The best companies seek long-term sustainability, says Blake Hutchins of Investec – and have often had over a century of success.
A quick scan of the larger holdings in the St. James's Place Worldwide Income fund, which is looked after by Investec Asset Management, reveals a common theme: vintage.
Among the 20 largest holdings in the portfolio, 16 of the companies go back more than 100 years, although in that time some have spun off from a long-standing parent company. Ten of the holdings can be traced to the nineteenth century; among them Reckitt Benckiser, Japan Tobacco and Johnson & Johnson1. Does Investec have a weakness for antique enterprises?
“The greater average age of these companies is an output not an input,” says Blake Hutchins, co-manager of the fund. “We like companies that have an ability to sustain exceptional economics – high returns on capital, profitability, great cash generation. Moreover, when it comes to going through the books, we look quite far back. We definitely go back 10 to 15 years, because you want to be sure to capture an economic cycle – the last recession needs to be in there.”
Hutchins highlights how profitable such companies are capable of becoming.
“The portfolio’s holdings generate returns on capital of 20%, which implies that, were they to retain all of their profits, those profits would double over a four-year period – which is double the market’s own rate,” he says. “We are wary of companies that rely on very high levels of capital expenditure as part of their core business model, because it sucks out cash flow.”
Indeed, while dividend yield remains a key focus, Hutchins is even more interested in finding companies that are able to grow their cash flow.
“We like some of the consumer staples, especially tobacco, IT and software companies,” he says. “IT and software companies are more prevalent in the fund now than they were 10 years ago, because they have reached a stage of maturity in which they are cash-generative as well as positioned for growth. Take Microsoft. We bought it at a cash flow yield of 10% but today it’s 5–6%, as the market has come round to our view.”
As for tobacco companies, they remain a long-standing favourite, due to the unique structure of the industry, which is highly consolidated and regulated, meaning it is almost inconceivable that any new entrants could meaningfully challenge the existing majors. Although there are major headwinds for the industry in the UK and Australia, emerging markets continue to offer significant opportunities – perhaps more surprisingly, so does the US.
“The US is the best tobacco market in the world, because affordability is favourable – volumes were actually positive last year,” says Hutchins. “Globally, however, volumes are falling. BAT’s acquisition of Reynolds earlier this year was a good move, but there is more consolidation to come. That makes it a very rational industry.”
If cash flow dynamics attract Hutchins to the tobacco majors, they have the opposite effect when it comes to the energy sector. He avoids both BP and Shell, put off by their “commoditised economics” (or sensitivity to the oil price) and by the fact that dividends are not covered by cash flow.
“The front-loading of capital expenditure is why we don’t like energy so much,” says Hutchins. “They sell a commodity and their asset base is depleting by 5% per year, whilst the cost of exploration just continues to go up. BP, Shell and Exxon have much higher production costs that some of the state players, which puts pressure on cash flows and therefore the dividend. Shell hasn’t covered its dividend in 10 years. It lacks financial flexibility compared to, say, Reckitt Benckiser.”
Old and new
Despite the longevity of many of the companies in the portfolio, Hutchins is highly sensitive to the disruptive power of technology – and its risk to companies that fail to adapt.
“Companies are more vulnerable to technology than ever and the speed at which companies can grow is undoubtedly faster than at any point in history,” he says. “Legacy companies, whether they are airlines, retailers or utilities, are all open to disruption. We have no retailers in the fund – technology is terrifying for them. We don’t like fashion risks and we don’t like their fixed costs, especially store leases. Debenhams has 15-year leases on its stores.”
What the fund does hold is technology companies, among them Microsoft and Visa. A less mainstream tech holding is Amadeus, which is worth around 3% of the fund. Amadeus sits between airlines and travel agents, and is paid according to the number of transactions rather the value of those transactions, which makes it less sensitive to downturns than the airlines.
“It’s the only truly global provider of this service, so airlines don’t really have anywhere else to go,” says Hutchins. “It also works with hotels and is now transforming the infrastructure and booking systems for InterContinental. Once that’s done, all the other hotels will want the same.”
1 Investec, 30 June 2017
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The opinions expressed are those of Blake Hutchins of Investec and are subject to change at any time due to changes in market or economic conditions. This material is not intended to be relied upon as a forecast, research, or investment advice, and is not a recommendation, offer or solicitation to buy or sell any securities or to adopt any strategy. The views are not necessarily shared by other investment managers or St. James's Place Wealth Management.