The Metrics That Matter
Mark Wharrier takes an in-depth look at the role that return on capital plays in our investment approach.
Reading time: 9 minutes.
Markets rebounded in September and there was a notable rotation in sector performance in equity markets, in what was a partial reversal of many of the extreme trends in both bond and equity markets in recent months. This was despite continued measures from Central Banks to loosen monetary conditions in response to weakening lead indicators of economic activity. Both the European Central Bank (ECB) and the US Federal Reserve Bank cut interest rates, which the ECB supplemented with a further programme of quantitative easing. Within the UK, the Brexit saga continued with an overturned prorogation of Parliament and increased probability of a further extension of Article 50. A general election seems likely in the coming months, with both major parties committed to increased levels of fiscal spending to appeal to the median income voter. Against this backdrop the Fund generated a return of 5.4% versus the FTSE All-Share Index of 3.0% (X Income Share Class, net of fees, GBP).
The strong relative performance was driven by several of the larger (and attractively valued) holdings in the portfolio such as Legal & General, Lloyds Banking, Wm Morrison and Tesco and the absence of positions in large index constituents such as Diageo, Unilever and Imperial Brands where performance was weaker. This sudden change in market leadership during the month was prompted by no obvious catalyst, but perhaps an indication that the ability of Central Banks to reduce interest rates further from this level is limited. We do not construct the portfolio in the expectation of significantly higher interest rates from here, we are after all in a low growth and low return environment, but we do expect the shape of returns to broaden across the market. This doesn’t mean simply buying lowly valued companies in anticipation of mean reversion but focusing on businesses which can deliver an attractive return on capital and with ongoing self-help and improvement potential which has yet to be reflected in valuations. We discuss this in more detail later in the newsletter.
Pearson was the one major negative during September after the company issued a profit warning at the end of the month reducing forecast earnings by 8% in relation to faster than anticipated print declines in the US Higher Education Courseware business. Pearson, and the wider industry, have been managing this decline for several years as the industry shifts toward digital products, and have introduced targeted measures to accelerate this transition through their own rental and digital access programmes. After 10 quarters of meeting or upgrading guidance, the double-digit share price fall reflects market disappointment and reduced confidence in the visibility of this transition. Pearson has done a good job over two and a half years of rebuilding the market’s confidence in its earnings outlook: this turn in sentiment is frustrating. The downgrades refer entirely to the group’s relatively small printed courseware business in the US, to which we attach a low valuation, rather than its broader operations elsewhere which grew 3% in the first nine months, meaning that Pearson was able to maintain guidance for top-line revenue stabilisation. We are closely monitoring peer reporting and the broader elements of the investment thesis to confirm that our view on the shares remains intact.
This month we wanted to share some thoughts on return on capital and the role it plays in our approach. Returns can be seen as a rather dry topic but is an important driver of both sustainable dividend growth and superior capital growth. Over time, share prices are ultimately driven by three factors; the cash flow a company can generate, the return it can achieve on capital and the change in the basis of valuation investors are prepared to pay. While valuation and cash flow generation are transparent and a view can be formed quickly, returns can be more subtle. Nevertheless, the return on capital and its sustainability is arguably the single most important driver of the terminal value of a company and ultimately the share price. High return on capital or “quality” has been a highly successful investment style in markets in recent years, perhaps no surprise when the anchor of very low bond yields (the cost of capital) has meant the opportunity cost of paying ever higher valuation multiples has been low.
While an income fund naturally veers towards value given the importance of high dividend yield shares, we have been keen to ensure a healthy balance between valuation, returns and growth; over time market returns tend to be a function of all three factors. The current challenge is that high return companies have enjoyed a significant rerating in recent years to a level where popular choices now trade at valuation levels where the prospect of an attractive investment return is low.
In a nutshell, our approach is to identify companies across a broad range of sectors which have similarly high return characteristics we feel can be sustained or those companies which are more capital intensive but there is unrecognised potential to improve returns. If both these dynamics are not reflected in current share prices there is the prospect of a superior capital return and an attractive running yield while we wait.
Figure 1: Non-Financial UK Income Fund holdings operating return on capital
Source: Bloomberg, based on last reported figures
There are many ways to view returns and this analysis just looks through one lens. The table above shows the non-financial holdings in our fund with two simple metrics. Firstly, the fixed assets on the balance sheet (property and equipment) and the operating income, which together give a simple return on fixed assets. This metric is by no means perfect; it is a pure measure which does not take account of leases, other financial commitments or goodwill, but it is a useful headline indication of the quality of a business and consequently its scope for cash generation and dividend paying capacity. While a high return on physical capital may be informative, it is more important to understand the intangible assets which are driving that return. These may be a range of factors which vary by company; sticky customer relationships, the network effect of scale, technologies or hard to copy business processes or brands and trademarks which are difficult to recreate. If these intangible qualities can be sustained and ideally serve a growing market, the scope to generate attractive equity returns is high.
Among the highest returning companies, there is typically a high degree of intellectual property in the case of the media and pharmaceutical companies. In other cases, such as the consumer facing businesses, it is a strong market position in a compelling consumer proposition which drives the returns. We also hold several positions in more cyclical industries (for example Meggitt, Travis Perkins, Hays and Electrocomponents) which are advantaged companies capable of generating a high, albeit more volatile, returns which can translate into a strong investment return over time given the starting point of valuation.
Further down the list there are more capital-intensive companies. These have a role in the portfolio for diversification given their asset backing, but more importantly they have significant levels of self-help potential which can drive returns to a higher level than implied by current share prices. Objective analysis here is key given there is finite recovery potential to most capital-intensive sectors, so gauging both the individual company strategy and the industry in which they operate is part of the investment jigsaw. We have excluded financial companies from the analysis as they are more levered businesses given that both gross and net balance sheets drive shareholder returns. Nevertheless, a similar approach is pertinent; ultimately, companies need to demonstrate the ability to generate a premium return, which is typically driven by an advantaged market position or self-help. We particularly focus on those capital intensive or financial businesses which are using scale to invest in technology to enhance competitiveness. Holdings in low return companies which stay low can never be long-term positions; the stockmarket rerating of a lowly valued company can only happen once. To be an attractive investment, the company needs to be capable of generating higher growth or higher returns.
Over the past year, many of the changes we have made to the Fund have been driven with the objective to maintain the value credentials of the portfolio and at the same time enhance the quality of the Fund with higher return companies. This has been reflected in the sales of Resource companies, Utilities, Telecom and Real Estate companies in favour of a wide variety of less capital-intensive businesses which have the prospect of generating higher levels of free cash flow generation, which in turn drives longer term dividend growth. While weak sterling and a sharp fall in bond yields have been headwinds to the relative performance of the Fund, we feel a portfolio of improving, higher return companies with a free cash flow yield of approximately 7% and a dividend yield of approximately 5% is an attractive proposition for the medium term.
We started a new position in PZ Cussons during the month, which is a personal care business with market leading businesses in UK, Nigeria and Indonesia. The group has struggled in recent years, partly due to macro headwinds but also due to poor capital allocation and weak execution. A recent meeting with the Chairman was reassuring in that change is underway with a new strategy to exit peripheral businesses, recruit external talent and focus on product innovation and operational efficiency in personal care. The working capital opportunity in the business versus industry peers is striking. The business has significant earnings potential and assets which have strategic value longer term. The shares yield 4%.
This purchase was funded by selling the remaining holding in ITV. While the business is undoubtedly lowly rated, we remain unnerved by the long-term prospects for core linear television advertising revenue given the proliferation of media choices, particularly for younger audiences. This seems unlikely to change. In this context, the balance sheet is stretched and the scope for cost cutting in response to a weaker domestic economy is limited. We also reduced the holding in Aviva, which has historically been a significant position in the Fund. While the shares are cheap, it remains to be seen if the management team have the appetite to shrink the disparate collection of businesses in order to realise this value.