The investment environment remains challenging and uncertain as we enter the new year.
Global growth appears to be weakening; trade tensions continue between the US and China; political risk is increasing in both developed and emerging markets; debt levels remain elevated across government, corporate and household sectors; and monetary conditions are tightening in the short term as central banks shift to more hawkish policies.
These challenges have manifested themselves in increased volatility in equity, commodity and currency markets, falling US Treasury yields and widening credit spreads. At the company level, as seen in particular by Apple’s recent revenue warning, forecasts in many cases are being revised downwards.
The prospects for 2019, therefore, remain uncertain for global equity market investors. However, we believe the active quality approach we follow in the Investec Global Franchise Fund, tends to provide better downside protection than the market, while still delivering strong through-cycle performance, in both absolute and relative terms.
Our ‘Quality’ approach aims to provide low volatility returns by investing in attractively priced, high quality global businesses. We aim to find businesses with strong and consistent track records with embedded identifiable strategies, low levels of leverage, strong management teams and good governance structures. These are companies that have clear and trusted brands, are income-orientated and have high free cashflows, which we believe are able to compound shareholder wealth through many market cycles.
In times of uncertainty, the quality attributes we seek do not change. Rather, they provide the necessary ingredients for our companies to continue to compound shareholder wealth.
- Hard-to-replicate, enduring competitive advantages
High quality companies have enduring competitive advantages, typically in the form of intangible assets such as brands, patents, licenses and networks, that create barriers to entry that protect them from competitive threats. As a result, these companies have been able to establish dominant positions in their industries and deliver persistent growth in intrinsic value, even through periods of economic and market weakness.
One such example is Visa, the global payments technology company. Visa and Mastercard (its closest competitor) have dominated payment processing for decades. Last year alone, Visa’s vast network processed 124 billion transactions globally, enabling the company to grow its net operating revenues by 12%, generate $12bn of free cash flow, and return over $9bn back to investors through share buybacks and dividends. As a result, Visa delivered total returns to shareholders of 16.5% in 2018, outperforming the MSCI ACWI by more than 25%.
- Low sensitivity to the economic and market cycle
Another key attribute of quality companies is resilience in times of economic and market stress. Defensive characteristics, resilient cash flow generation and low cyclicality have enabled quality companies to survive multiple economic cycles with their market position and competitive economics intact. This has enabled them to deliver returns to shareholders that have been not only stronger than the market, but also relatively defensive and uncorrelated.
Nestlé and Unilever are examples of high-quality defensive companies. Both have large portfolios of dominant brands, generate recurring revenues from repeat purchases of everyday low-ticket items, are globally diversified, and are well positioned in attractive categories, markets and channels. As well as compounding shareholder wealth over the long term, both stocks also demonstrated their defensive qualities in the short term, significantly outperforming the market through Q4 2018 when the MSCI ACWI fell by 13%.
- Healthy balance sheets and low capital intensity
A strong financial model is critical to successfully navigate more challenging economic and market conditions. Low financial leverage and low capital expenditure requirements provide valuable operational flexibility for high-quality companies in times of market weakness. In contrast, highly leveraged low-quality companies could see further stress put on their balance sheets should rates continue to rise and cash flows weaken.
Since inception, the portfolio constituents in the Investec Global Franchise Fund have demonstrated consistently lower debt levels than the wider market. As at 31 December 2018, net debt/EBITDA for the Global Franchise portfolio was 0.27x, more than six times lower than the corresponding figure for the MSCI ACWI of 1.71x.
- Strong cashflow generation and disciplined capital allocation
The generation and strategic allocation of cash is a vital determinant of the sustainability of a company’s long-term growth. Top line revenue growth is not enough if this does not feed through to cashflow, which in turn needs to be allocated responsibly and efficiently and in alignment with the interests of shareholders and other key stakeholders. We are therefore wary of companies where future cashflows are uncertain yet high multiples are pricing in significant long-term growth. Shares in such companies can be very volatile, particularly at times of investor nervousness, as we saw with certain technology stocks in the second half of 2018.
An example of the type of technology stock we do own is Microsoft. Its transformation has been primarily organic through highly effective capital allocation. It has now become a dominant player in cloud computing with significant long-term structural growth prospects and generates free cashflow in excess of $30bn annually, and has net cash on the balance sheet of around $50bn. Effective capital allocation and a highly cash generative business and financial model have enabled Microsoft not only to deliver very strong performance over time, but also to demonstrate greater resilience than the wider market and technology sector through last year’s volatility.
- In search of future resilience and structural growth
As well as providing resilience in current volatile markets, quality companies are also ‘future-proofing’ their businesses by continually investing in Research & Development (R&D). This investment helps drive product innovation and improves brand awareness and loyalty. In so doing, it not only contributes to self-funded future growth, but also strengthens barriers to entry and protects companies from disruption and competitive threats. In aggregate, companies in the Investec Global Franchise portfolio spend roughly 3.5 times more on R&D as a percentage of sales than the wider market, and still generate far higher levels of profitability.
As companies evolve to deal with disruptive technological forces and structural changes to the industries in which they operate, we have also evolved the Investec Global Franchise portfolio while staying true to our quality approach.
Finally, it is important to maintain valuation discipline by investing in quality companies at reasonable prices, not quality at any price, particularly in volatile and uncertain markets such as these. Valuations must be properly assessed in context, whether that context be the quality one is paying for, longer term history, the wider market or other asset classes.
As the outlook ahead remains uncertain with the potential for more market volatility, we maintain conviction in our investment approach. We continue to position our portfolio for resilience and structural growth by focusing on attractively valued quality companies with relatively low sensitivity to the economic and market cycle.
For more information about investing offshore, click here.