needing new equity capital in difficult times, which heightens scope for investors to suffer a permanent loss of capital).
We take sustainability seriously
Another important element of quality is the degree to which companies practice sustainability. In our bottom-up research we use our proprietary framework to identify whether companies treat their stakeholders fairly – not to do so potentially creates social or governance risks, both of which can weaken investment quality. Stakeholders range from a company’s suppliers through to employees.
We also screen for environmental impacts, specifically for climate change, cognisant of operational locations and infrastructure exposure to physical risks (i.e. flooding or drought). This helps us, in our discussions with management teams, to understand how focused they are on mitigating and limiting their business’s exposure to climate risk.
A good example of considered climate risk is Fever-Tree, a top 10 position in the Fund*. At least 40% of the company’s revenues come from tonic sales**. The key ingredient in their tonic water is quinine, which is sourced from the Democratic Republic of Congo. Climate change (increasing number of hot days) is likely to place pressure on crop yields and production. Recognising this, we have engaged with management to understand the level of their awareness to such risk and their planned response (adoption of hydrological best practices, securing alternative supply) to ensure the franchise’s investment quality is sustainable over the long-term.
Finally, it is worth emphasising that ESG credentials are embedded in our stock selection process as a facet of sustainable investment quality, not for ESG credentials per se. Indeed, whilst the Fund scores highly on ESG criteria, we will invest in companies with poor ESG reporting practices, provided we know that ESG risks are well-managed in practice.
*As at 30 September 2020.
**Fever-Tree & Mirabaud Asset Management June 2020.
