Fishing in uncrowded pools to find hidden quality
It seems apt that as post-Brexit trade talks between the UK and EU supposedly hang in the balance over the niche but highly emotive topic of fishing rights, I should explain how we seek to fish for our investments in less crowded waters to generate long-term value for clients.
The investment environment across asset classes, and certainly within equities, over the last couple of years has been accurately described by a leading strategist as dominated by “T-zero investing”*. By this, he means that decision-making often appears to have been driven by what is happening at just that moment – be it a tweet or any other announcement or news release – rather than by ‘zooming out’ to take the longer-term perspective, looking back to the past to gain perspective as well as casting into the future. This T-zero world has brought some challenges for investors who, like us, believe that the greatest pricing inefficiencies are often found where the perception of a company’s fundamentals and prospects today are markedly different from how they have been viewed in the past and may be viewed in the future.
Let me explain a little more. One of the key deficiencies of human nature of which we seek to repeatedly take advantage is ‘recency bias’, which shows itself in over-extrapolation of the most recent pieces of information. Stocks which are viewed as ‘dish of the day’ today can very quickly find themselves off the menu if the ‘trend’ underpinning investors’ willingness to pay higher prices turns out to have been either a fad or at the peak of a cycle. In the last decade or so, I can think off the top of my head of West African iron ore miners, shale gas and Research in Motion (RIM, later Blackberry), as three examples of this but there are clearly many more.
Instead, within the ES R&M UK Dynamic Equity Fund, I’m trying to find potential holdings where the quality of the business – typically its competitive advantages or the irreplaceable nature of its asset base – is not obvious to the average investor today, meaning it isn’t the most popular dish on the menu today, but can become so in the future. In our experience, some reasons that franchise quality is temporarily hidden from the mainstream are typically (but not limited to) because the company:
- has cyclical earnings and its end markets are at a low point in that cycle;
- is investing (or has recently invested) significant costs to grow a future revenue stream, obscuring attractive margins at maturity;
- has experienced a hiatus in growth as some parts of the business reach maturity so grow more slowly, while faster-growing parts have not yet reached 'critical mass';
- has experienced operational issues, which may be the result of production bottlenecks or integrating an acquisition;
- is perceived to face competitive (e.g. a new entrant) or regulatory threats;
- has a small market cap, so is off the radar of some investors, or may be considered riskier.
Evidently, during our analysis we need to assess whether these issues are structural (more permanent); but where we consider these conditions to be temporary in nature, or their risk to be overstated, we will often also find a low valuation which puts the probabilities of better outcomes – i.e. that growth re-accelerates, or margins improve, or investors start looking at smaller companies again – in our favour. Note that these opportunities exist across the company life cycle (Growth, Quality, Recovery and Asset-backed).
“Stocks which are viewed as ‘dish of the day’ today can very quickly find themselves off the menu if the ‘trend’ underpinning investors’ willingness to pay higher prices turns out to have been either a fad or at the peak of a cycle.”
A good example in the portfolio is Tyman, an engineered window and door components manufacturer selling most notably into the US residential market. Cyclical end markets and some operational issues had conspired to hide the true quality of a franchise that was still making a 17% return on capital in 2019, despite not firing on all cylinders. Layering on the fact its market cap was below £500 million, we were able to buy shares near enough 5x the free cash flow that they had proven they could deliver and with consensus forecasts which implied a significant slowdown in the housing markets, in contrast to the trends the company was experiencing.
Opportunities today for investors who are prepared to fish in less crowded pools are as rich as they have been in a long time. There are few less crowded waters in financial markets than UK equities today, but in contrast to our fishermen and women we welcome international investors to come and fish in our sea!
*T+ is broadly explained as a dealing terminology used to denote the time at which a purchase or sale will take place in relation to the day in which the trade is done. For example, a trade placed on a Monday where the transaction is concluded on a Wednesday will be T+2.
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ES R&M UK Dynamic Equity Fund
This fund’s unconstrained approach enables investors to have targeted exposure to, what we believe to be, the strongest opportunities in the UK market.
At present, it represents an opportunity to buy into one of the best value stock markets in the developed world. The fund benefits from a manager who has an excellent performance history and works within the proven framework of the Potential, Valuation and Timing (PVT).
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