Letting our portfolio companies do the hard work
This note is inspired by having had the pleasure of reading Nick Sleep’s Nomad Investment Partnership investor letters over the Christmas period.
This note is inspired by having had the pleasure of reading Nick Sleep’s Nomad Investment Partnership investor letters over the Christmas period. As one of this millennium’s genuine visionaries within the investment industry, with his deep understanding of areas of competitive advantage such as network effects, they are naturally enormously insightful and well worth reading, should you get the opportunity.
One thing that struck a chord was his closing letter, where he thanked the management teams of the portfolio companies, including through a separate letter to Warren Buffett at Berkshire Hathaway, for doing the hard work of compounding the Nomad Partnership’s clients’ capital.
“It appears to all the world that the performance that Nomad has enjoyed over the years was created by Zak and me. That is not the case. As time goes by, the performance that our clients have received is the capitalisation of the success of the firms in which we have invested. In other words, the real work is done by you and the good people of Berkshire.”
It’s a thoughtful reflection on the benefits of finding advantaged business franchises with excellent capital allocators in the management hot seats. This is where we really get to see the compounding effect of high reinvestment rates in businesses with attractive incremental return on investment characteristics due to attractive economics and barriers to new entrants.
When I look at the ES R&M UK Dynamic Equity portfolio today, I’m reminded of this sentiment with two holdings, in particular. What’s interesting about both is that they began as turnarounds under the current management teams, so they neatly encapsulate the concept of the company lifecycle with a corporate re-generation from the Recovery phase back to the compounding Quality phase in which they now find themselves.1
Electrocomponents, spearheaded by CEO Lindsley Ruth, is a high service global industrials and electronics distributor. Under his tenure, operating margins have increased from near historic lows sub-10% to above 13% in 2019. More importantly, margin accretion has not been achieved at the expense of re-investment. Investment in a well-developed online service offering (>60% sales), in particular, is very difficult for smaller players to replicate and has led to strong market share gains, particularly during COVID-19 lockdown periods. Suppliers are consolidating into quality distributors with an online presence, so these gains are likely to prove sticky. We also assess that they have a group culture and strategy, supported by clear targets and KPIs, that are shaped by corporate responsibility, which marks it out as a sustainable leader in its field. This culture of excellence can be seen in the addition of Amazon, which at one time was the ‘bear case’, becoming one of Electrocomponents’ fastest growing accounts, lured by the value-added services and technical support that it cannot supply itself. The exciting next leg of growth is likely to be through M&A in the US, where prior organic investment in distribution centres can be leveraged through bolt-on deals adding volume through their network at high incremental return.
I first acquired shares in defence company Chemring in Q2 2018, excited by the Recovery opportunity for return on capital that could be exploited by a CFO, Andrew Lewis, who I knew well from his previous role at former R&M UK Smaller Companies fund holding Avon Rubber. The need for focus on operational efficiency, including rationalisation of the manufacturing footprint and working capital, played right into his specialisms that we had already benefitted from at Avon. Joined since by CEO Michael Ord, re-investment of cash gains into manufacturing automation has simultaneously improved safety and driven efficiency gains within the historic core operations. The investment case has transitioned from a financially vulnerable, short-cycle business, exposed to the ups and downs of conflict budgets to one exposed to higher quality long- term contracts, supported by a strong balance sheet. Both their US sensors business and Roke, the cyber security division, offer the prospect of high margin, low capital employed revenue growth over the medium-to-long- term based on unique Intellectual Property.
Last year, more than ever, we were constantly reminded of the ingenuity and adaptability of the highly capable management teams in charge of our portfolio companies. So, I thank them for all their hard work in 2020 and look forward to many more years of them doing the hard work in sustainably compounding our own clients’ capital.
1 - We consider stocks for inclusion in the portfolio based on four categories of 'potential', as outlined below:
Growth - the delivery of strong revenue and profits growth
Quality - a business franchise that delivers a superior return on investment
Recovery - the process whereby a company produces a recovery in profits to 'normal' levels, following a decline
Asset-backed - the delivery of asset-backed growth to a long-term investor.
This information has been prepared and issued by River and Mercantile Asset Management LLP (trading as “River and Mercantile” and “River and Mercantile Asset Management”). River and Mercantile Asset Management LLP is authorised and regulated by the Financial Conduct Authority (Firm Reference Number 453087).
The value of investments and any income generated may go down as well as up 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.
Please note that individual securities named in this article may be held by the Portfolio Manager or persons closely associated with them and/or other members of the Investment Team personally for their own accounts. The interests of clients are protected by operation of a conflicts of interest policy and associated systems and controls which prevent personal dealing in situations which would lead to any detriment to a client.
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.