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/Blackberry) as three examples of this but there are clearly many more.
Instead 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 mainstream 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-overstated, we will often 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 lifecycle (Growth, Quality, Recovery and Asset-backed).
A good example in the portfolio is Meitec, a market leader in the Japanese market for outsourced R&D engineers. Technical outsourcing is structurally increasing in a tight employment market with ageing demographics and limited immigration, and Meitec deliver research engineers for complex development problems of a quality that allows them to charge a 40% premium compared to competitors. Cyclical end markets have hidden the true quality of a franchise that delivered more than 40% return on capital in 2019 (once excess cash equivalent to 35% of the market cap is considered). Layering on the fact its market cap was ~$1 billion and only covered by 1 broker, we were able to buy shares on 7x the free cash flow the company expects to earn in the medium term.
Opportunities for investors today who are prepared to fish in less crowded pools are as rich as they have been in a long time. Indeed, there are fewer less crowded waters in financial markets than UK equities today, but in contrast to our fishermen and women we welcome global investors to come and fish in our sea!