Investing through times of change

The investment philosophy and process that has served our funds so well since launch remains consistent. We continue to seek businesses that are compounding their earnings and cashflows, and where we believe balance sheet strength is supportive of growth.

Change is guaranteed, and we strive to allocate capital to those companies we believe are best equipped to deal with both the threats and opportunities that come their way. Firms with talented management, adequate capital and an operating environment which enjoy economic and structural tailwinds, should serve stakeholders well over the long term. When we are meeting company management teams and applying our fundamental analysis, it is qualities such as these that excite.

The stock market is a discounting mechanism, and at the time of writing, investor concerns about the direction of the global economy are creating a volatile environment for equity investors. Over the recent past, significant focus has been given to the cause and effect of a flattening US yield curve. In addition, investors have needed to digest monetary policy direction from Jerome Powell, the Chair of the Federal Reserve. During 2018, with the US economy fuelled by corporation tax cuts, full employment, high consumer confidence and operating margins at a cyclical peak, The Federal Reserve made it clear that US rates at 2% had further to rise.

‘Interest rates are still accommodative, but we are gradually moving to a place where they will be neutral…We may go past neutral, but we are a long way from neutral at this point, probably’ (Jerome Powell 3 Oct 2018)1

Softening global economic data, in particular towards the end of 2018, has resulted in a dovish about turn. US policy rates are now expected to remain on hold until the end of 2019.

Much time can be spent on trying to second guess short term monetary policy adjustments and although this can effect global capital flows, it is essentially a distraction for long term investors. For example, the unprecedented impact of technological change is overwhelmingly more relevant when trying to ascertain whether or not a business can compound its earnings on a sustainable basis.

The great financial experiment of quantitative easing has been a significant contributor to global financial liquidity and many argue this has resulted in elevated asset prices and the misallocation of capital. In the US in particular, the direction of travel is now for liquidity to be reduced via quantitative tightening and actions by the Federal Reserve are consistent with this. Investors are responding and attempting to anticipate the effect on both asset prices and the global economy. Rapidly rising interest rates are a headwind for long-duration assets such as equities and bear markets are nearly always caused by central banks draining liquidity beyond what an economy can take, in an attempt to control inflation.


Brexit: No closer to a conclusion…

In the UK, Brexit discussions continue to meander with no obvious certainty in sight. Once the negotiations are complete and a revised trading relationship with Europe is finalised, business will adjust to the new rules of the game and should once more flourish. Until then, sentiment will remain fragile, investment decisions will be affected, and investors will likely continue to shun the UK equity market.

Thankfully politicians do not run businesses (and long may this remain the case!) and management teams are acutely aware that they cannot wait until March 2019 before reacting to Brexit. The working assumption by several management teams is that the UK leaves the European Union without a trade deal. For example, Joules the lifestyle retailer, has brought forward investment in a warehouse in Rotterdam so that sales of goods to mainland Europe never touch the UK. Also, Dechra Pharmaceuticals, the veterinary products business, has made the assumption that the testing and qualification of its products will need to be carried out in both the UK and Europe and has assumed the duplicate costs associated into the future.

We are entering uncharted territory and even the best laid plans are unlikely to be enough to counter potential supply chain disruption, heightened bureaucracy and a potential pick-up in inflation. As companies work to ensure a smooth transition, we anticipate a pick-up in working capital investment over the next six months, as businesses aim to ensure they have the raw materials and inputs, to weather any potential challenges.

We believe that despite the rhetoric, a no-deal Brexit is not in the interests of either side. There will be inevitable noise and volatility over the next few months, and as such it will be vital to keep a cool head and focus on the long-term from an investment perspective.

Quantitative tightening, Brexit, the risk of a socialist Corbyn administration and Donald Trump’s global trade policies are all creating stock market angst. These factors, combined with the unprecedented effect of algorithmic trading platforms, may mean that increased stock market volatility will be more common, at least for the foreseeable future.

Volatile stock markets are unsettling and when macroeconomic hedge funds and algorithmic trading platforms dominate the capital flows, individual stock movements can be indiscriminate and when this occurs, opportunity may not be far away.

Politicians come and go, the cost of capital rises and falls while economies ebb and flow, however there are powerful, established secular trends that are far more persistent and impactful on investment outcomes. It is these, together with company fundamentals, that we focus upon.


Technology - disrupter and enhancer

The speed at which technology is evolving and the dramatic impact that is having on businesses and entire industries is far more powerful and relevant to an investment thesis than many of the ‘issues du jour’ set out above. It did not matter if your printed encyclopaedia was the most complete, beautifully bound and best value on the market, Google destroyed its worth.

Technology both disrupts and greatly enhances our lives and when assessing an investment opportunity, these effects form part of our due diligence. When thinking about investing in technology, investors typically focus on those companies that generate, protect and commercialise intellectual property as principal creators, for example ARM holdings, the semiconductor and software design company. Typically, however, the benefits of technological innovation are more widespread and can benefit both the creators and users. We are often impressed by the way companies embrace technology in order to gain competitive advantage.

Many of our holdings are embracing technology to enhance both revenues and productivity. For example, retail group Dunelm, is using driverless forklift trucks in its new warehouse in Stoke to increase efficiencies and reduce error rates.

Electrocomponents have introduced software robots to increase the speed of transactional processes (incidentally the company has named its robot ‘Ruby’). We believe this should improve customer service and reduce cost to serve. Rentokil is using radar connected mouse traps to allow immediate response should a mouse be detected. The information collected is delivered in real time to the customer and the Rentokil team via the ‘MyRentokil’ portal. This negates the need to regularly check traps and means that when a mouse is humanely killed, it can be removed. Via technology, we believe Rentokil is improving both customer service and the efficiency of its operating cost base.
Elsewhere, payment processing group, Worldpay is using its technology to facilitate cashless payments globally for its omni-commerce client base.

In addition, Aveva is, we believe, at the forefront of the industrial software market. It is aiming to increase the efficiency of its customers by supplying the visualisation tools, analytical engines as well as predictive and inferencing tools, to enable it to design industrial plants more effectively and run its businesses more predictably, efficiently and profitably.

‘Digital technology, despite its seeming ubiquity, has only just begun to penetrate industries. As it continues its advance, the implications for revenues, profits and opportunities will be dramatic (McKinsey 2017).


Evolving opportunities

Secular growth thematic drivers should endure, and the UK equity market space should continue to offer a dynamic cohort of businesses able to adapt and develop, so they can take advantage. Populations will continue to age, the generational shift in consumer habits from millennials to Generation Z will progress, regulation should continue to intensify, data growth and analytical processing power will likely develop further. These elements and more, should provide us with an even better understanding of human behaviour and corporate dynamics. In addition, the mesmeric rise in automation and artificial intelligence will continue to excite and frighten in equal measure.

Over the short term, our investment style can be buffeted by world events, interest rate movements, economic data and capital flows. However, we continue to believe that investing in UK-listed companies that are compounding their earnings and dividends, where corporate governance is world leading, where contract law and title law are dependable and where company management teams are permanently accessible, should be a rewarding strategy.


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