The Capital Intensity Conundrum

April Outlook

Paul Marshall, founder of the eponymous hedge fund Marshall Wace, wrote that “markets misprice change.” We agree. Our company lifecycle approach to analysing value creation and mispricings looks to benefit from this on both sides of the ledger – sometimes the stock market prices too little change for companies where profitability is struggling (‘Recovery’), sometimes too much change for companies doing well (‘Growth’ and ‘Quality’).

The period between doing well and a recovery, if it indeed comes, is typically a painful one for shareholders. The signs are usually obvious, in hindsight, because they often include a subtle change over time in an important metric, such as the capital intensity required to deliver growth, which can signify a deteriorating competitive position. This is relevant today to the dynamics in the Software sector, where the capex-to-sales ratio has more than doubled from 5% in 2015 to 11% expected in 2024.

For the many investors who have pinned their stylistic colours to the mast of investing in ‘capital light’ business models and remain heavily invested in the Software sector, this is surely a conundrum. For those of us who believe in a ‘capital cycle’ approach (aligned to our lifecycle framework), the conclusions are clear. Higher investment in capital across an industry often leads to lower returns on that capital in future.

We continue to investigate potential investments for the fund across a diverse opportunity set: flavour and fragrance ingredients, life sciences tools, chemicals, exchanges, utilities, semiconductors, and a handful of ideas in Brazil all feature among our current work-in-progress. The breadth of ideas speaks to our ongoing opportunity to offer investors a well-balanced, attractively valued portfolio compared to highly concentrated, momentum-driven benchmark indices.

 

Market Overview 

Global equity markets suffered a reversal in April (MSCI ACWI -3.3% total return in USD) following the exceptionally strong returns in the first quarter. While there was little style dispersion between MSCI ACWI Growth (-3.6%) compared to MSCI ACWI Value (-3.0%), large cap and the momentum factor both gave up their relative leadership (MSCI ACWI Equal Weighted -1.4% and MSCI ACWI Momentum -3.9%). Financial markets have once again started to price inflation remaining elevated and fewer interest rate cuts. The US 10-year bond yield rose from 4.3% to 4.7% and real yields from 1.8% to 2.3%. Lead indicators, such as PMIs, continue to point to a strengthening demand picture within the global economy, adding fuel to the ‘higher for longer’ rates narrative.

 

Strategy Update

Performance

The fund returned -0.1% in April. In comparison, the MSCI ACWI index returned -2.4% (all in GBP). Since inception, the fund has returned +27.4%, compared to the global benchmark’s +23.2%.¹

Anglo American (+35% in GBP) was the largest positive contributor. It received an unsolicited bid from its larger diversified mining peer, BHP Billiton, which was subsequently rejected by the Board as materially undervaluing the business. The bid is complex because of Anglo’s structure, including a full demerger of the listed entities Kumba and Amplats, but what is clear is that its copper assets are considered particularly strategically attractive (to a wider range of potential bidders than just BHP). The arrival of the activist Elliot in the top 10 Anglo American shareholders is likely to act as a catalyst in a realisation of the sum of its parts one way or another. Mondi (+12%) rose as industry pricing has started to increase, driving forecast upgrades, and it showed good discipline in stepping away from a competitive bidding process with US-listed International Paper for DS Smith.

There were no material detractors from performance.

 

Activity

We added no new positions during April.

We exited the remaining holding in Valmont Industries. This was a disappointing investment, but we lost conviction around management’s approach to capital allocation and earnings quality has also deteriorated.

In short, there are too many unknowns in the investment case and we have built greater conviction in other holdings, such as Arcosa and Hitachi, which offer similar end market exposures.

¹Inception: 7 July 2022. Fund: F share class (GBP), midday to midday pricing. Benchmark: close-of-business to close-of-business pricing.

 

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