Low Prices, Attractive Value

Outlook

We were reminded of the plethora of high-quality, well-developed business models on offer to investors on the other side of the Atlantic at a recent US industrials conference, during which we met with ten small and mid-cap companies. We prefer to assess a business’s fundamental attractions before making a judgement about its “cheapness” and it is the second stage of this process which has proved more of a challenge to our doing further deep-dive work on most of these ideas today, rather than the former.

This remains the challenge for global equity investors. We wholeheartedly agree there is greater choice of ‘quality compounder’ investments in the US. Finding those where risk-reward is heavily skewed to the upside is harder, however, with most we’ve looked at trading on 3-4% free cash flow (FCF) yields. It is not an impossible task, though! The portfolio has over 50% weighting to the US and 8 of our top 10 holdings are US-listed. We certainly continue to find it easier to uncover investments that fit our quality and value criteria at the smaller end of the market cap scale.

Relative to the return on capital and FCF per share growth that we expect our portfolio holdings to deliver over the next 3 to 5 years, the 7-8% FCF yield at a headline portfolio level is an excellent starting point.

The portfolio should offer attractive diversification benefits alongside the alpha opportunity we are pursuing. It contains a breadth of end markets, earnings drivers, and stock specific catalysts which help offer investors a well-balanced, attractively valued fund compared to highly concentrated, momentum-driven benchmark indices.

Strategy Update

Activity

We bought one new holding in November.

Cosmos Pharmaceutical is a disruptive Japanese retailer with an ‘Every Day Low Pricing’ strategy that can self-fund its rapid store opening programme through cash float from negative working capital. Risk-reward is currently very favourable, with recent share price weakness due to market short-termism as investors reacted to weak same-store sales figures compared to an elevated base for comparison last year. This has brought the share price to a low valuation in a historic context and improved prospective returns, underpinned by high single-digit top line growth and profitability recovering back to ~20% return on capital as stores mature.

The corporate name is somewhat misleading, as ~60% of revenues are generated from food. Its rapid organic store rollout has enabled Cosmos to dominate its local market (50% market share in Kyushu) and take share in new markets (Kansai, Kanto, Chubu) through a ‘limited catchment area model’. Best-in-class cost control means the group can exist with gross margins the competition could not tolerate (20% vs peers 30%) while generating in-line operating margins (~4%). By turning over assets quickly (2x asset turn) Cosmos produces industry-leading return on capital despite the low gross margin model. Stores are twice as big as drug store competitors but cost the same to build (¥300bn capex) meaning drug stores cannot compete with the breadth of offering, while supermarkets can’t match the purchasing power and overhead control so can’t compete on price (Cosmos is ~20% lower). This saves the consumer both time and money on very high frequency purchases that would otherwise be made elsewhere.

Performance

The Fund returned +5.8% in November. In comparison, the MSCI ACWI index returned +4.9% and the MSCI ACWI Value +4.2% (all in GBP).1

Baker Hughes (+17% in GBP) was the Fund’s strongest contributor. Following a positive reaction to its Q3 results in October, last month it benefited from the belief that the Trump administration will be more favourable towards oil & gas production activity in the US. Arcosa (+17%) re-rated along with other domestically exposed US cyclicals. Its Q3 results at the end of December demonstrated stronger than expected margin performance. McKesson (+27%) and Waters (+20%) both delivered very strong quarterly updates, which led to earnings upgrades.

Eiken Chemical (-8%) released a weak Q2 update, which led to earnings downgrades. Based on our meeting with the company, the primary challenge was delayed orders for its colon cancer screening tests. Eiken has subsequently received orders which cover almost all the missing revenue. Meanwhile, activist Dalton Investments has raised its stake in the company to over 22%. JEOL (-9%) had no stock specific news, but companies exposed to semiconductor capex were generally weaker owing to the expectation of tighter controls around exports to Chinese customers. Owning no Tesla shares cost -0.3% in relative performance.

 

[1] Fund: B share class (GBP), midday to midday pricing. Benchmark: close-of-business to close-of-business pricing.

 

KEY RISKS

The value of investments and any income generated may go down as well as up in response to general market conditions and the performance of the assets held, and is not guaranteed. An investor may not get back the amount originally invested.

Past performance is not a reliable guide to future results.

Changes in exchange rates may have an adverse effect on the value, price or income of investments.

There is no guarantee that the Fund will meet its stated objectives.

The movements of exchange rates may lead to further changes in the value of investments and the income from them.

There is a risk that any company providing services such as safe keeping of assets or acting as counterparty to derivatives may become insolvent, which may cause losses to the Fund.

 

For professional investors only.

Capital at risk.

 

For more information about the fund and how the fund is positioned, please visit our fund centre below: